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 liquidity funds. However, as pension schemes mature, they need more cash for pension payments. Most corporate UK 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 regulation mean many pension schemes will likely need higher cash levels within their LDI portfolios for collateral purposes. On balance, cash will become more important 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 a 3-month money market note is a cash instrument and a 10-year corporate bond is not, there is no hard rule. There is only a sliding scale of reduced liquidity and increased return (and hence risk).
Another important point is even within comparable cash vehicles (same liquidity/risk profile), there can be wide return dispersions. We analysed 19 comparable institutional sterling liquidity funds over a 5yr period and found the highest net return to be 0.71% p.a. and the lowest, 0.36%. In fact, £100m would have grown by £3.6m over the 5yr period in the higher-yielding fund, but only by £1.1m in the other. Pension schemes can take advantage of the sliding liquidity/ return scale by matching it with their own sliding scale of liquidity requirements. You require some immediate cash to cover ongoing expenses and potential collateral needs, some in the medium term to cover pension payments, and longer-term 'strategic cash' to cover unforeseen changes. This sliding scale of cash requirements can be matched with a so-called 'liquidity Making a splash with your cash waterfall', with cash divided into tranches of assets with increasing illiquidity.
At the bottom is pure cash, next is a tranche of liquid money market instruments and at the top is a tranche of more exotic short-dated instruments. As cash is taken out at the bottom, the less-liquid assets trickle down the waterfall.
The yields within such a waterfall could range from negative, up towards 3% at the top. The overall yield depends on the cash requirements of each scheme and the particular liability profile and/or LDI portfolio. Efficient cash management requires detailed and ongoing analysis of a scheme’s liquidity requirements. Going forward, such analysis will be worthwhile for many pension schemes to enhance return on an increasingly vital part of a portfolio, while ensuring smooth operations.