Pension scheme liquidity: are you prepared if the tap gets turned off again?
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While the immediate storm has passed, it is worth considering how prepared you are for a future liquidity crunch and whether there are ways that your scheme could manage its cash more efficiently. With a new liquidity principle on the way as part of the revised defined benefit (DB) funding framework, and significant content on liquidity governance expected in the Pensions Regulator’s (TPR) forthcoming Single DB Code, it’s clearly a good time to consider whether a loan or similar arrangement might be useful for your scheme.
Autumn 2022 liquidity crisis – what stopped the flow?
Many pension schemes use liability-driven investment (LDI) – a strategy of investing in funds that seek returns matching the amounts schemes are going to have to pay out, rather than seeking the greatest possible return. Often these investments are leveraged; the LDI funds borrow money to obtain investment returns on a larger pool of assets. Importantly, the amount of borrowing is set at a certain level, for example two times the amount of the fund’s assets.
At a high level, the problem in autumn last year was that the market volatility following the mini budget caused the value of assets in leveraged LDI funds to drop. To keep the ratio of borrowing in line with their requirements, the funds made a cash call on pension schemes. This left schemes scrabbling for liquid assets to retain their LDI fund positions.
The Bank of England stepped in to prop up the market and regulators reacted with a range of statements and guidance. TPR set an expectation that pension schemes would review their liquidity positions, including considering whether a loan arrangement could help.
Loan arrangements – the lifelines
During the market turmoil, we helped a number of our clients to put agreements in place rapidly to ensure they had enough cash to hand to pay fund managers’ calls and members’ pensions. These lifelines took various forms, with funds coming from banks, employers and through existing asset-backed contribution arrangements (arrangements set up to make payments to a scheme derived from an underlying asset owned by the employer) and in a range of structures to suit our clients’ situations and needs. The common theme was flexibility and ease of access: unlike many other forms of funding, loans can be made available to a pension scheme on short notice, and can be repaid without penalty when no longer required.
Are pension schemes allowed to borrow?
There are restrictions on pension schemes borrowing money but borrowing is permitted for the purpose of providing liquidity for a scheme on a temporary basis. Schemes need to be careful to ensure they meet regulatory conditions and consider tax restrictions, as well as staying within their own rules. We can advise on how to structure loan arrangements to help fit within these constraints.
Would a loan arrangement be a good idea for your scheme?
While the immediate pressure has now lifted, this is not the first time we have seen a liquidity crunch, and may well not be the last. TPR is clear that schemes should be reviewing their liquidity provisions and considering what lessons can be taken from the events of last year, and this expectation is reflected in the upcoming DB funding framework and Code.
There are of course many ways that schemes can manage their liquidity, including keeping sufficient liquid assets on hand to cover the perceived risk. But holding cash is inefficient and can be a drag on returns, so we are seeing clients considering loan arrangements that would allow them to draw cash quickly if this was needed in future. Where a loan facility is provided by a bank or other commercial lender, there is an up-front cost of putting the facility in place and an ongoing commitment fee to ensure its availability, but these costs may be worthwhile compared to the alternatives. Loan facilities can be structured in various ways, but if an employer is supportive then it may be feasible to adapt the form of the employer’s own loan facilities as the basis for a pension scheme loan, which (among other benefits) cuts down on the negotiation and cost of implementation.
If you are considering whether a loan or similar arrangement might be useful for your scheme and would like to discuss how we could help you, please do get in touch with any of the A&O team listed at the start of this article.