Liquidity planning means having the right amount of cash readily available to make future payments. If an investor does not have enough cash then they may need to sell illiquid or volatile assets at a loss. If they have too much cash then they risk missing out on the returns available on other assets.
Institutional investors use liquidity waterfalls to ensure they always have enough, but not too much cash available. In this post I will explain how institutions like pension funds construct these, and then give a real life example.
Mapping out future payments
The first step is to fully map out all the institution’s potential cash requirements. These may include:
- Payments to pension fund members/insurance policyholders/charity beneficiaries etc.
- Cash that assets may require themselves (private asset cash calls, derivatives etc.)
- Other expenses of running the fund – advisor fees etc.
The institution will also need to account for money that it is receiving, for example payments from the institution’s sponsor or income from bonds and other assets.
(For more on what causes liquidity needs see the last post.)
Assigning pots to the liquidly waterfall
Pot 1: cash
The institution will then assign assets to different pots. The first pot in the liquidity waterfall is the most liquid. This pot contains assets that can be accessed in a day or less – usually cash and money market funds.
To decide how much to hold in this pot, the institution will assess which of its obligations will require cash very quickly and estimate the size of these payments.
For a DB pension fund, payments that fall into this category include:
- the next month’s payments to members,
- member requests to transfer out of the pension fund,
- payments to fund private assets that have been called for and collateral payments for LDI and other derivatives.
The institution will need to understand what these requirements will be when it is business-as-usual, and what they could be if cash requirements are much higher than normal.
This is especially true for the derivatives. The institution will need to estimate the impact of rapid and large changes in financial markets and make sure there is enough cash put aside to meet the collateral calls that would follow. This is at the same time as being able to make the usual payments to pensioners etc.
The various cash inflows and outflows into the first pot of the liquidity waterfall can be very complicated to manage. This may be done by the institution’s administrator or a specialist treasury team, or it could be partly delegated to the asset manager, as is the usually the case with the passing of collateral for LDI assets.
Pot 2
The institution will need to top up the first pot from time to time. This is the job of the second pot of the liquidity waterfall. Taken together, the first two pots should cover all the medium-term cash requirement of the institution, perhaps 6 months to a year’s worth of payments. Assets in the second pot still need to be very liquid and should not be very volatile. This is to reduce the risk of being forced to sell them after a market dip.
However, as institutions will probably have some notice that they need to access the second pot, it can be invested in assets that take a little longer than cash to realise – perhaps 2 to 3 days. This means that it can contain assets with more return potential than cash.
One possible asset is short-term (1–3-year term) corporate bonds, issued by highly rated companies. These are usually very liquid and are much less volatile than, say, equities, but offer a higher interest rate than cash.
Pot 3
The institution will hold more volatile asset like equities and high yield bonds in the third pot. These assets are very liquid most of the time, however their volatility makes them unsuitable for the second pot. The institution might expect to use these assets to top up the second pot a couple of times a year.
Illiquid assets like real estate, infrastructure, private equity and private debt will not be part of the liquidity waterfall, and the institution will only sell these assets as a last resort.
Money will also be passed back up the waterfall if too much has accumulated in a lower pot (for example if payments into the institution are higher than expected).
A real life liquidity waterfall is shown in the diagram below.
Time horizon based investing
Individuals don’t need to worry about collateralising derivates or the pros and cons of holding very illiquid assets like infrastructure. However, they may still need to think about liquidity.
If their income falls or their outgoings increase, they may need to spend some of their savings to make up the difference. If this is the case, it will be helpful to have some money in liquid and stable assets like cash that can be accessed quickly. They may also have some illiquid assets. Their home, if they own it, is an obvious example.
Time horizon-based investing is a close relative of liquidity waterfalls and can be applied to individuals’ financial circumstances. I’ll explain more in the next post.
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