Abstract
AbstractDefined benefit pension funds invest in illiquid asset classes for return, diversification or liability hedging reasons. So far, little is known about factors influencing how much they invest in illiquid assets. We conjecture that liquidity and capital requirements are pivotal in this decision. Short-term pension payments and margining on derivative contracts generate liquidity requirements, while regulations impose capital requirements. Consistent with our model we empirically find that these requirements create a hump-shaped impact of liability duration on the fraction of risky assets invested in illiquid assets. Further, we report that pension fund size, type, and funding ratio impact illiquid assets allocations.
Highlights
Pension funds are important investors in illiquid asset classes such as real estate, mortgages, private equity, hedge funds, and infrastructure
A pension fund that is ten times larger in terms of assets under management (AUM) has a 7.4 percentage points higher fraction of risky assets allocated to illiquid assets
Panel B provides the summary statistics of the variables specified in Section 3: allocation to illiquid assets, allocation to risky assets, fraction of risky assets allocated to illiquid assets, liability duration (DV), collateral requirements on interest rate derivatives (CRr), collateral requirements on currency derivatives (CRfx), bond hedge ratio, fraction of investments outside euro area, log of total AUM (Size), required funding ratio (Rfr), and one period lag of the actual funding ratio (Fr)
Summary
Pension funds are important investors in illiquid asset classes such as real estate, mortgages, private equity, hedge funds, and infrastructure. A pension fund with a high liability duration is less liquidity constrained as it will have to pay less pensions in the short-term This allows for a higher allocation to illiquid assets. A high liability duration implies more exposure to interest rate risk through the present value of its liabilities This restricts the opportunity to invest in illiquid assets as more of the available capital is required for interest rate risk. A pension fund that is ten times larger in terms of AUM has a 7.4 percentage points higher fraction of risky assets allocated to illiquid assets.
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