Cash

Cash is King

10-second Summary

In the future, pension schemes may have to hold more cash or liquid assets in their strategic asset allocation. The impact on return is a key consideration. With the right allocations, this can be done without unduly impacting return.

Context

UK pension schemes are facing a new world where cash is set to become an increasingly central component of asset portfolios. This will pose a performance challenge given the ambitious asset returns many schemes require to reach their funding objectives. It will also pose an operational challenge in terms of ensuring the right level of liquidity is available at the right point in time. This operational challenge is further exacerbated by recent regulatory changes that mean liquidity in markets is becoming scarcer and more expensive.

The increased cash requirements are broadly driven by what we define as the “pensions end game” playing out: schemes maturing and positioning themselves for de-risking and unwinding in a continuously changing market environment.

As schemes become increasingly cash flow negative over time, they will have to make more of their assets available for pensioner payments. The new pensions freedoms also mean there may be an increase in the number of scheme members that wish to cash out their pension pot and hence the need to hold cash.

Another source of higher cash requirements as part of the end game is the need to de-risk via leveraged LDI portfolios using derivatives backed by collateral.

Historically, pension schemes have been able to mainly post gilts for collateral purposes; however, the recent introduction of central clearing of swaps means that this ability has now been reduced and more cash will be required going forward.

New banking regulation has also had a negative impact on the availability of liquidity via bank deposits and “repoing” of gilts respectively.

So, at the same time as cash is becoming more important for pension schemes, it is also becoming harder and more expensive to access.

So what now/next steps

So how do you deal with the need to hold more cash while achieving the required asset return, and at the same time addressing the increasing obstacles to accessing cash cheaply and easily in the first place?

We think the overall solution is careful cash flow planning and detailed analysis, as well as the incorporation of cash flow management as an integral part of the overall scheme management and strategy.

For some pension schemes a first step may simply be to analyse their basic liquidity facilities, to ensure that these provide the highest possible return while adequately addressing the changing market conditions from a risk management perspective.

For other schemes it may be required to take things one step further and to set up a liquidity asset structure, a so-called liquidity ladder, that is specifically tailored to their requirements. Such a structure is more complex than a simple cash fund, but can yield significant benefits in terms of a higher return while closely managing risks and timing cash holdings to specific needs.

What is cash?

Cash is the most basic asset available for investment purposes, and yet at the same time perhaps also one of the most complex to define.

From a pension scheme perspective the main attraction of cash is its liquidity, as it provides neither outperformance, nor matching, of the liabilities. For that reason it is perhaps more useful to talk about “liquidity instruments” rather than cash, and to define such assets as a range of instruments with increasing levels of risk/return and reducing levels of liquidity.

The common feature of such liquidity instruments is that they are contractual in nature (generate a predictable return if held to maturity), and generally they will have relatively short maturities, usually no more than a year.

Below we have divided liquidity instruments into three broad categories: Operational Cash, Strategic Cash and Reserve Cash. We use these categories as the starting point for constructing liquidity ladders for our clients, which we will return to in the next section.

Operational cash

At the most liquid end cash instruments can be defined as “same day cash” (settlement is “T+0”), which can be accessed immediately and is therefore suitable for ongoing operational needs, such as daily collateral requirements of derivatives.

Such operational cash can either be held directly in bank accounts or, preferably, in very low-risk liquidity funds investing in overnight bank deposits (essentially diversified bank accounts).

Recent changes to regulation have made it more unattractive for banks to offer large cash deposit facilities for corporations. This means the overnight cash market has become squeezed, with more limited supply of suitable deposits. Going forward we therefore think liquidity fund performance will become more differentiated based on manager skill and networking capability in terms of gaining access to limited investment opportunities.

Reserve cash

“Reserve cash” can be viewed as a back-up buffer for Operational Cash: Not quite same day cash, but still very liquid. We group government-issued debt under this category, which for UK schemes will mean gilts.

Gilts are the one exception to the short-dated criteria for liquid assets: Even very long-dated gilts can be counted towards a liquidity portfolio. This is due to the fact that gilts can be turned into temporary cash via lending arrangements known as “repos”, meaning they can generate liquidity without being sold. The ability to turn gilts into cash via repos has become more important now that cash is increasingly the only collateral accepted for derivatives. However, the cost of doing so has unfortunately increased, as new regulation means banks pay a higher capital cost for accepting gilt collateral on repo arrangements.

Strategic cash

At the very upper end of what can be characterized as “liquidity assets” you find short-dated credit instruments such as asset-backed securities and shorter-dated corporate debt. These assets can have up to a week’s delay in investors being able to get hold of them.

Such assets are suitable to hold for longer-term strategic purposes; e.g. to cover future liquidity needs that cannot currently be foreseen (or are not well-defined).

We generally recommend to access liquidity assets at this more “racy” end of the spectrum via pooled fund structures, which will ensure a high level of diversification in the underlying exposures. It will also mean delegating monitoring and risk management to a specialist and highly skilled stakeholder (asset manager).

In summary there is a broad range of liquid assets available for pension schemes in financial markets with varying degrees of actual liquidity and hence risk/return characteristics. Going forward we think it will become essential for many (if not most) UK pension schemes to set up bespoke liquidity ladders using these instruments to manage their cash requirements efficiently and safely.

Fact box

How to pick the right operational liquidity fund?

Our recent review of the UK daily liquidity fund market with “T+0” settlement terms revealed significant differences in how funds are risk managed and how they perform.

High fees eat performance

From a performance perspective we concluded that fee levels are a key driver of investor outcome, given the relatively low gross returns expected from this asset class. Whereas our review revealed fee levels at as much as 20bps per annum, we would normally not recommend our clients to pay anymore than 10bps for a basic liquidity fund. Otherwise fees eat too much into the net outcome, or alternatively the manager is incentivised to take on too much risk to compensate for the fees.

Funds should generate performance without undue liquidity mismatch

We also noted that some managers appeared to be relatively reliant on instruments with longer settlement periods than the one offered by the liquidity fund itself to generate performance. While such less liquid instruments are reasonable to hold in smaller allocations, we would not want them to constitute a key driver of performance as this could lead to liquidity mismatch issues. A good liquidity manager should be able to generate a yield pick-up with a minimal allocation to such instruments.

Relationship management is key

Finally we noted that regulatory understanding and relationship management with banks are becoming increasingly important for successful liquidity fund managers. Managers are now competing to access a scarce resource in terms of suitable bank deposits to invest in, as banks are pulling out of this market due to new regulation making it less attractive for them.
Therefore liquidity managers’ scale in the market (and hence their importance to banks as counterparties and customers), as well as their ability to build long-term strategic relationships with the banks, have become a key differentiator.

How can a liquidity ladder help you?

For pension schemes with significant ongoing liquidity requirements we recommend putting in place a so-called “liquidity ladder”. This is a portfolio that is set up to closely match a pension scheme’s specific liquidity needs, whether for the purpose of LDI collateral requirements or pensioner payments.

The key idea of the liquidity ladder is that it consists of different “rungs” of liquidity assets with increasing levels of risk/return, and hence reducing levels of liquidity, as you move up through the ladder.

At the bottom of the ladder you will have Operational Cash (same day), above that you will have Reserve Cash (gilts), and at the top of the ladder you will have Strategic Cash (short-dated credit instruments and/or an absolute return bond style pooled fund). As you take out liquidity at the bottom of the ladder, the assets in the upper rungs will trickle down through the system to replenish the same-day cash holding.

The allocations to the individual asset types within the ladder, and hence the expected return of the overall liquidity portfolio, will depend on the specific circumstances of a given pension scheme and its liquidity requirements.

For LDI collateral purposes, as a starting point we recommend that a scheme holds at least enough same day cash to cover collateral requirements in a “1-in-20 event” over a 1-year time horizon. A “1-in-20 event” means that in any given year there would be a 5% probability that the pension scheme would need to post this much (or more) cash for collateral purposes due to rising interest rates and/or falling inflation. We think of this cash as a scheme’s “primary liquidity reserve”.

The remainder of the liquidity portfolio, the “Secondary Reserve”, can then be divided between gilts and credit-based instruments, depending on the specific position the scheme.
We have shown an example of such a portfolio, and the liquidity and expected return of each element, below.

Liquidity Assets held Allocation ER above libor
T+3 Strategic Cash Absolute Return Bonds 24%  2.92%
T+1 Operational Cash Gilts 40%  0.57%
T+0 Reserve Cash Cash 36%  -0.30%
0.83%

We estimate this liquidity ladder would generate an expected return of cash+87bps. Compared to a “cash only” return, this would lead to a cumulative extra gain of c. £4m over a five-year period for a £100m portfolio. The liquidity ladder shown is of course illustrative only, and any comparative advantages would depend on a pension scheme’s existing liquidity structure.
Overleaf we illustrate the impact introducing a liquidity ladder for LDI collateral purposes could have for a “typical” UK pension scheme.

For a scheme that is cash-flow negative, we propose to also build shorter-term expected pensioner payments directly into the liquidity structure. Longer-term pensioner payments can potentially be addressed via a “buy-and-hold” portfolio of credit instruments that are set up with coupons and notionals that match the pensioner payments.

Once a liquidity ladder portfolio has been set up, it is crucial to then closely monitor and review the underlying assets on an ongoing basis to manage the liquidity risk.

For any instruments with a credit component, we strongly recommend to undertake bottom-up fundamental analysis on an individual instrument level, rather than relying on broad, generic analysis such as credit ratings. Ideally this is delegated to a specialist fund manager via investing in a pooled
fund. This will also ensure a high level of diversification in the underlying exposures.

In summary using a liquidity ladder approach that is closely tailored to a pension scheme’s specific liquidity requirements can lead to a significant return pick-up compared to holding cash only. However, the approach requires in-depth analysis and ongoing monitoring in order to manage the liquidity risk appropriately.

We think that going forward many pension schemes will find themselves in need of such a tailored liquidity management approach.

Before/after example of Scheme

Below we show an example of the effect the introduction of a liquidity ladder could have for a “typical” UK Pension Scheme that has previously been backing its LDI swaps overlay with gilts, but has now been forced to hold more cash (7%) due to central clearing.
The Scheme is closed, 75% funded, hedged at the funding level and is de-risking towards an “end game” on a swaps basis.




Compared to a scheme that has previously mainly held gilts as collateral (with a 7% cash holding to address clearing requirements), the allocation effect of introducing a liquidity ladder is to reduce gilts while increasing outright cash at one end of the liquidity scale, and increasing credit-based short-term instruments at the other end.

The effect of this “barbelling” of the Scheme’s liquidity portfolio is three-fold:

  1. It increases immediate liquidity due to the higher outright cash holding.
  2. It increases asset return due to the higher allocation to credit-based assets.
  3. It reduces scheme risk due to a reduction in the gilt holdings (as holding gilts creates basis risk for a scheme with a swaps liability basis).

In short, the outcome is a pension scheme with better immediate liquidity, a higher return, and less risk.

This outcome is of course highly dependent on the specific circumstances of a given scheme, and if say a scheme is using a gilts basis rather than a swaps basis cash requirements (and hence the impact from introducing a liquidity ladder) would be quite different.

We also note that our example only addresses liquidity needs relating to LDI collateral requirements, and does not include any liquidity requirements arising from pensioner payments.

So what is the conclusion?

  • Thinking carefully about your liquidity needs and introducing a liquidity structure that is more closely aligned with these needs can yield real, meaningful benefits.
  • Such benefits can take the form of an improved risk/return profile of the pension scheme, which is more relevant than ever in a low-yield environment where every basis points counts.
  • It can also take the form of improved operations, ensuring that the right amount of cash is available at the right point in time for the right purpose.
  • The actual benefits achieved will of course depend on the specific profile and future liquidity requirements of your pension scheme.
  • However, we think that increasingly pension schemes of all shapes and sizes will find themselves in a position where they simply cannot afford to not address this area.
  • In fact we believe that schemes not addressing liquidity management heads-on will increasingly find themselves facing operational complications and inefficiencies, especially if they have significant levered LDI portfolios.