Do Pension Funds Know Their Cost of Liquidity?

The conventional wisdom suggests that pension funds have ample liquidity, and therefore can use it to harvest illiquidity premium – excess return due to low liquidity. But while measuring the available excess return by asset class is relatively easy, it is much harder to assess whether that excess return adequately compensates the fund for giving up liquidity. As it happens, the required compensation for giving up liquidity is sufficiently high to rethink asset allocation.
For some time now LINKS have been advocating a more structured and thorough approach to liquidity management at pension funds at the portfolio construction phase. Presently, liquidity is managed at best by holding a certain proportion of the portfolio in the most liquid government paper. Ontario Teachers’ Pension Plan (OTPP) describes the liquidity management with one sentence: “We manage the risk of not having sufficient cash on hand to meet current payments to plan members by holding at least 1.25% of the plan’s assets in unencumbered Canadian treasury bills”. At worst, liquidity management is left to treasury/accounting.
This attitude is not surprising, given the perceived ample liquidity that pension funds possess. Yet, with changes in banking regulation that make long duration assets more expensive, banks turn more and more to pension funds for liquidity provision. Moreover, most asset classes have sub-categories that are less liquid, but promise higher return, such as emerging and frontier markets in equities or high-yield or mortgage-backed securities in the fixed income universe. The question is: just how much excess liquidity does a pension fund have and how much should it be compensated for giving it up? In other words, what is a hurdle rate of liquidity?
To be clear, the answer to this question does not entail estimating the liquidity risk premiums for different asset classes. These estimates are broadly available for most assets however by themselves they do not answer the posed question. Is 1.5% liquidity risk premium of infrastructure investments sufficient to compensate pension funds for locking their cash?