In a quest to reduce exposure to reinvestment risk are pension funds jumping out of the frying pan and into the fire by taking on more illiquidity risk, or is there a balance to be struck?
For many pension funds 2013 was a relatively good year. Developed market equities rallied (the S&P500 was up nearly 30%), credit spreads tightened and even real yields showed some improvements, albeit marginally so.
Those funds positioned to benefit from this would have seen their funding ratio rise, and for some, rise faster than anticipated by their flight plan. Those fortunate enough to find themselves in this position will likely be contemplating how to “bank” these gains and take a little risk off the table.
De-risking can take many forms but it will typically involve moving out of more volatile, less predictable and higher returning assets (such as equities and hedge funds) into more stable and predictable sources of returns, such as credit.
However, as pension funds systematically reduce their exposure to risks such as equity, interest rates and/or inflation (i.e. those that can be measured using a Value-at-Risk model) other risks that may require additional lenses to quantify and monitor, start to become increasingly significant.
Some may even come to dominate a pension fund’s overall risk profile.
Reinvestment Risk
A pension fund’s longer dated liabilities cannot be perfectly matched with allocations to liquid credit, such as corporate bonds, as these are typically much shorter dated. Pension funds will therefore be exposed to a significant amount of reinvestment risk, especially as they increase their allocation to credit through time.
Reinvestment risk is the risk that when it comes time to reinvest the coupons and/or principal payments, credit spreads may have tightened to such a degree that a pension fund might have to seek riskier/higher yielding investments to meet their required return, and maintain the flight plan.

To counteract this risk many pension funds are increasingly making allocations to longer dated, and more illiquid credit, such as commercial real estate (CRE) debt, secured long leases and infrastructure debt.
The main benefits of these asset classes are typically: longer maturity profiles, an illiquidity premium and low correlation to traditional asset classes.
Thus a pension fund is able to lock into higher/ more attractive spreads for longer, which can help mitigate their exposure to reinvestment risk. But at what cost?
Illiquidity Risk
As a rule of thumb, the longer dated the asset the more difficult it will be to sell at short notice for fair value (i.e. the more illiquid it becomes).
In addition, increasing the allocation to illiquid assets, at the expense or more liquid assets, reduces the overall liquidity of a fund’s portfolio.
This could have a negative impact on a pension fund’s ability to make benefit payments and/or collateral payments (on any out-of-the-money derivative positions), in the event of a crisis.
The Balancing Act
There is no one-size-fits-all solution for determining the appropriate balance between illiquidity and reinvestment risk.
But the important thing to note is that there is a balance to be struck. Clearly no pension fund should be 100% allocated in illiquid assets, nor 100% blind to the risk reinvestment poses to their chances of meeting their long term funding objectives.
Pension funds considering what the appropriate balance might be can develop bespoke tests aimed at determining an appropriate “Illiquidity Budget”. This could consist of a maximum allocation to illiquid assets dictated by the fund’s short/medium term collateral requirements, medium/long term cash requirements to pay member benefits and long term desired asset allocation.
Integrating the Illiquidity Budget into the day-to- day decision making of the fund will ensure that a pension fund always maintains an appropriate balance between these two risks.

Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer.