Chipping away at cash
Understandably, pension funds concentrate much of their attention on appointing fund managers and monitoring their performance. This is our equivalent of the investment manager buying, selling or holding investments. Yet at least one commentator claims that 80% of the difference in pension funds’ performance can be explained by the strategy adopted (not manager choice) and the remaining 20% by cost control. As we all know, sadly, strategy can have a negative as well as positive effect but cost control is generally only positive. Adding a basis point or two here and there assists in the long-term performance tables. Such cost-control contributions can be gained from a whole range of measures such as transaction analysis, commission recapture and monitoring foreign exchange and custodial efficiency. More recently pension funds have been focusing on the role of cash management, not least at the Railways Pension Scheme (RPS).
The RPS is complex. With the privatisation of British Rail it has moved from a single-employer to an industry scheme of 100 independent sections. To aid efficiency the investments are held in six pooled funds (or internal unit trusts). There were two ‘pots of cash’ in the scheme. The first is that held by the investment managers, to which I will return later. The second was cash held centrally in the scheme. In the main this comprised cash destined for property investment or from private equity realisations awaiting appropriate re-investment opportunities But it also included pension payments and contributions for the month. Over the past few years central cash has typically been in the range of £100m–£150m (about 1%).
The primary purpose of holding this cash centrally was security; following the well-known epithet that it is the return of the cash rather than the return on the cash that is important. Nevertheless, we have been measuring all our treasury managers’ performance over the last decade and the in-house team has consistently outperformed investment managers at lower cost.
Although internal cash management was seen as a success we still identified it as a subject for Railpen’s regular review process which is feature of the way we work. After some pretty basic thinking, using approaches adopted in a business process re-engineering exercise elsewhere in the company, we decided that this apparent success was distracting us from a more fundamental point. Instead of optimising returns on cash we should be minimising the level of cash.
WM figures show that over the past 10 years holding 1% cash instead of equities reduced total performance by about 6 basis points. Now, while the next 10 years may well be very different from the last, there is no reason to believe that cash will outperform equities in the long term. Accordingly, we set about reducing the central cash. We set an initial £10m cash target that would eventually reduce to near zero. This reduction was achieved by placing an equity derivative overlay on the private equity cash. Property index certificates were considered as a way of gaining similar market exposure for the property cash but we felt the market was not yet liquid enough and so we cross invested it in our bond and equity portfolios to replicate property performance characteristics. Cash-flow was tightened by introducing a financial modelling package to assist in estimating the actions of our 100 employers.
However, reducing total cash held would affect treasury management as it would result in either a reduced number of counterparties which would increase risk or reduced loan sizes which might reduce returns. Furthermore, as our cash management costs were essentially fixed, the cash reduction would result in our management costs being higher than those of external management. For both reasons we decided to place the remaining cash with a market cash fund. After a search we chose a fund managed by one of our existing investment managers. This new arrangement now runs smoothly. Instead of arranging a number of loans we just have to decide whether to deposit or withdraw from the fund.
Thus the first step of the cash review has been completed and we are now turning our attention to the much larger sums held by the investment managers (the industry average is 3%). Where managers chose to hold cash for strategic reasons we will be looking for market cash fund returns and security either from their own fund or by sweeping to an independent fund. However, where the cash is only frictional or opportunistic we will be seeking to gain an appropriate derivative overlay. Investment managers who are less than keen on this extra complexity will be reminded that, on the WM figures, 3% cash represents a 16bp annual loss to the customer – in this case my railway pensioners.
Malcolm Gray is finance director at the Railways Pension Scheme in London