Cash… A Risky and Costly Investment For Pensions

Source: Cash…A Risky and Costly Investment For Pensions

Pension funds tend to have a cash portfolio, which is usually held by the custodian bank and often has an average maturity/duration of about 3 months. That cash “bucket” is meant to fund monthly benefits (and expenses). Any deficiency in the cash account to fund monthly benefits creates a cash sweep of other assets, including dividends and interest. This practice causes cash to be a risky and costly investment decision for the following reasons:

1. Reinvestment Risk – Pension liabilities (benefits and expenses) are monthly payments. It is rare that the allocation to cash matches the characteristics of the liability cash flows for the next 3 months. There could be either excess cash or an inadequate cash allocation. Excess cash has some reinvestment risk. A cash shortage usually requires the plan sponsor to sweep liquid assets from growth assets, including dividends and interest income, thereby creating a reinvestment drag or risk on future returns (ROA) of growth assets.

2. Opportunity Cost – Cash is usually the lowest yielding asset since the portfolio has a Treasury bias and maturities are short. This creates an opportunity cost when compared to cash flow matching (CFM) given the longer maturities and much higher yields.

3. Funding Cost – Funding liabilities with cash creates a pay-as-you-go strategy, which tends to be the highest cost strategy to fund liabilities. This is in direct contrast to a defeasance strategy using CFM to fully fund liabilities.

Solution: Cash Flow Matching (CFM)

CFM is designed to fully fund net liability cash flows in a cost-efficient manner. CFM skews the assets to the longer maturities within the maturity range it is funding. The Ryan ALM model (we call the Liability Beta Portfolio™ or LBP) is an investment-grade portfolio skewed to A/BBB+ securities. Bond math tells us that the longer the maturity and the higher the yield, the lower the cost. For example, if CFM is funding liabilities out to 10 years, it will have skewed the weights to the 5-10-year area. This means that 0-1 year liabilities are being partially funded by the cash flows of the longer maturities. The benefits of CFM as the liquidity assets are numerous:

1. Higher yield than cash, enhancing the probability of achieving the ROA.

2. Buys time for the alpha assets to grow unencumbered.

3. Reduces the cost of funding liabilities by about 2% per year.

4. Eliminates a cash sweep that significantly diminishes the ROA of growth assets.

5. Neutralizes interest rate risk since it is funding liability cash flows (FV numbers).

6. Enhances funded ratio/status since it outyields cash and traditional bond portfolios.

CFM should be the core portfolio and liquidity assets of a pension since it best represents the true client objective: funding benefits in a cost-efficient manner with prudent risk.