Rising tide of cash
What are the reasons why pension funds might hold cash, and how do consultants suggest their pension fund clients manage these holdings?
“The starting point would be an ALM study, to find out if cash has a place in the strategic asset allocation,” says Peter Eerdmans, senior analyst at Watson Wyatt in London. “But hardly ever would we advise a strategic asset allocation to cash.” The exceptions would be where a pension fund needs cash for some particular liability, but this is very rare, he says.
Michael Robarts, associate in the investment practice at Hewitt Bacon & Woodrow, agrees it is very unusual for cash to take a position in the long-term benchmark of a pension fund. “The nil risk position for a pension fund is to invest in an asset class which mirrors the liabilities,” he says. The worst match for pension fund liabilities is cash, because it is completely exposed to inflation. A pension fund’s normal liabilities on the other hand are subject to inflation, because they are linked to salaries, which increase more or less in line with inflation.
Any cash in a client asset allocation would have much more of a technical nature, says Eerdmans. If a fund were changing between asset managers, there would be liquidity to be managed during that switch. Or if the fund manager, for example, had identified an attractive market, which they wanted to get into, cash would have to be available for a limited period of time.
Tactically, cash positions are currently slightly larger than would normally be the case. But the increase is marginal, say consultants.
Tom Murphy, head of Mercer Investment Consulting in Dublin says equities mandates do not appear to be holding more than 2 to 3% in cash at the moment. For balanced mandates, the level is perhaps 4 to 5% – two percentage points above its normal level. “But there certainly hasn’t been a seismic shift towards cash,” he says.
What consultants would advise clients to do with this cash position would depend how large the position was and how long it was expected to be there. One option, says Eerdmans, would be to let the asset manager deal with the cash and invest it at their discretion. Another is to allow the custodian to sweep the portfolio for cash and use one of their Dublin-based cash funds for the liquidity.
Alternatively, the client can keep the money on call overnight, he says. “Where the position is sizeable and available for longer, we would look to invest it better than call. If you invest it wisely, you can get a better return.”
Even with cash, risk is a major factor. “Even if it is just held overnight, you have exposure to the one bank who has the call money alone; but if it is in a Dublin-based fund, it is diversified.”
In the relatively rare cases where a client has a cash position which is expected to be held for at least a year, that client can pick an active cash manager, using Watson Wyatt’s research, says Eerdmans. Such a manager would need to achieve Libor or Libor plus 30 or 40 basis points, and would be judged in the same way as any other active manager.
However, there are some advantages to using a pooled fund for cash over a segregated fund. It should be cheaper to match in and outflows with the needs of other clients in the pooled fund, he says.
Robarts agrees diversification is important. If a pension fund is holding cash with a bank, it is basically an unsecured liability of that institution, he says. “If you are holding £20m (E31.4m) in cash, it is not brilliant to put it on deposit with one bank. So one thing we stress is that it is good to use a cash fund because it is diversified.”
In practice, cash, he says, tends to be held with custodians. This is the default option for most pension funds. However, there is a hidden risk here, which has only recently come to light.
The custody industry is dominated by US banks. But under US legislation, deposits held by US banks for foreign clients are subordinated to those held for domestic customers. “This is little known and certainly not disclosed – even the Bank of England did not know about it,” until recently, says Robarts.
This subordination results from an act passed in the US in 1993, he says. The Federal Deposit Insurance Corporation guarantees the first £100,000 of deposits made to banks by US citizens. If the FDIC is forced to pay out, as a domestic creditor, it ranks ahead of foreign creditors in pecking order.
Although, as Robarts points out, this is not a problem unless the bank goes bust, it does mean investors with deposits with US banks are running an additional risk which should be, but is not, rewarded with additional return.
“The more this little wrinkle is known about, the sooner the banks will be forced to do something about it.”