Longer horizons lead to more investment

The impact that length of investment horizon has on pension funds’ allocations to illiquid assets was the subject of a new study by Dutch researchers. The authors, Dirk Broeders, Kristy Jansen and Bas Werker, looked at the asset allocation of 220 Dutch defined benefit pension funds from 2012-16.

They took liability duration as a proxy for investment horizon and found that up to a period of 17.5 years, a longer liability duration positively affects the illiquid asset allocation; after that, the positive correlation starts to decline.

The researchers attribute this to the liquidity and capital constraints to which pension funds are exposed.

The liquidity constraints on a pension fund consist of two components: short-run pension payments and collateral requirements on interest rate and currency derivatives.

As for capital constraints, defined benefit pension funds need to have sufficient capital to manage factors such as interest-rate risk, market risk, currency risk and longevity risk.

A pension fund’s liability duration shows the weighted average time to maturity of its pension payments. Having fewer short-term liabilities, as a fund would with a longer liability duration, creates opportunities to invest in illiquid assets.

However, a longer liability duration is also associated with a quadratic increase in interest-rate risk, which limits the opportunity to invest in illiquid assets, due to a higher capital requirement.

A pension fund can hedge risk exposures to reduce the capital requirement but hedging strategies using derivatives involve collateral requirements, which impose a liquidity constraint.

The authors also found other pension fund characteristics that affect investment policy. For example, size positively affects the allocation to illiquid assets. Also, corporate pension funds tend to invest less in illiquid assets than industry-wide and professional-group pension funds do.

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