Too long the unloved asset
Most individuals know how much cash they have and why they keep it. Curiously, institutional investors have a more difficult relationship with money. Cash is often neglected, or regarded as an inferior investment, if an “investment” at all. More recently, however, many pension funds have started to reconsider their position towards cash. There are two main reasons for this:
q Inefficiency. It is often felt that cash management of pension plans is not up to the standards of good corporate treasury operations;
q Market volatility. Cash is trash in the bull market but many institutional investors were burnt in recent years. When stock and bond prices move down together, cash is king.
Keynes, in his ‘general theory’, gave three motives for holding cash: transaction, precaution and speculation. These motives are quite intuitive to households. You use cash for day-to-day transactions; you put some money aside to be able to cope with unexpected events; and you keep liquid reserves to exploit upcoming investment opportunities. Money hoarding also reflects trust, or the lack of it: in times of high uncertainty, liquidity preference prevails. Some
folks even keep money under the mattress.
What about pension funds? Why should they hold cash? Nobody would dispute the need for some cash as liquidity. However, opinions are rather split about cash as an investment, whether tactical or strategic.
What do the statistics say? Pension plan allocations to cash are on average 5% or below in most countries. Also, fluctuations in weightings seem to be mostly the result of market movements rather than conscious decisions. However, such statistics need to be interpreted very carefully. Cash it is often just a residual. Also, the distinction between cash and (short-term) bonds is blurred. In any case, it is difficult to separate between cash held for liquidity or investment purposes.
Cash has typically been the stepchild among asset classes in pensions investment. This is surprising, given that in standard portfolio theory, cash is literally the starting point as the riskless asset. Why?
q Long-term returns. Statistics show lower returns for cash against equities and bonds. Also, real rates of returns of cash are very small, if positive at all, in the long run;
q Benchmark risk. Investment benchmarks often include little or no cash element. Holding cash then carries heavy relative risk;
q Mismatch. Pension plan liabilities are typically longer term while the duration of cash is close to zero. This implies continuous re-investment risk – cash is not riskless!
q Inflation risk. Pension liabilities are often inflation-linked. Although there is some co-movement of inflation and central bank rates over the cycles, there is no direct link of
cash rates to inflation as in inflation-protection bonds.
In a nutshell, there is a view that cash is not a suitable strategic asset class for pension funds at all. This seems extreme. Some arguments speak in favour of including, or at least explicitly considering, cash in strategic asset allocation, whether it is driven by asset-liability-models or liability-based benchmarks:
q Capital preservation. This good old virtue, often forgotten, is a major advantage over most other asset classes. It is only a nominal protection, but that is fine in a deflationary environment – as in the case of Japan;
q Diversification. The money market is hardly correlated with other markets – cash is a good diversifier in portfolios;
q Liability matching. Cash has a role to play even here. Retirement benefits are being paid in cash. Mature pension schemes have particularly high nearer-term cash flows;
q Defined contribution plans. The safest option is often popular with many investors. The strategic role of cash becomes apparent in life cycle models for individuals where weightings rise towards 100% close to retirement age.
Even in case of a nil strategic allocation, cash is an extremely important instrument in pension portfolio management. Apart from the obvious transaction needs, it is used in areas such as:
q Bonds. Money market instruments are essential tools for duration management in bond portfolios;
q Tactical asset allocation. Speculative cash positions for TAA and currency overlay strategies;
q Derivatives. The need of collateral for futures and derivatives, eg, in currency hedging;
q Alternative investments. Cash is a primary investment tool, eg, for hedge funds with shorting strategies;
q Absolute return. Money market rates are the key reference point for absolute return strategies.
Cash as investment covers a lot of different things. The main categories are bank deposits, securitised money market instruments (eg, TBs, CDs, CPs, FRNs, repos), short maturity bonds, and money market funds. Money markets have developed a lot in recent years, particularly in Europe. The actual portfolio mix depends on the specific investment purpose and the changing market conditions.
A strategic allocation to cash is better invested on a well-diversified basis in a specialist money market fund than in a single bank deposit. After all, banks can go bust. Enhanced cash portfolio strategies can provide extra yield. However, the inherent duration, credit or liquidity risks need to be properly managed and communicated.
An often overlooked aspect of cash management is foreign currency. One person’s safe haven is another person’s currency risk. Most pension plans have their liabilities clearly expressed in one single currency but this may become less clear-cut in future. On the asset side, external fund managers often live on a different planet, eg, the dollar world.
Cost is another important factor when looking at cash investments. In a low interest rate environment in particular, management and transaction fees can have a strong impact on the net return.
The transaction aspect of cash management by pension plans may look less exciting then the investment side, but it is still very important. Pension plan cash flows – whether regular or one off – may look relatively simple, but they are not trivial. It is worth distinguishing between ‘operational’ and ‘investment’ accounts.
Operational accounts deal with cash flows relating to the pension benefits and administration, in particular contributions from employers and employees, payment of retirement and other benefits, transfers, administrative costs, fees to advisers, delegates and services. Investment accounts provide liquidity for the purchase of assets and receive inflows from interest income, dividends, security sales, tax reclaims, etc.
Who manages cash accounts? Sometimes nobody, it seems. Operational cash management is often treated as a routine administrative exercise. This can be both risky and costly. Risky, because there are frequently strict legal requirements, eg, deadlines for contributions or pension payments. Costly, because ineffective cash flow management means loss of interest to the pension fund.
It is therefore advisable to set clear responsibilities for the management of cash accounts. It is important to get the incentives right for delegates. To name a few:
q Outsourced administration. The ‘stick’ normally prevails (eg, penalties for errors and delays);
q Investment managers. Weak cash management still seems to be widespread although performance-related fees could be a good carrot;
q Custodians. Benchmarking their cash and currency management performance is still a challenge for pension funds.
A final important question is: Where is the money? The pension plan’s operational bank account is often with the sponsor’s house bank. How safe are such arrangements? Furthermore, does anybody consolidate the cash and currency held in the various accounts and funds?
As a matter of good governance, pension plan directors are advised to have thorough controls and regular reviews in place. They will cover critical parameters such as the credit rating of the (custodian) banks used, the quality of reporting and service received, and the people involved. More often than not, there is room for improvement in this area. As Bagehot says, “money will not manage itself”.
Georg Inderst is an independent consultant based in London, firstname.lastname@example.org