As the cash requirements for pension schemes become more complex, we explore the benefits of bespoke optimisation strategies.
The cash needs of pension schemes are becoming more complex and varied, requiring sophisticated liquidity management. Several factors are driving this development.
As defined benefit (DB) schemes become increasingly mature, they are turning cashflow negative and need cash to meet benefit payments to current and future pensioners. The introduction of pension freedoms has also resulted in large lump-sum transfers out of many schemes, placing significant strains on their liquidity at short notice. Other calls on cash, such as running costs and fees, are an added challenge at an aggregate level.
Cash and gilts have become more important as collateral in derivative based liability-driven investment mandates
Evolving investment strategies and asset allocation has further intensified liquidity management. Cash and gilts have become more important as collateral in derivative-based liability-driven investment (LDI) mandates, and the timings of funding real asset investments means the availability of liquidity is a key consideration.
Complicating the picture further, the growing importance of cash has coincided with the “lower-for-longer” interest rate environment in which cash positions can create a higher drag on returns than in the past.
Taken together, these factors have transformed cash into an important investment asset for pension schemes. As such, they stand to benefit from bespoke management of their cash, not only to preserve capital and provide the required liquidity, but to also maximise returns.
Segmenting liquidity needs: Cash as a multi-dimensional asset
The first step towards cash optimisation is to identify these varying cash needs and categorise them into operational, reserve, and strategic liquidity requirements. The goal is to allocate cash to investment strategies with correspondingly appropriate investment horizons and risk-return characteristics.
A timing mismatch can arise between the investment commitment and cash drawdowns
For example, a pension scheme may recognise that a proportion of its liquidity is used to fund illiquid assets, and a timing mismatch – from a few months to a few years – can arise between the investment commitment and cash drawdowns. This proportion of liquidity can have a slightly longer horizon than operational cash earmarked to support more immediate needs such as benefit payments.
To achieve better optimisation, a scheme could allocate the interim cash to enhanced reserve or strategic cash-style investments, designed to incrementally increase risk-return characteristics.
Figure 1: Segmenting your cash needs
For illustrative purposes only. Source: Aviva Investors, November 2021
Designing a bespoke cash optimisation strategy will consider client-specific investment parameters, which requires a partnership approach between scheme and investment manager, aligning client needs and manager expertise.
Once the needs of the scheme have been analysed and the strategy has been designed holistically, an investment manager can match the different operational, reserve and strategic cash requirements with the most appropriate assets. Investing across the spectrum of money market instruments and short-duration fixed income securities within the prevailing market conditions, the manager will aim to provide a solution that meets cash requirements and delivers attractive returns.
Figure 2: Selecting the right investment manager
Due diligence
Given the large diversity of funds and managers in the liquidity market, due diligence is essential.
Manager expertise
Managers with expertise across short-, medium- and long-term cash investing, as part of a wider fixed income capability, can seamlessly allocate across a continuum of investments, while simultaneously enhancing yield opportunities and delivering required levels of liquidity.
Evaluation
As well as the expertise in cash investing across all time horizons and risk dimensions, schemes should rigorously assess the robustness of a manager’s investment process, risk management and credit capabilities.
Track record
In general, pension schemes can benefit from partnering with investment managers with a track record of delivering cash solutions to what is a distinct client base. Familiarity with the complex nature of pension cashflows and their associated array of liquidity needs is essential for a fruitful partnership.
Source: Aviva Investors, November 2021
Segregated mandates
Every pension scheme has distinct cashflow and liquidity needs. Those wanting a bespoke solution and control over investment parameters may find significant benefits from a segregated mandate. With such approaches, clients have direct ownership of the underlying investments and full control over the investment guidelines, allowing them to create a finely tuned risk-return profile.
Segregated mandates allow pension schemes to take a proactive approach to liquidity, satisfying their varying cash needs and readily adapting to changes in circumstances. By combining cash needs into one mandate, pension schemes can manage liquidity more efficiently, which can lead to more optimised asset allocation at the portfolio level and, in turn, lessen the drag on returns. A consolidated approach to managing the various calls on cash empowers schemes to enhance returns and optimise allocations.
Nearly 90 per cent of schemes consider wider ESG risks as part of their investment decisions
Increasingly, pension schemes are looking to partner with investment managers that combined a breadth of money market and fixed income expertise with experienced, well-resourced environmental, social and governance (ESG) teams. By actively integrating ESG considerations into a liquidity management approach, schemes can create bespoke portfolios to meet a range of goals and principles.
A broad spectrum of ESG considerations can be addressed within a segregated mandate, including climate requirements, such as decarbonisation and net-zero targets, as well as emerging areas of focus, such as biodiversity and supply chain transparency.
Working in partnership with an investment manager that has strong ESG credentials, pension schemes can build sustainable portfolios with the power to create positive change through the underlying investments as well as active engagement.
Within a segregated mandate, pension schemes can set objectives in terms of duration, spread risk and ratings. It also allows for limits in concentration risk, for example to regions where the scheme’s assets are heavily exposed. Such adherence to multiple, specific parameters is often not achievable with a pooled-fund approach.
Figure 3: Bespoke cash optimisation
For illustrative purposes only. Source: Aviva Investors, November 2021
Case studies:
1. Aligning optimised cash investments with climate objectives
- Make cash reserved for collateral work harder by segmenting and investing core (three-six months) and strategic cash (one+ year).
- Abide by ESG investment restrictions as per scheme’s responsible investment policy, including 30 per cent lower-carbon intensity versus representative benchmark and screens for certain activities related to fossil fuels.
- Identify appropriate carbon intensity metric as Carbon Intensity = tCO2e/US$ million’s sales.
- Establish sufficient portfolio coverage of carbon metrics.
- Assign Bloomberg Barclays Euro-Aggregate Corporates Index as benchmark for carbon intensity comparison purposes.
- Implement carbon intensity restrictions: portfolio targeting 30% lower weighted average carbon intensity versus the representative benchmark.
- Zero tolerance framework for issuers generating revenue from fossil fuels.
- Optimising for risk-adjusted returns simultaneously.
2. Optimising cash while adhereing to multiple restrictions
- Optimise liquidity and returns across full spectrum of cash needs.
- Adhere to unique investment restrictions, including specific issuer and sector concentration constraints as well as limits on duration, maturity and credit rating.
- Improve operational simplicity and cost effectiveness.
- Outsource all cash management and investment decisions to one asset manager with proprietary optimisation tools to achieve target yield.
- Utilise segregated mandate, allowing asset manager to achieve returns beyond what would be attained by allocating to a range of pooled funds while adhering to multiple investment constraints.
- Implement custom-built mandate offering flexibility to alter mandate guidelines, cutting the costs associated with switching between various pooled vehicles.
Key points
- The cash management landscape for defined benefit pension schemes is shifting as liquidity requirements grow in complexity. Key drivers for change include maturing liability profiles, changing investment strategies and an increasing need to align with net-zero objectives.
- Cash optimisation can empower pension schemes to address the extraordinary challenges of today’s environment. The goal is to identify what proportion of cash can be made to work harder, what must be available on a day-to-day basis to meet operational cash needs and everything else in between.
- No two pension schemes are the same. Where schemes have more complex needs that can’t be addressed via direct investment in pooled funds, segregated mandates are an ideal vehicle for cash optimisation. They can help meet the dual need to enhance cash returns while remaining within the unique and diverging investment restrictions facing many pension schemes today—for example, matching a segregated mandate to proprietary measurements of carbon intensity.
