The Pensions Regulator (TPR) has urged trustees to improve their understanding of the liquidity risks their schemes are exposed to, and to monitor and mitigate those risks.

In a blog, TPR executive director of regulatory policy, analysis and advice, David Fairs, acknowledged that illiquid investments can offer trustees the opportunity to capture an illiquidity premium, improve the overall risk and reward trade-off, and improve member outcomes.

However, he warned that the extent to which trustees invest in illiquid assets should be determined by their scheme characteristics, including investment, risk management, governance and funding arrangements, as well as consideration of the holding structure for those investments and the degree of investor protection embedded.

TPR wants trustees to get a better understanding of the cashflow and liquidity dynamics of their scheme, and how those dynamics might develop in the future or change due to market stress.

“We also want trustees to better understand the impact that margin calls might have on those dynamics and how ‘mark to market/mark to model’ impacts might reflect on the values of assets realisable in times of market stress,” he added.

TPR is therefore expecting more robust liquidity risk analysis to be carried out to allow for severe stress testing for simultaneous market shifts, the extent and composition of derivatives exposure to margin calls, and alternative assumptions that could apply in times of market stress and the impact they might have of the assets’ ability to be liquidated.

Fairs also referenced TPR’s recent code of practice consultation, noting concern from the industry around the proposed expectation for governing bodies to ensure that no more than a fifth of scheme investments are held in assets not traded on regulated markets, unless there are exceptional circumstances.

He acknowledged that there was a “range” of investments that may not be admitted to trading on regulated markets but could be suitable for pension scheme investments.

“However, we have observed a few smaller schemes where the trustees have sought to exploit the underlying principles of the OPS (Investment) Regulations 2005 and have invested significantly (up to 49 per cent) in unregulated investments,” Fairs wrote.

“In issuing our code for consultation, we believed it would be helpful to set out an appropriate maximum allocation for any scheme other than in exceptional circumstances. However, we do not want this expectation to limit the ability of trustees to invest in assets which may be illiquid and which may offer the opportunity of improved scheme outcomes, once they have taken appropriate advice and understand their scheme’s liquidity risks. 

“We acknowledge that some concerns have already been raised, particularly around the level of the limit and we are considering what adjustments might be appropriate. We welcome views on the draft expectation that we have set.”

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