Cash: a necessary evil

Increasing maturity, reduced contributions and central clearing are all forcing cash to the top of the trustee’s agenda, says Pádraig Floyd.

Cash has only ever had one role within pension schemes in the UK – to pay pensions and settle any bills that become due.

Schemes hold the bare minimum – maybe 1% or 2% of the portfolio – but as they mature, they are finding the old system no longer balances the books and they are rapidly becoming cashflow negative.

This has worsened for schemes that are closed and lack new contributions, but all are increasing in maturity and new regulationswill require them to make allowances for holding even higher levels of cash.

The paltry returns on cash held on deposit combined with the need for liquidity, means that cash is fast becoming a headache for schemes they could well do without.

A NECESSARY EVIL

The historical view of cash hasn’t changed much, as it is is seen as “a necessary evil”, says Mette Hansen, vice president, investment consulting, Redington.

“Funds need cash to match liabilities and they want assets to outperform outperform liabilities, but cash doesn’t do that,” says Hansen.

With the limited governance bandwidth trustees have, little time is ‘wasted’ on cash and so it is held in bank accounts or a liquidity fund, but this won’t do in the future, says Hansen.

Schemes will find themselves holding cash strategically and permanently, so need to view it holistically, she says, as even a few basis points can make a considerable difference.

Mature schemes have to pay out more in pensions, but the pension freedoms mean they may also see an increase in transfer requests.

The type of sponsor will influence this, as will the strength of its covenant – the weaker it is and closer it is to the Pension Protection Fund (PPF) will encourage transfers, particularly among those with benefits above the compensation cap. And as schemes mature, they have an increasing need for collateral to service their liability driven investment (LDI) arrangements.

That requirement is going to increase considerable with the arrival of central clearing, not because you need more collateral, but of a different type.

“Historically, schemes have been very clever at managing LDI by holding gilts as collateral,” says Hansen. “It is extremely efficient, but central clearing means that gilts can only be held for the initial margin, not the variation margin, which must be cash.”

Like it or not, schemes will have to hold more cash, in an environment that is increasingly

hostile towards accommodating the requirement. Banks are less keen to accept bilateral agreements for holding cash or gilts, and they are insisting schemes use proprietary vehicles or services for managing cash or they won’t play ball.

UNDER PRESSURE

As the fund becomes cashflow negative and company contributions decrease, trustees need to get to grips with their income requirements. Not because they necessarily need income, but to avoid becoming a forced seller of assets.

Trouble is, many schemes are not really focused on their payouts as a percentage of their assets and yet they have a negative yield requirement, says Andy Green, chief investment officer at Hymans Robertson.

“If they need less than 2%, traditional rebalancing is the way to go, by selling the assets that have done well to deliver the cash flow,” says Green. “But if they now need 5% to 6% per annum or more, there are few assets that can guarantee to deliver that.”

What’s to be done? Well, there are a number of different possibilities, says Green. The first is use leveraged funds, LDI funds and synthetic equities and/or credit to free up capital by leveraging/hedging whatever costs you the least to keep a cash call of one to two years.

Take whatever income you can, which is easier in a segregated investment, but is still possible in a pooled fund, and you can even take a coupon on bond funds, though this is more difficult. A simple solution is to make use of DGFs which hold a spread of assets that’s not that dissimilar from your other assets and is a simple proxy solution that may offer a 3% or 4% return.