Contact: Ian Howell, (01962) 847540; email: [email protected]

1 Summary

1.1 This report reaffirms the policy for managing the Hampshire Pension Fund's cash balance, for the Panel's approval. It also reports on the impact of the transition to the new investment management structure on the cash balance, including the temporary increase in cash pending the increase in the property portfolio.

2 Recommendation

That the County Treasurer be authorised to manage the Fund's cash balance in accordance with the policy set out in this report.

3 Background

3.1 The Fund's cash balance is held by the County Council and managed by the County Treasurer. It is placed on deposit as part of the management of the County Council's own cash balance. Interest is paid to the Pension Fund by the County Council at the seven day market interest rate. On occasions, larger cash balances are placed on specific longer term deposits and the interest earned is credited directly to the Pension Fund. The County Council has rigorous procedures in place to ensure the security of its cash deposits, including criteria for the quality of counterparties and limits on the amount that can be placed with any one party. An Annual Investment Strategy is approved by Cabinet and County Council in February each year.

3.2 The Fund requires a cash balance to be able to pay pensions and other benefits. The Fund receives cash each month from contributions by employees and employers, and from investment income. Dividends from shares and interest receipts from bonds are retained by the fund managers for reinvestment, but rent income from the Fund's direct property portfolio is credited to the Fund's cash balance held by the County Council.

3.3 The Fund currently generates a surplus of income over expenditure of around £60m per annum as the annual income from contributions and investments exceeds the annual outgoings on pensions and benefits. This surplus is expected to continue at least for the medium term, in line with the actuary's assessment of the need for higher contributions to reduce the Fund's deficit. The surplus is invested to meet the Fund's future liabilities.

3.4 Over the years, part of the cash balance has been periodically transferred to the Fund's investment managers for longer-term investment in equities, bonds and property. A minimum of £20m is held by the County Council to provide day-to-day cashflow cover to avoid the Fund becoming `overdrawn'.

3.5 The Panel last considered the Fund's cash balance on 25 November 2005 when the balance was forecast to reach £133m by 1 April 2007. The Panel decided not to make any further transfers of cash to the managers pending the outcome of the review of investment management arrangements.

4 Transition to the new investment management structure

4.1 In planning the transition in December 2006 from the former managers to the new structure, it was necessary to set aside sufficient cash to fund the proposed increase in the Fund's property portfolio from £107m to £277m (for the portfolios managed by CB Richard Ellis and Arlington). This increase will be required to fund purchases over the next 12 to 18 months from the Fund's cash balance as the two managers identify suitable investments. In addition, provision was allowed for possible draw downs for the alternative investment portfolio.

4.2 Northern Trust were asked to return £86m of cash to the County Council as part of the transition to the new investment management structure in mid December 2006. In the event, markets moved to the Fund's advantage during the transition period and Northern Trust were able to return £130m of cash to the County Council (£44m extra) after seeding the new managers' portfolios with the target amounts. This added to the cash balance of £115m already held by the County Council to give a total of £245m.

4.3 The increase in cash returned by Northern Trust, rounded to £45m, was transferred to the new managers on 1 April 2007 for long-term investment. It has been allocated between the managers pro rata to their initial allocations.

4.4 The remainder of the temporary cash balance could have been transferred to the equity and bond managers for investment pending the calls from CB Richard Ellis and Arlington for cash. This would have ensured that the Fund maintained exposure to equity and bond markets. Alternatively, the cash could have been invested in an index tracking fund for UK equities. Both options, however, would have involved additional transaction costs in buying stocks or units and then selling them almost immediately over the following months as and when the cash was required for property investment. Using a UK equity tracker fund would also have required a formal procurement process to select a provider and would have taken some months to complete.

4.5 Cash flow profiles provided by CB Richard Ellis and Arlington for the property portfolios indicated that most of cash would be required over the course of 2007/08 and on that basis it was decided to hold it temporarily as cash.

5 Equitisation of the cash balance

5.1 Holding such a large balance in cash, even for a relatively short temporary period, can involve risks from not being invested in equity and bond markets should they rise. A further option, of using futures to `equitise' the cash was also investigated with the assistance of Aberdeen in order to expose that cash to the movements of the stock market.

5.2 Under this proposal, Aberdeen arrange the purchase of FTSE 100 Index futures on behalf of the Fund to the value of the amount of cash that the Fund wish to equitise. These futures are closed when the Fund wishes to use the cash and the Fund benefits or otherwise from the movements up or down in the capital only version of the FTSE 100 Index (ie, excluding dividend returns). The FTSE 100 Index was chosen as there is a more established futures market than for the other components of the FTSE All Share Index.

5.3 The Fund is required to deposit with the broker only a small proportion of the amount equitised (about 3%) as margin. If the Index falls, additional margin has to be placed with the broker. The remaining cash can be placed on deposit by the County Council to earn interest which provides income that can be considered as the equivalent of the dividend element of the `total return' version of the Index. The brokerage fees charged are less than those incurred in investing in the underlying shares so that this is a cheaper way of gaining short term exposure to the UK stock market.

5.4 This approach has been used to equitise £150m (61%) of the initial cash balance of £245m. This proportion is based on the Fund's strategic asset allocation in which 65% of the Fund is invested in equities. The remainder of the cash balance has been placed on deposit. The amount equitised has since been reduced following the transfer of £45m to the managers for long term investment on 1 April 2007 and will be further reduced as CB Richard Ellis and Arlington invest their portfolios.

5.5 This has ensured that the Fund's temporarily large cash balance has been exposed to the stock market. The Fund will not miss out if the stock market rises but it will lose if the stock market falls. However, this would also be the case if the cash had been passed to the managers for investment.

6 Cash flow forecasts

6.1 The latest cash flow projections for the Fund for 2007/08, 2008/09 and 2009/10 are summarised below:

6.2 Once the investments in the property and alternative investments portfolios have been completed, probably during 2008/09, the cash balance will be managed at a minimum of £20m to cover the Fund's day-to-day cash flow by transferring the excess to the managers for longer-term investment.

6.3 If this cash flow forecast is achieved, the equitisation of the cash balance will be fully unwound by 31 March 2008.

7 Future cash management policy

7.1 The proposals in this report can be brought together in a policy for the Fund's cash flow management as follows:

· a minimum cash balance of £20m should be held by the Fund for cash flow purposes

· the Fund's cash balance should be held as cash and not transferred to the equity and bond managers for longer-term investment until the two property portfolios are fully invested

· 65% of this temporary cash balance should continue to be equitised using FTSE 100 Index futures to gain exposure to the UK stock market

· the increase in the alternative investments portfolio to 10% of the Fund should be funded over the next three to four years from the Fund's positive cash flow

· the County Treasurer is authorised to transfer additional cash to the managers for long term investment at regular intervals, using these transfers if necessary to rebalance the Fund's strategic asset allocation in line with the policy on rebalancing set out in Item 9 on this Agenda

· the Fund's remaining cash balance is placed on deposit by the County Treasurer in accordance with the County Council's Annual Investment Strategy

· interest is paid to the Fund by the County Council on the cash balance on the basis of the seven day market interest rate or, if specific deposits are made in respect of the Fund's cash balances, the interest actually earned by those deposits

· the County Treasurer will report to the Panel annually on the Fund's cash balance.

Section 100D - Local Government Act 1972 - background documents

The following documents discuss facts or matters on which this report, or an important part of it, is based and have been relied upon to a material extent in the preparation of this report.

NB: The list excludes:

None.

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