With an ever-increasing population of pensioners, longer life expectancies and a trend across Europe for pension schemes to be funded, there will be more assets invested – good news all round! However, along with this infusion of investment, pension fund managers will come under increasing pressure to produce the best possible returns while ensuring their liabilities are met. The cry to “keep those returns high, but minimise risk” will become ever more forceful.
Along with all the securities investments we currently see and are used by pension funds – equities, bonds, property, and doubtless numerous new instruments which become vogue, cash will still play an important role.
There has been an increasing demand for, and continuing emphasis on, appropriate risk management for pension funds throughout the last 10 years. Top-tier global custodians have been playing an important role in support of this trend by not only offering detailed online investment accounting information, but also by supplying comprehensive risk management programmes (including performance measurement) combined with compliance monitoring and policy monitoring. In addition, some are able to offer a wide range of value-added products and services, such as securities lending, foreign exchange and cash management, to enhance the returns of the fund and maximise the investments at all times.
Over the last few years, the management of short-term cash has developed significantly. Contractual settlement of cash associated with securities trades and the ability to report on cash positions intra-day have greatly assisted investment managers with efficient trading. Understandably there are different types of requirements for which pension funds need cash, which in turn govern the short-term investment options. Not only do global custodians achieve synergy in providing effective short-term cash management alternatives as a complement to custody services for both their clients and themselves, they can also offer the intellectual capital necessary to structure appropriate short-term alternatives and offer clients the most effective choice to meet their specific needs. Differing requirements are catered to through a variety of different short-term products, ranging from interest bearing accounts to custom cash funds. Let us take a look of some of these options.
Interest-bearing accounts offer custody clients the ability to earn interest on their residual cash balances in all their portfolios, whilst offering maximum flexibility to ensure the cash is available for immediate investment purposes by the investment managers at short notice. Interest-bearing accounts meet the needs of many global custody clients, and are offered in a number of currencies to match up with the majority of cross-border investments.
Equally, pension funds may require a known amount of cash at some specific point in time in the future. For these funds, both the certainty factor and the knowledge upfront on the return may combine to make placing the funds on a fixed term deposit through their custodian bank more attractive.
Alternatively, pension fund managers can choose to place their cash in an actively managed cash fund. This approach has appeared more frequently and these vehicles have grown enormously in number and size in recent years. As result, investment management firms have responded to their clients’ needs and can now offer stand alone, off-balance-sheet vehicles that are professionally invested and controlled by a specialist fund manager.
The overriding benefits to clients of these funds, as against interest bearing accounts or on balance sheets vehicle, are in the diversification of assets and the avoidance of balance sheet risk. Of course the balances to be invested must normally be greater and there may be less flexibility on the availability of funds.
In normal cases, an off-balance-sheet cash fund is comprised of a variety of instruments with differing maturity dates. The portfolio manager ensures that the fund has a certain percentage of cash available on a same day basis for client withdrawal. This percentage is usually in the 10% to 20% range, depending on overall size of the fund.
The less immediately liquid portion of the fund is fully invested across a variety of high quality instruments, all of different maturity dates and asset classes. A combination of maturities allows for the funds average life to increase from a pure overnight position (such as an interest bearing call account product) to a target weighted average life.
These funds are increasingly popular with a range of clients, all of whom have two specific requirements. Firstly, those clients who require a pure off-balance-sheet cash sweep vehicle, and those that have significant residual core balances in certain currencies that may be used for future but as yet unknown projects and purchases. Both types of clients reap the rewards of participating in such a pooled fund, as on one hand the liquidity client enjoys diversification and enhanced yields, whilst the core balance client has immediate same day usage of funds, as and when this is required.
Investment instruments range from fixed bank time deposits to floating rate notes. The instrument diversification allows the client to enjoy certain benefits such as protection from any major shocks to the underlying interest rate environment. The fund is still exposed to overnight volatility, as a certain percentage of the fund is always available for client withdrawals, and is only invested once the fund has closed. Most funds have a closing deadline of 1pm local currency time, which allows for same day processing.
Portfolio managers analyse economic and fundamental data together with technical research in order to assess central bank policy and the direction of interest rates. As the fund contains fixed and floating rate investments, the slope of a yield curve together with the level and slope of the appropriate forward curve must be understood and analysed on an ongoing basis. By using internal rate of return analysis, a fund manager can also assess the implied slope of short dated cash rates and pick value in the very short end of the cash curve.
The use of an offshore pooled cash fund can provide a number of benefits in a variety of ways:
q Moody’s AAA-rated vehicle;
q Off-balance sheet product, with no credit exposure to the provider;
q Pooling with others to gain benefits of scale;
q Reduced administration by amalgamating cash in one place;
q Daily cash sweep ability ;
q Same day movement of contributions and withdrawals;
q Actively managed interest rate exposure;
q Asset diversification - split between fixed and floating rate products.
Pension fund managers have an increasingly demanding set of challenges to deal with, most notably - at a high level – managing risk and enhancing returns. They need to be able to provide assurances on all these points to increasingly well informed groups of trustees, contributors and beneficiaries.
Ultimately the pension fund manager needs to feel comfortable that the options available offer them an appropriate range of choices, with the necessary flexibility and risk profile which can be “mixed and matched” to suit their overall strategy and both short and long term needs.
Lucille Knapp is responsible for European business development for global custody for Northern Trust in London