AXA IM: Investing under the Wtp requires greater flexibility and liquidity

May 23, 2025

^{This article was originally written in Dutch. This is an English translation.}

With the introduction of lifecycle investing under the new pension system, pension funds will experience more time pressure in the investment process. Pension funds can prepare for this by constructing a smart portfolio and implementing a sound ‘liquidity waterfall’.

By Martin Sanders

As Dutch society ages, more and more pension funds are experiencing negative cash flows: they receive less in contributions than they spend on benefits. The transition from the FTK to the Wtp is accelerating this process, because part of the buffers will now also be paid out. Another change is that under the new pension system, more will be invested in illiquid asset classes due to the expected higher returns. Compared to the current situation, this means that there will be fewer liquid investments in the portfolio. Finally, under the new pension system, the portfolio will be rebalanced much more frequently, probably on a monthly basis. This requires a smart construction of the strategic portfolio. The simplest solution is to maintain a structural cash position, for example in money market funds, to ensure that there is always sufficient liquidity available to pay pensions and meet other short-term obligations. In order to maintain the strategic asset mix in line with the risk profiles of the various cohorts, a liquid proxy category can be maintained at the top level alongside each illiquid category. For example, alongside private equity, listed equity and alongside private debt, high yield (see Figure 1).

Figure 1: Example of a strategic asset mix

Figure 2: Mandates and instruments

By linking liquid and illiquid categories, it is easier to rebalance when necessary, for example at month-end, or when the strategic minimum or maximum is approached or exceeded. The liquid assets can also serve as a source for commitments that are yet to be called. A fund that wants to maintain a strategic position in the new pension system in, for example, private debt, can immediately bring this allocation up to the required level by first investing in high-yield bonds and gradually drawing on these as each commitment is called. The same applies to investment-grade credits and mortgages, as well as listed equities and private equity investments. A fund that wants to reduce an illiquid category – which can take years – can temporarily compensate for this by underweighting liquid proxy assets. In this way, the desired risk profile of the participants in each cohort can be achieved in a relatively simple manner.

Operational liquidity management

In addition to the strategic view of a portfolio's liquidity, there is also an operational side to liquidity management. This is particularly evident in the management of the protection portfolio, but also in the use of derivatives and cash management. To begin with the latter, under the FTK, pension funds rarely include a strategic allocation to money market funds. Liquid assets are often a result of investments, ‘friction cash’. However, in recent years, more and more cash has crept into the LDI portfolio with the advent of ‘cleared’ interest rate swaps. This cash is often held in short-term, triple A money market funds with ESTR as the benchmark. The challenge is to achieve, after costs, the six-month Euribor interest rate used in swap contracts. With the ESTR interest rate recently (and normally) below this benchmark due to the ECB's interest rate cuts, this is proving difficult.

For this reason, a number of market participants have exchanged part of their money market funds for an allocation to short-duration euro bonds. These offer a yield above Euribor. A disadvantage is that these bonds are not available overnight to deposit cash collateral, but they can be used in bilateral swap contracts to meet the variation margin.

Other liquid instruments that can be used in an LDI or CDI portfolio, in addition to traditional government bonds, are investment grade credits for an extra spread, bund futures and bond ETFs. These instruments trade in different markets with different actors and are traded continuously in large volumes. When using bund futures, collateral cash must also be available. This is not the case with ETFs, but they cannot be used as collateral in the same way as government bonds.

Finally, pension funds are advised to have repo contracts available so that they can quickly obtain cash against bond collateral in the event of extreme market conditions. However, there must still be sufficient government bonds in the portfolio to be able to use them. If a fund only uses cleared swap contracts and no longer has government bonds as collateral, a repo contract is not possible, which limits its liquidity. This increases the risk that the swap contract will be terminated and the interest rate hedge will be lost in extreme market conditions. It is also possible to keep a bank loan in reserve. Make sure that this is a committed credit facility, otherwise it will not be possible to call on the bank in times of need. This is a relatively expensive form of liquidity.

De-risking before and after the transition phase

With a view to the transition to the new pension system, it is important to maintain flexibility and thus liquidity. Work on the liquidity of the strategic asset allocation can already be done in the preparatory phase. A lot of time will need to be set aside for changes to the strategic mix, even after the transition. The combination of liquid and illiquid proxies maintains the desired risk profile while the transition gradually takes shape. The LDI portfolio can also be adjusted to a more liquid composition for the transition. This will help to quickly bring the interest rate hedge into line with the desired positioning shortly before or after the transition.

Figure 3: Overview of the transition period