OECD flags enduring obstacles to illiquid investment

A recent report by the OECD’s Pensions Unit, Strengthening Asset Backed Pension Systems in a Post COVID World, argues that pension funds in the 38-member country organization can invest to support the post-pandemic economic recovery in a way that also provides long term returns for beneficiaries.

Pension funds in OECD countries are already seasoned and diversified investors and their scale and long-term horizon allows them to consider illiquid investments. They should increasingly invest in less liquid assets like infrastructure and SME financing to boost economic recovery, it argues.

For example, surveys on the impact of COVID-19 on SMEs shows that more than half of SMEs faced severe losses in revenues. Pension providers could complement banks to help SMEs cope with these urgent liquidity needs, but pension providers’ engagement in SME financing remains limited.

Obstacles

However, obstacles impede greater involvement by pension providers in supporting economies by investing in illiquid assets. These include a lack of investment opportunities, regulatory barriers, and limited investor capability to handle complex investments, raising fears of the risk of poor investment decisions in illiquid assets. Investing in these assets may also cause investors to deviate from their strategic asset allocation to seize investment opportunities, say the report authors.

Other challenges are also blocking pension funds’ ability to invest in illiquid assets. For example, members of defined contribution pension arrangements can switch providers. This means individual savers are freely able to switch investments, reducing pension providers’ appetite for illiquid investments, particularly those without a readily ascertainable market value, such as infrastructure.

Beneficiaries can also choose from a range of investment options with varying risk profiles, and transfer between the different options available within certain limits. This means that pension providers may be exposed to significant outflows, reducing the expected duration and investment horizon of their investment strategy. Pension providers may hold more liquid and short-term assets to accommodate for unexpected outflows, reducing the amount they can invest in long-term assets.

Another limit on the ability of pension funds to invest in illiquid assets includes the fact investments may require specific skills and expertise that some pension providers may lack. Several risks are typically more relevant for alternative investments alongside illiquidity like integrity risk, operational risk, limited transparency, valuation weaknesses, control issues, counterparty risk and conflicts of interest, lists the report. Finally, measures taken by governments to grant contribution holidays and help members access their savings during the COVID crisis may reduce room for investment in illiquid assets.

The ability to give employees and employers short-term relief may create liquidity constraints and reduce pension providers’ capacity to invest in illiquid assets, continues the report. Pension providers need to hold cash and liquid assets in their portfolios to address liquidity demands from regular benefit payments and exceptional withdrawals. They also count on contribution inflows to manage liquidity needs. However, certain countries have allowed employers and/or employees to defer or even stop contributions to asset-backed pension arrangements to provide them with short-term financial relief.

In addition, members who have lost their jobs or experienced a reduction in working hours can more easily access their savings early to weather financial hardship in several countries. Not only may this force pension providers to act pro-cyclically by selling assets in falling markets and materialise losses, but it also increases liquidity demands. These measures jeopardise the capacity of pension providers to invest in long-term, illiquid assets, such as infrastructure, as they need to keep a larger share of the portfolio in liquid assets. These measures may also create a precedent for future withdrawals, so that pension providers might not trust that assets will be locked away for the long-term going forward, further reducing their appetite for long-term investment.

The report urges policy makers to carefully consider the effect that policies granting early access to retirement savings accounts have on investment policies. Not only do such policies pose adequacy concerns, but they also limit pension providers’ capacities to invest in long-term, illiquid assets. Pension providers need to hold more cash and liquid assets to face potential withdrawal requests. This leaves less room for other illiquid investments that could support businesses and boost the economy.

Encouraging illiquid investment requires safeguards and appropriate investment structures, write the report authors. Strong governance and well-defined investment and risk-management strategies are necessary to prioritise the interest of members when engaging in new investment opportunities. Policy makers can also facilitate the mobilisation of private capital to long-term investment through public-private partnerships, financial incentives, or special vehicles for alternative assets.