Pension Game - Find the Liabilities

The true objective of a pension is to fund liabilities (benefits + expenses) in a cost-efficient manner with prudent risk. Although the management of pensions should have a liability driven objective, it is hard to find a focus on liabilities in any of the critical pension management functions. This has led to a singular focus on assets versus assets for several decades.

Asset Allocation

Most pension asset allocation (AA) models are designed to earn a return equal to the return on asset (ROA) assumption. Asset management is required to perform versus a generic market index for their asset class as their benchmark. Most AA models use the historical returns of these generic market indexes benchmarks to create an average or expected asset class return as their forecast of future returns. These market indexes average returns are then weighted for each asset class based on the target exposure in the fund to arrive at the ROA. This asset allocation process is usually the job of the pension consultant. The pension actuary will then use this ROA to calculate the annual contributions needed to attain full funding. This ritual is repeated at some frequency by both the pension consultant and actuary in conjunction with the pension Board. So, what’s missing… liabilities and the funded status.

If the true objective of a pension is to fund liabilities in a cost-effective manner with prudent risk, then the funded status is paramount. Obviously, the pension objective is a cost objective not a return objective! Logically a 60% funded plan would need a higher ROA to reach full funding than a 90% funded plan. But regrettably AA models ignore the funded status and work with an asset only focus.

To make matters worse, the funded ratio/status ignores future contributions as future assets. The truth is assets fund net liabilities after contributions (benefits + expenses - contributions) not gross liabilities. GASB requires a test of solvency whereby a plan sponsor must prove that they can fully fund total liabilities with contributions. We applaud GASB for this test and funding awareness. Ryan ALM modifies this solvency or asset exhaustion test (AET) to calculate the accurate ROA needed to fully fund net liabilities after contributions. It has been our experience that the actual ROA is always different and most often lower than the current ROA target (maybe significantly). We recommend the Ryan ALM calculated AET be employed as part of the asset allocation process to determine the accurate ROA needed to fully fund the pension plan’s net liabilities.

Asset allocation should be responsive to the funded status rather than strategic (long-term) or tactical (short-term) AA that ignore the ever-changing funded status. If the funded status is steadily improving, then AA should respond by shifting the allocation to more fixed income to cash flow match (defease) liabilities and thereby reduce risk while increasing the certainty of full funding which should lower contribution costs. Funded ratios have improved dramatically since 2020 but the allocation to fixed income has not.

Ryan ALM offers the following solutions to fix this asset only focus of pensions:

Solution: Asset Exhaustion Test (AET)

Based on each client’s actuarial projections of benefits, administrative expenses and contributions, the Ryan ALM modified AET will create a matrix of ROAs to calculate what ROA is a best fit to fully fund net liabilities (B+E) – C. The projected contributions can be adjusted as well if the calculated ROA is meaningfully different than the current target.

Solution: Custom Liability Index (CLI)

Most institutional objectives mandates are liability driven (Pensions, OPEB, SFA grants, Lotteries, etc.). Yet it is hard to find the liability objective in anything the asset side does (asset allocation, asset management (other than LDI), performance measurement, etc.). There seems to be a definite disconnect here. If all asset managers outperform their generic index benchmark but lose to liability growth… did the client win or lose? Clients lost and may have to pay a penalty (higher contribution costs). The true objective for liability driven clients is to fund their unique and proprietary liabilities in a cost-efficient manner with prudent risk. Similar to snowflakes… no two liability cash flow schedules are alike. As a result, it is impossible for any generic index to properly represent the client’s liability objective. Only a CLI could be the proper benchmark for a liability objective. Now pensions can compare asset growth versus liability growth as the proper performance measurement for a pension. Ron Ryan and his team developed the first CLI in 1991… it remains as one of the key products of Ryan ALM and an essential tool in our turnkey proprietary cash flow matching system.

Liabilities are the realm of actuaries. They are usually difficult and tedious calculations. As a result, actuarial projections are produced annually months after the end of the fiscal year. This is not in harmony with active asset management which needs to monitor their objective often in detail. The Ryan ALM CLI is a monthly report that provides all the calculations and data needed for successful asset liability management (ALM). Our CLI will take the annual actuarial projections and convert them to monthly NET liability cash flows. Assets need to know what they are funding. Usually it is monthly (benefits + expenses) – contributions = net liability cash flows.

Ryan ALM will then price the CLI using our proprietary ASC 715 discount rates. Ryan ALM is one of a few ASC 715 vendors providing such rates since the inception of FAS 158 in 2008. In addition to a monthly net liability cash flow schedule, our CLI will provide numerous statistics based on ASC 715 discount rates: average duration, YTM, growth rate, interest rate sensitivity, etc.

Solution: Cash Flow Matching (CFM)

The value in bonds is the certainty of their cash flows. Bonds may be the only asset class with such value. Ryan ALM has consistently recommended to use bonds for the certainty of their cash flows. We do not consider bonds as performance or Alpha assets. We view bonds as liquidity or Beta assets. Bonds have always been the chosen asset class for the cash flow matching of liabilities. In the 1970s it was called Dedication. CFM has a long successful record of being the core portfolio to defease and fully fund the liability objective. With interest rates much higher today than in the last 20-years, CFM should be in vogue. We urge clients and their consultants to use CFM as the bond allocation to fully fund the net liability cash flows chronologically and replace the allocation to highly interest rate-sensitive active core bond strategies managed to a generic market index.

We call the Ryan ALM CFM model… Liability Beta Portfolio™ (LBP). Our LBP is a cost optimization model composed of investment grade bonds skewed to A/BBB+ issues at low cost to fully fund net liabilities. The LBP will cash flow match monthly liabilities chronologically based on the CLI data. We recommend funding 1-10 years of Retired Lives as the minimum target area to fund given the certainty of the liability cash flows and to buy time for the performance assets (the fund’s residual alpha assets) to grow unencumbered. The LBP will provide the liquidity needed to fully fund these net liabilities in a cost-efficient manner thereby reducing or eliminating the need to do a cash sweep from the performance assets. S&P data shows that dividends reinvested account for over 50% of the S&P 500 total return over 20-year periods since 1940. Since our LBP is skewed to A/BBB+ corporate bonds it should outyield traditional bond management which will enhance the fund’s ability to achieve the ROA. More importantly, our LBP should reduce funding costs in this rate environment by about 2% per year (20% for 1-10 years), reduce the volatility of the funded ratio, contributions, and reduce asset management costs (our fee = 15 bps).

Benefits

The benefits of the Ryan ALM process are numerous:

• AET will calculate the ROA that accurately fully funds liabilities after contributions

• CLI benchmark provides all the data and calculations needed for efficient ALM

• LBP de-risks the plan by cash flow matching benefit payments with certainty

• LBP provides liquidity to fully fund net liabilities so no need for cash sweep

• Eliminates interest rate risk since it is funding benefits (future values)

• Reduces funding costs by about 2% per year = 20% on 1-10 years

• Reduces asset management costs (Ryan ALM fee = 15 bps)

• Enhances ROA by out-yielding active bond management

• Reduces volatility of the funded ratio + contributions

• CLI + ASC 715 discount rates provided at no cost

• Buys time so Alpha assets grow unencumbered

Negative Cash Flows… Good or Bad for Pensions

It is traditionally considered that it is bad for a pension to be cash flow negative (CFN). But let’s take a closer look. CFN means that benefits exceed contributions (B > C). Contributions are an extra cost caused by a funding deficiency where the present value of assets < present value of benefits. If the true objective of a pension is to fully fund and secure benefits in a cost-efficient manner, then you would think that the pension objective is to reduce or at least stabilize contribution costs. This is exactly what cash flow matching (CFM) achieves. Let me explain…

Spiking contribution costs have been a most onerous burden for many pensions, especially public pensions, since 1999. As I wrote in my 2013 book “The US Pension Crisis” I deduced that the pension crisis was created through spiking contribution costs. I featured New York City Employees Retirement System (NYCERS) where contribution costs increased more than 43 times in 12 fiscal years from $68,619,745 in FY ending 6/30/00 to $3,017,004,318 in 6/30/12 equal to a 37.1% annual growth rate. I quoted the financial objective of NYCERS in my book as:

… to fund benefits and to establish employer normal contribution rates that would remain approximately level over the future…

This spiking contribution cost trend was evident throughout pension America and was created by a heavy allocation to equities. The critical period was 2000 to 2002 when the S&P 500 had three consecutive negative return years that resulted in a cumulative negative return of -37.6%. Compounding this issue was the fact that interest rates were in a secular decline. On a market value basis, using ASC 715 discount rates, we calculated that most pensions had a cumulative liability growth rate of about 55.1% for those three years (2000-2002). This would have reduced the funded ratio for the average DB pension plan by about 60% sending most pensions from a surplus funded ratio to a deep deficit. As a result, contribution costs spiked throughout pension America damaging budgets, income statements, balance sheets, and credit ratings. Notably, several large cities were forced to file bankruptcy (e.g. Detroit, Jefferson County, Stockton, etc.) and corporate pensions decided to exit pensions through a pension risk transfer (PRT) thereby selling their pension liabilities to insurance companies.

Solution: Cash Flow Matching (CFM) Pensions are better funded today than at any time since 1999. To avoid another repeat of the spiking contributions dilemma (this time it may come from a private equity or alternatives bubble and another secular decline in rates), pensions should install a CFM strategy as the core portfolio.

CFM was the dominant asset strategy in the 1970s and 1980s when pensions were fully funded and was called Dedication. CFM is a best fit for the true pension objective since it is designed to fully fund net liability cash flows in a cost-efficient manner. Bonds are the only asset class with certainty of its future cash flows (interest income and principal payments at maturity). When CFM is done correctly, it 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 emphasizing 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 overweighted exposure to the 5-10-year area. This means that the 0-5 years liabilities are being partially funded, if not fully funded, by the cash flows (and higher interest rates) of the longer maturities.

The benefits of CFM as the liquidity assets are numerous:

1.     Reduces contribution volatility

2.     Provides timely liquidity to fully fund monthly liabilities (B+E)

3.     Eliminates need for a cash sweep which erodes the ROA of growth assets

4.     Buys time for the growth assets to grow unencumbered (enhances their ROA)

5.     Reduces the cost of funding liabilities by about 2% per year (1-10 years = 20%)

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

Conclusion: 

If the true pension objective is to fully fund and secure benefits in a cost-efficient manner with prudent risk, then pensions want to allow negative cash flows by letting the asset cash flows fully fund liability cash flows rather than increase contribution costs. This is best accomplished through a CFM strategy as the pension fund’s core portfolio.

Bond Math… Let THE FORCE be with you!

Source: Bond Math… Let THE FORCE be with you!

Defined Benefit pension planseverywhereface serious risk factors:

Liquidity Risk

The true objective of a pension is to fund liabilities in a cost-efficient manner with prudent risk. Pension liabilities are a term structure of monthly payments of benefits + expenses (liability cash flows). Funding liabilities in a cost-efficient, risk-controlled manner is increasingly difficult in a volatile market.Most pension plans rely on assets with uncertain cash flows which do not match the pension benefit payments schedule (liability cash flows). This mismatch creates unnecessary risk, unnecessary costs, and unnecessary stress. For many plan sponsors, this feels like fighting a battle with no clear weapon… let bond math, aka “THE FORCE”, be with you by adopting a Cash Flow Matching (CFM) strategy.

Funding Risk

When a pension sponsor adopts a CFM strategy, there is a significant funding enhancement. Instead of anxiety about market outcomes, contribution spikes, or liquidity needs, a CFM strategy turns the pension plan into aprecision cash flow process that fully funds liability cash flows in a cost-efficient manner with prudent risk. With Ryan ALM’s CFM in place, here is what life looks like for the plan sponsor:

• Liquidity risk is eliminated, no more cash sweeps

• Funded ratio stabilized for the portion of the plan using CFM

• Non-CFM (performance) assets grow unencumbered, enhancing total return

• Benefits are fully funded with cash flow certainty for the portion using CFM

• Funding costs are significantly lower by 2% per year (20% over 10 years, 40% over 20 years)

Cash Flow Matching (CFM) Methodology

Cash flow matching (Ryan ALM model = Liability Beta Portfolio™ or LBP) will secure monthly benefits and significantly reduce funding costs. Our LBP is a cost optimization model that goes through several iterations to find the optimal cost savings that will fund monthly liability payments with certainty. Since liabilities are priced like bonds… they behave like bonds (FASB or GASB discount rates require pricing as if liability cash flows are a portfolio of zero-coupon bonds). As a result, bonds become the proper proxy and assets to match and fund liability cash flows. Bond math tells us that the longer the maturity the lower the cost and the higher the yield the lower the cost for the same par value. Our LBP is comprised of investment grade bonds skewed to longer maturities and A/BBB+ credits. Importantly, the LBP yield of A/BBB+ bonds creates an excess return (Alpha) over the ROA assigned to bonds (YTM), which further enhances the funded status and reduces contribution costs. It will also outyield liabilities priced as AA corporates (ASC 715 discount rates) by roughly 50 - 100 bps. Skewing the portfolio weights to longer maturities within the designated liability term structure we are funding. As an example, means thata 30-year coupon bond will partially fund 29 years of benefits through interest income. The same is true for a 10-year bond partially funding 1-9 years of liabilities through interest income. Adding principal payments cash flow at maturity adds even more cash flow. Our LBP model will calculate a portfolio of asset cash flows (interest income + principal payments) that will match and fully fund monthly liability cash flows at a significant cost savings.

This is NOT how duration matching (DM) works, which has definite liability cash flow mismatches and cost inefficiencies. Since the longest duration bonds are around 19-years today, duration matching is forced to use Treasury zero-coupon bonds (STRIPS) to fund any liability past 19-years. Since Treasuries are the lowest yielding bonds… they are the highest cost bonds to fund and match liabilities. Moreover, duration is a present value (PV) calculation that is very interest rate sensitive. Duration matching (DM) is focused on matching liability growth rates and not on matching and funding benefit payments (future values). DM usually tries to match an average duration of liabilities or a series of key rate durations. Since duration matching is a PV focus, it does not produce a CFM of liability cash flows (future values) and can be an extremely interest rate sensitive strategy. Cash flow matching fully funds monthly liability cash flows thereby providing a more accurate and tighter duration matching fit.

BOND MATH = “The FORCE”

Just like “The Force” in Star Wars, bond math provides great power and control over asset cash flows. Bond math tells us:

The longer the maturity → the lower the present value

The higher the yield → the lower the present value

Example (bond Future Value = needed to fund $100 million liability payment):

YTM	Maturity	Present Value	Cost Savings	Savings %
5%	5 years	$78,352,617	$21,647,383	21.65%
5%	10 years	$61,391,325	$38,608,675	38.61%
6%	5 years	$74,726,215	$25,273,785	25.27%
6%	10 years	$55,839,479	$44,160,521	44.16%

Note: A 10-year bond at 5% YTM saves 52.8% more than a 5-year bond at 6% YTM. Bonds are the only asset with certain future values (interest income + principal)

Only cash flow matching (defeasement) can secure benefits and reduce funding costs with certainty. By matching and fully funding liabilities (benefits + expenses) our LBP reduces risk accordingly. Our LBP has numerous benefits that best achieve the true pension objective:

Benefit: Eliminates Liquidity Risk

• LBP fully funds liability cash flows chronologically (no need for cash sweep)

Benefit: Enhances Funded Ratio /Status

• LBP outyields ROA for bonds (usually skewed to an index heavily weighted to Treasuries)

Benefit: Reduces Funding Risk

• LBP provides certainty of asset cash flows to fully fund liability cash flows

Benefit: Reduces Costs

• LBP reduces Contribution, Funding and Asset Management Costs

Benefit: Reduces Volatility

• LBP matches and funds liability cash flows reducing volatility of funded status

Benefit: Eliminates Interest Rate Risk

• LBP and liability cash flows are future values (FV) which are not Interest Rate Sensitive

Benefit: Reduce and Stabilize Contribution Costs

• LBP will fully fund liabilities thereby reducing the volatility of contribution costs

Benefit: Buys Time

• LBP fully funds liabilitiesbuying time for other assets (Alpha) to grow unencumbered

Benefit: Portable Alpha

• As Alpha assets grow unencumbered, transfer (port) Excess Returns to LBP

The LBP should be the core portfolio of asset allocation since it best represents and funds the true client objective (funding benefits in a cost-efficient manner with prudent risk). The greater the allocation to the LBP, the greater the cost savings and stabilization of the funded status. We strongly recommend replacing the current bond allocation to active bond management managed versus a generic bond index with our LBP cash flow matching portfolio that manages assets versus liabilities. Since Retired Lives are the most certain and most important (most tenured employees) liabilities, we recommend funding Retired Lives through our LBP as a high priority of the pension plan. Ryan ALM can cost-effectively fund the Retired Lives liability cash flow schedule with low risk. Our Liability Beta Portfolio complements the performance or risky assets by removing the cash sweep and buying time for them to grow unencumbered which should significantly help them achieve their target ROA.

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.

What Do Pension Sponsors Want For Christmas?

Source: What Do Pension Sponsors Want For Christmas?

When asked this question, most pension sponsors would answer:

• Lower or stable pension cost

• Lower volatility on funded status

Yet the asset allocation of most pension plans is skewed to risky and volatile assets. This skewness has created a long history of volatile funded ratios and increasing contribution costs. Fortunately, there is a product that will provide the answers pensions have long sought: Cash Flow Matching!

Given that the true objective of a pension is to fully fund benefits and expenses (liabilities) in a cost-efficient manner with prudent risk, plan sponsors and their consultants should be installing a strategy that is the best fit to achieve this true pension objective. CFM is a portfolio of investment grade bonds that provide an accurate and timely match of monthly asset cash flows to fully fund monthly liability cash flows.

The intrinsic value in bonds is the certainty of their cash flows (only asset class with such certainty). Bond math teaches us that the longer the maturity and the higher the yield… the lower the cost. The Ryan ALM CFM portfolio is created through a cost optimization model that fully funds monthly liability cash flows at a cost savings of about 2% per year (20% to fund 1-10-year liabilities). We call our CFM mode the Liability Beta Portfolio (LBP). The LBP should be the core portfolio for any DB pension fund replacing active fixed income management, which is highly interest rate sensitive. Since pension liabilities are future value costs the monthly payments are not interest rate sensitive. As a result, by matching the FV of liabilities, CFM mitigates interest rate risk! By matching and funding liabilities chronologically, the LBP also buys time for the performance or Alpha assets to grow unencumbered. The pension plan can gradually enhance its funded status and stabilize contribution costs by having CFM work in harmony with the Alpha assets. There are numerous benefits to a CFM strategy:

• No need for cash sweep as LBP provides the liquidity to fully fund liabilities

• Secures benefits for time horizon LBP is funding (example 1-10 years)

• Buys time for performance assets to grow unencumbered

• Outyields active bond management enhancing ROA

• Reduces Volatility of Funded Ratio/Status

• Reduces Volatility of Contribution costs

• Low Investment Advisory Cost = 15 bps

• Reduces Funding costs (2% per year)

• Mitigates Interest Rate Risk

Pension Doctor: Specialist or Generalist?

Source: Pension Doctor: Specialist or Generalist?

When a person gets sick or has an injurythey go see a doctor. Usually, they prefer to see a Specialist who is the recognized expert on the ailment they have rather than a Generalist who has less expertise related to this particular medical condition. Well, the same should be true for pensions. If a pension plan needs a certain strategy to help enhance (cure) the funded status, they call in a specialist for that strategy.

Given that the true objective of a pension is to fully fund benefits and expenses (liabilities) in a cost-efficient manner with prudent risk plan sponsors and their advisors should be dialing up a risk mitigation specialist, such as Ryan ALM. For more than 50 years, our cash flow matching (CFM) strategy is the best fit and proven strategy for the pension objective. CFM provides an accurate and timely match of monthly asset cash flows to fully fund monthly liability cash flows. The CFM is a portfolio of investment grade bonds. The intrinsic value in bonds is the certainty of their cash flows (only asset class with such certainty).

Bond math teaches us that the longer the maturity and the higher the yield… the lower the cost. The Ryan ALM cash flow matching product is a cost optimization model that fully funds monthly liability cash flows at a cost savings of about 2% per year in this interest rate environment. We call our CFM model the Liability Beta Portfolio (LBP). The LBP should be the core portfolio of any DB pension and replace active fixed income management, which is highly susceptible to changes in rates. By matching and funding liabilities chronologically, the LBP buys time for the Alpha or performance assets (non-bonds) to grow unencumbered. By working in harmony with the Alpha assets the plan can gradually enhance its funded status and stabilize contribution costs. There are numerous benefits to a CFM strategy:

• No need for cash sweep as LBP provides the liquidity to fully fund liabilities

• Secures benefits for time horizon LBP is funding (1-10 years)

• Buys time for performance assets to grow unencumbered

• Outyields active bond management… enhances ROA

• Reduces Volatility of Funded Ratio/Status

• Reduces Volatility of Contribution costs

• Low Investment Advisory Cost = 15 bps

• Reduces Funding costs (2% per year)

• Mitigates Interest Rate Risk

We urge pensions to use CFM as the core portfolio strategy to achieve their true objective. To our knowledge Ryan ALM is the only firm that specializes in CFM… our only product.

When is a Pension Fully Funded?

Source: When is a Pension Fully Funded?

The Funded Ratio tends to be the acid test and benchmark for funded status… but is it? We have written several research white papers (www. RyanALM/Research/White Papers) about the glaring issues with the Funded Ratio. Here are just a few of the inconsistencies with the Funded Ratio:

Actuarial Value versus Market Value

The Funded Ratio (FR) of a pension is usually based on the actuarial value of assets / actuarial value of liabilities. The Funded Status (FS) is the actuarial value of assets – actuarial value of liabilities. Actuarial values are different than market values… sometimes quite different. Market values are the better measurement of economic reality since you can’t spend actuarial dollars. As a result, this valuation difference can seriously distort the FR and FS calculation.

Present Value versus Future Value

Notably, the FR and FS are present value calculations. But pension liability cash flows (benefits + expenses (B+E)) are future value (FV) projections. Since the FV of most assets is not known this becomes a true pension conundrum. Bonds are the only asset class with a known and certain future value. That is why bonds have been the chosen asset class for defeasance, immunization and cash flow matching for several decades. The disconnect between PVs and FVs haunts pensions. The true objective of a pension is to secure and fully fund liability cash flows in a cost-efficient manner with prudent risk. As a result, the objective should be for asset cash flows to match and fully fund liability cash flows.So, when is a pension fully funded... when asset cash flows (future values) fully fund liability cash flows (future values). This is best accomplished thru cash flow matching and is best measured by the Asset Exhaustion Test.

Contributions = MIA

The FR and FS both ignore contributions as an asset. The truth is that contributions are future assets and should be a high consideration in any asset liability management (ALM). We recommend using the Ryan ALM modified Asset Exhaustion Test (AET) as the best way to measure the solvency and funding status of a pension. We take asset cash flows (based on a ROA) and compare them to NET liability cash flows (benefits + expenses – contributions) to understand if assets can fully fund the liability cash flows. We use a matrix of ROAs to determine what ROA is the best fit. This calculated ROA is in sharp contrast to the current ROA that is based on an asset allocation model that ignores the FR and FS. It is common that a pension plan with a 60% funded ratio and another funded at 90% have the same or similar ROA. How is this possible? Shouldn’t the 60% funded plan need assets to work harder? Yes, but that does not have anything to do with the current ROA calculation. Whatever shortfall there is in asset cash flows to fund liability cash flows (B+E) must be paid by higher contributions… this is not in the best interests of a pension plan and the sponsor’s budget. Clearly, the current ROA is not a calculated return based on the FR and FS that will guarantee a fully funded

status if achieved long-term… nor will it guarantee that contributions will go down. This has been a sad and costly trend for the last 25+ years.

Discount Rates

A most troubling issue is what discount rate to use. FASB and GASB tend to disagree on this.

FASB = high quality AA corporate zero-coupon yield curve

GASB = ROA

Since the ROA is a much higher rate (usually 100 to 200 bps) then liabilities would be priced at a much lower PV (12% to 24%). This would enhance the FR by 8% to 22%. Market rates are best in determining the market or economic value of liabilities. FASB 144 says it well:

“The objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the pension benefits when due. Notionally, that single amount, the projected benefit obligation, would equal the current market value of a portfolio of high-quality zero coupon bonds whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments. The determination of the assumed discount rate is separate from the determination of the expected rate of return on plan assets”

Ryan ALM Solutions:

Custom Liability Index (CLI): The first step in prudent pension management is to calculate the liability cash flows that assets must fund. This should be a net liability cash flow (benefits + expenses – contributions). Until liabilities are monitored and priced as a Custom Liability Index (CLI) the asset side is in jeopardy of managing to the wrong objectives (i.e. ROA and generic market indexes). Only a CLI best represents the unique liability cash flows of a plan sponsor. Just like snowflakes, no two pension liability schedules are alike due to different labor forces, salaries, mortality and plan amendments. How could a static ROA or genericmarket indexes ever properly represent the risk/reward behavior of such a diverse array of pension liabilities? Once the CLI is installed, the pension can now know the true economic Funded Ratio and Funded Status which should dictate the appropriate Asset Allocation, Asset Management and Performance Measurement.

Asset Exhaustion Test (AET): GASB requires a test of solvency (AET) to document that the asset cash flows (at the ROA) will fully fund the net liability cash flows (benefits + expenses – contributions). GASB correctly understands that assets are funding net liabilities after contributions… and that contributions are future assets. This net liability is rarely focused on by the asset side in asset allocation. Ryan ALM enhances the asset exhaustion test by calculating the ROA that will fully fund net liability cash flows. Usually, we find that a lower ROA can accomplish this goal and is a better fit than the current ROA. This would suggest a more conservative asset allocation and a heavier allocation to fixed income to defease liability cash flows chronologically. This is a common and serious issue. This calculated ROA should be the asset allocation model focus. We urge all pensions to incorporate this modified AET before acting on asset allocation.

Liability Beta Portfolio™ (LBP):The intrinsic value in bonds is the certainty of its cash flows. That is why bonds have been used for decades to defease liability cash flows. The core or Beta portfolio for a pension should be in investment grade bonds that cash flow match and fully fund liabilities chronologically thereby buying time for the growth (Alpha) assets to outgrow liabilities and erase the deficit. The proper Beta portfolio for any liability objective should be… a Liability Beta Portfolio™. Ryan ALM has developed a LBP which will cash flow match liabilities chronologically and reduce funding costs by about 2% per year (1-10 years = 20%) as well as reduce the volatility of the Funded Status and contribution costs. The LBP should be the core portfolio of any pension and replace active fixed income management. By matching and funding liabilities chronologically, the LBP buys time for the growth or Alpha assets (non-bonds) to perform. By working in harmony with the Alpha assets the plan can gradually enhance its funded status and reduce contribution costs.

Liability Alpha Assets: The non-bond assets should be managed vs. the CLI to exceed liability growth (earn liability Alpha) and enhance the economic Funded Status. The goal here is outgrow liabilities in $s (relative returns) by enough to erase the deficit over a time horizon equal to the average life (duration) of liabilities (calculated by the CLI). As the Alpha assets achieve the required annual Alpha, any excess returns vs. liability growth should be ported over to the Liability Beta Portfolio™ to secure the victory. Had this been in place during the decade of the 1990s when pensions had surpluses… there would be no pension deficits today.

Pension Conundrum: Same or Similar ROA

Source: Pension Conundrum: Same or Similar ROA

The Funded Ratio (FR) of a pension is usually based on the actuarial value of assets / actuarial value of liabilities. The Funded Status (FS) is the actuarial value of assets – actuarial value of liabilities. Actuarial values are different than market values… sometimes quite different. Notably, the FR and FS are present value calculations. But pension liability cash flows (benefits + expenses (B+E)) are future value (FV) projections. The disconnect between PVs and FVs haunts pensions. We have written several research papers about this glaring issue.

The return on assets (ROA) assumption is not based on the funded ratio or funded status. Instead, it is based on the expected return from the pension plan’s asset allocation. The same or similar asset allocation will produce the same or similar ROA focus. This brings up the question from my title – how could 60% and 90% pension funded plans have the same ROA? Shouldn’t the 60% funded plan require assets to work harder? Yes, but that does not have anything to do with the ROA calculation. Whatever shortfall there is in asset cash flows to fund liability cash flows (B+E) must be paid through higher contributions. As a result, the ROA is not a calculated return that will guarantee a fully funded status if achieved long-term… nor will it guarantee that contributions will go down.

Ryan ALM Solutions:

Custom Liability Index (CLI): The first step in prudent pension management is to calculate the liability cash flows that assets must fund. This should be a net liability cash flow (benefits + expenses – contributions). Until liabilities are monitored and priced as a Custom Liability Index (CLI) the asset side is in jeopardy of managing to the wrong objectives (i.e. ROA and generic market indexes). Only a CLI best represents the unique liability cash flows of a pension plan. Just like snowflakes, no two pension liability schedules are alike due to different labor forces, salaries, mortality and plan amendments. How could a static ROA or genericmarket indexes ever properly represent the risk/reward behavior of such a diverse array of pension liabilities? Once the CLI is installed, the pension fund will now know the true economic Funded Ratio and Funded Status, which should dictate the appropriate Asset Allocation, Asset Management, and Performance Measurement.

Asset Exhaustion Test (AET): GASB requires a test of solvency (asset exhaustion test) to document that the asset cash flows (at the ROA) will fully fund the net liability cash flows (benefits + expenses – contributions). GASB correctly understands that assets are funding net liabilities after contributions… and that contributions are future assets. This net liability is rarely shown or focused on by the asset side in asset allocation. Ryan ALM enhances the asset exhaustion test by calculating the ROA that will fully fund net liability cash flows. Usually, we find that a lower ROA can accomplish this goal than the current ROA target. This would support a more conservative asset allocation and a heavier allocation to fixed income to defease liability cash flows chronologically. This is a common and serious issue. This calculated ROA should drive asset allocation decisions. We urge all pensions to incorporate the AET before acting on asset allocation.

Liability Beta Portfolio™ (LBP):The intrinsic value in bonds is the certainty of its cash flows. That is why bonds have been used for decades to defease liability cash flows. The core or Beta portfolio for a pension should be in investment grade bonds that cash flow match and fully fund liabilities chronologically thereby buying time for the growth assets to outgrow liabilities and erase the deficit. The proper Beta portfolio for any liability objective should be… a Liability Beta Portfolio™. Ryan ALM has developed an LBP which will cash flow match liabilities chronologically and reduce funding costs by about 2% per year (1-10 years = 20%), as well as reduce the volatility of the Funded Status and contribution costs. The LBP should be the core portfolio of any pension fund and replace active fixed income management, which is subject to great interest rate risk. By matching and funding liabilities chronologically, the LBP buys time for the growth or Alpha assets (non-bonds) to perform. By working in harmony with the Alpha assets the plan can gradually enhance its funded status and reduce contribution costs.

Liability Alpha Assets: The non-bond assets are managed vs. the CLI to exceed liability growth (earn liability Alpha) and enhance the economic Funded Status. The goal here is outgrow liabilities in $s (relative returns) by enough to erase the deficit over a time horizon equal to the average life (duration) of liabilities (calculated by the CLI). As the Alpha assets achieve the required annual Alpha, any excess returns versus liability growth should be ported over to the Liability Beta Portfolio™ to secure the victory. Had this been in place during the decade of the 1990s when pensions had surpluses… there would be no pension deficits today.