By Mette Hansen
Nobody is excited to hold cash. Historically, pension schemes have tended to hold only the minimum required to pay pensions and administrative costs. There has therefore been little interest in how to manage cash beyond bank accounts and simple liquidity funds.
However, as pension schemes mature, they need more cash for pension payments. Most corporate UK pension schemes are now closed to new members and many to accruals as well. Hence, they will become increasingly cash flow negative over time.
Furthermore, recent changes in banking and market regulation mean that many pension schemes will likely need higher cash levels within their Liability Driven Investment (LDI) portfolios for collateral purposes.
On balance, this means cash will become a more important part of pension asset portfolios in the future as liquidity takes precedence. Cash is more complex than you might think, especially in institutional investment. It is most easily defined by its central feature: liquidity.
As the liquidity of a given cash instrument is reduced, the yield increases to compensate for this. When does cash stop being cash and become something else, you may ask? While most people can agree that a 3-month money market note is a cash instrument, while a 10-year corporate bond is not, there is no hard rule for classifying cash instruments. There is only a sliding scale of reduced liquidity and increased return (and hence risk).
Another important point is that even within comparable cash vehicles (same liquidity/risk profile), there can be a wide dispersion in returns. We analysed 19 comparable institutional sterling liquidity funds over a 5-year period and found the highest net return to be 0.71% p.a. and the lowest 0.36% p.a. That is a significant level of dispersion, which can make a real impact over time. In fact, £100m would have grown by £3.6m over the five-year period if invested in the higher-yielding fund, but only by £1.1m if invested in the lower-yielding fund.
We think pension schemes can take advantage of the sliding liquidity/return scale of cash by matching it with their own sliding scale of liquidity requirements. You will broadly require some cash available immediately to cover ongoing expenses and potential collateral needs, some available in the medium-term to cover medium-term (pension) payments, and some “strategic cash” available for the longer term to cover unforeseen changes.
This sliding scale of cash requirements can be matched with a so-called “liquidity waterfall”, which is a cash holding divided into tranches of assets with increasing illiquidity. At the bottom is “pure cash”, next is a tranche of liquid (government) money market instruments, and at the top is a tranche of more “exotic” short-dated instruments such as Asset Backed. As cash is taken out at the bottom, the less liquid assets higher up trickle down the waterfall.
The yields within such a liquidity waterfall could range from negative at the bottom, up towards 3.0% at the very top. The overall yield depends on the cash requirements of each pension scheme and their particular liability profile and/or LDI portfolio.
Efficient cash management therefore requires detailed and ongoing analysis of a pension scheme’s liquidity requirements. Going forward, we think that such analysis will be worthwhile (and even necessary) for many pension schemes to enhance the return on an increasingly important part of their asset portfolio, while ensuring smooth operations.
Mette Hansen is vice president, investment consulting at Redington
