Pension Problem: Future Values
Printable Version: Pension Problem: Future Values
The true objective of a pension is to secure promised benefits in a cost-effective manner with prudent risk. Pension benefit payments are future value numbers. We do not know the future value of pension assets except for bonds who have the certainty of their cash flows (principal + interest payments). The least risky way to secure benefits is to cash flow match (CFM) these future value benefit payments with U.S. Treasury STRIPS (zero-coupon bonds). However, STRIPS may be too costly since they have lower yields. The least costly way to secure benefits is through CFM with investment grade bonds because of the certainty of their cash flows.
Funded Ratio / Status
Actuarial practices use present values (PV) to calculate the funded ratio and funded status… but benefit payments are future values (FV). This suggests that the future value of assets vs. the future value of liabilities would be the more appropriate and critical evaluation. Most asset classes are difficult, if not impossible, to ascertain their future value. Only bonds (and insurance annuities) have a known future value and, accordingly, have historically been used to cash flow match liabilities (i.e. defeasance, dedication). To prove my point as to the potential misinformation with using a PV calculation, let’s use a simple example below. Two pensions both at $100 million market value with a 15-year duration would have the same funded ratio in PV$. But pension B is 100% invested in corporate bonds that outyield pension A (100% invested in Treasuries) by 100 bps per year. Certainly, plan B has a much greater future value (@ 15.6% higher) and funded status if we used future values. This suggests that the funded ratio and funded status are not the best indicators of the true economic solvency:
| Pension | Composition | YTM | PV | FV |
|---|---|---|---|---|
| A | 100% Treasuries | 4.00% | $100 million | $180 million |
| B | 100% Corporates | 5.00% | $100 million | $208 million |
The point of all this is that we need to focus more on the FV of assets vs. liabilities or cash flows. The AET is the appropriate methodology to compare assets versus liabilities cash flows (future values).
Pensions are all about cash flows… asset cash flows to fully fund liability cash flows! For some reason the funded ratio / status ignores contributions as asset cash flows. Actuaries say this is because contributions are in the future and could be altered. Well, isn’t this true about benefit payments? Such projections of contributions and liabilities are recalculated annually by the actuaries so the AET should be monitored annually after the new actuarial projections. We congratulate GASB 67/68 on requiring a test of solvency (AET) where projected asset cash flows including contributions grow based on the ROA and are compared to projected net liabilities (benefits + expenses – projected contributions or ((B+E) – C). Ryan ALM modifies this AET approach where we calculate the ROA needed to fully fund net liability cash flows. In almost all cases, we find it would take a lower ROA to fully fund net liabilities. This calculated ROA should be the hurdle rate for asset allocation.
The AET is a critical and accurate gauge of the solvency of a pension plan since it focuses on asset cash flows funding NET liability cash flows (future values). It is a valuable tool for all pensions (Private, Public, and Multiemployer). Notice, it includes contributions as a pension asset where the funded ratio and funded status do not. The AET correctly considers contributions as future assets.
A corporate bond portfolio cash flow matched to net liability cash flows would secure pension benefits and reduce funding costs (FV of liabilities - PV of assets) with certainty. This is why cash flow matching of net liability future values is the most prudent and lowest cost methodology to de-risk a pension through asset liability management (ALM).
SOLUTION: Cash Flow Matching
As stated earlier, funding the net liability benefit payment schedule (liability cash flows or FVs after contributions) in a cost-effective manner should be the quest of a pension plan sponsor. Ryan ALM has built a liability cash flow matching product, Liability Beta Portfolio™ (LBP), as a cost optimization model that matches and fully funds the net liability payment schedule or cash flows ((B+E) - C) chronologically at the lowest cost given the investment policy restrictions of our clients. By focusing on future values, we avoid the present value problems of duration matching (i.e. interest rate sensitivity changes daily and is a forecast of rates). By matching future values chronologically, the LBP has mitigated interest rate risk which dominates the present value behavior of bonds. (Note, FVs are not interest rate sensitive.) The LBP is a perfect complement to the AET by cash flow matching each liability cash flow payment chronologically (FV of benefits + expenses). By matching future values, the LBP enhances the SOLVENCY of any pension at a reduced funding cost.
The LBP currently provides a roughly 2% per year funding cost savings (i.e. 20% on a 1- 10-year net liability cash flow schedule). This is a serious cost reduction and should be a major consideration of any pension asset allocation strategy. Yes, the LBP model may have some credit risk, but it remains very small since we are using investment grade bonds (BBB+ or better) with credit filters (no bonds on negative watch list, low Bloomberg default risk, etc.) plus the cost savings provides a large risk cushion.
The funded ratio/status should dictate the allocation to bonds. A surplus or high funded ratio should have a high allocation to bonds cash flow matched to liabilities and vice versa for a high deficit or low funded ratio plan. Unfortunately, current asset allocation practices do not respond to the funded status. In the late 1990s with funded ratios at 120% to 150%, why didn’t all pensions cash flow match liabilities (defease) and secure this victory? Amazingly, instead of increasing their bond allocation in response to a growing funded ratio most pensions reduced their bond allocation to the lowest in modern history by 1999 to achieve a target ROA (@ 8.0%). Had pensions cash flow matched liabilities then they would have secured benefits at low cost in harmony with the true pension objective and created a surplus portfolio that could have been maintained for decades and used for other purposes (pay OPEB liabilities).
“Where is the knowledge we have lost in information”
T.S. Eliot