Pension Liquidity Risk

Research highlights:

• Little is known about liquidity risk in the global pension system, but the stress in the UK pension market in September and October 2022, triggered by a sudden spike in British interest rates, highlights the vulnerabilities inherent in pension funds’ interest rate hedging strategies.
• Using unique data on Dutch pension funds we show that interest rate hedging with swaps exposes pension funds to margin call risk that can be as large as 15% of a pension fund’s total assets, exceeding their cash holdings by several orders of magnitude.
• Our analysis uncovers three key findings: (i) pension funds with tighter regulatory constraints use swaps more aggressively; (ii) in response to rising interest rates, triggering margin calls, pension funds predominantly sell safe and short-term government bonds; (iii) we demonstrate that this procyclical selling adversely affects the prices of these bonds.
• Our findings challenge the conventional wisdom that pension funds, in their role as long-term investors, are immune to liquidity risk. This liquidity risk is the unintended consequence of the combination of capital requirements for defined benefit pension funds – aimed at making these funds safer - and collateral requirements of interest rate swaps.