Public Pensions Need Actuarial Analysis to Understand Their Capacity for Illiquid Assets

This article shows how actuarial factors influence the ability of public pension funds to invest in illiquid assets using a stress testing approach with asset/liability modeling. We find that one of the most critical characteristics influencing the ability to invest in illiquid assets is plan funding. The more quickly and aggressively a pension fund increases contributions in response to market downturns, the greater its capacity for investing in illiquid assets. We also analyze the impact of the liability maturity, such as the level of benefit payments, and find it to have a smaller, though still significant, impact. We further explore the interaction between funding and plan maturity, finding that the combination of weak funding and a mature liability causes the greatest challenges for liquidity. Then we explore how this analysis could be adapted for investor types such as corporate pension funds, endowments, and foundations. Without such actuarial analysis, many institutional investors cannot have a full understanding of how much illiquidity their portfolios can handle, and thus risk suboptimal portfolio construction.