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When Pensions Run Out of Cash

With CalPERS lowering its cash holdings, a research analyst warns that cash-poor pensions could trigger market swoon.

Pension funds are likely to follow the California Public Employees’ Retirement System’s recent move to lower its target for cash as investors desperately look to generate higher returns, a strategy that may ultimately set off a market swoon.

According to client research from global investment bank Canaccord Genuity, which was reviewed by Institutional Investor, pensions with small cash cushions may end the credit-led bull market once they aren’t able to meet margin calls, or demands for cash deposits made by brokers.

“These margin calls prompt the pensions to panic sell their holdings of credit investments and stocks, triggering a financial market disaster,” wrote Canaccord analyst Brian Reynolds in the research note.

Reynolds said most industry watchers focused on CalPERS’ decision last month to keep its equity allocation at 50 percent. But the bigger story, he said, was the pension fund’s move to lower cash and other liquid assets from 4 percent to a minimal 1 percent.

“The real significance of this change is that we believe other pensions will be making similar reductions to their cash holdings in the years to come,” he wrote.

[II Deep Dive: CalPERS Sticks With Equities]

Reynolds explained that because allocation decisions at pensions are largely determined by a small group of consultants, other funds will likely reduce the amount of cash they hold over the next two to three years. In the short term, the cash injection into the market may prolong the market’s run-up. But, ultimately, pensions will run up against margin calls, a situation that has always ended what he calls credit-led bull markets.

“The reduction in liquid assets will make it less likely that pensions can meet the margin calls that typically mark the end of a credit cycle,” the analyst wrote.

Canaccord’s research also highlighted the increasing risk of cash vehicles. During the financial crisis, investors found that money market funds were full of sub-prime investments, and regulators have since enacted rules on holdings for money market funds. But Reynolds said investors have moved about $300 billion out of money markets and into less regulated funds that offer higher yields by investing in mortgages, collateralized loan obligations, and other vehicles.

“When the credit cycle ends, investors are likely to be surprised once again to find that some of their cash is less liquid than they thought,” he wrote. In the short term, these cash funds are helping inflate the credit bubble.

Meanwhile, Reynolds said pensions’ inability to meet their margin calls may not come for another few years. “These margin calls that pensions cannot meet typically come two years after the yield curve inverts, so we still do not expect this to happen for another three to five years.”

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