Ryan ALM Turnkey System
Pension Problems: Volatility of Contributions and Funded Ratio
Pension Solution: Ryan ALM Turnkey System
Pension Objective
To secure and fund the projected benefit payments in a cost-efficient manner with prudent risk. Pensions are all about asset cash flows versus liability cash flows. In addition, corporate pensions want the annual dollar growth of pension assets to match or exceed the annual dollar growth of pension liabilities to reduce or eliminate pension expense and enhance corporate earnings.
Facts
Pension assets fund NET liabilities after contributions not gross. Contributions are the first source to fund benefits + expenses (B+E). Pension assets need to know what they are funding… net liabilities. Unfortunately, net liabilities are not calculated by the actuary.
Problems
Most bond assets are managed vs. generic market indexes and not plan liabilities
Liabilities priced at ROA discount rate (assets and liabilities = same growth rate)
Liquidity to fund B + E comes from a sweep of several asset classes
Funded Ratio / Status does not include contributions as an asset
ROA is based on asset allocation and not the funded status
Solutions… Ryan ALM Proprietary Turnkey System
1. Custom Liability Index (CLI)
In 1991, the Ryan team invented the first CLI as a best fit for the true pension objective. No two pension liabilities are alike… different labor force, salaries, mortality, plan amendments, etc. As a result, no generic bond index could ever properly represent and measure the liability growth rate and interest rate sensitivity (IRS). The proper pension plan benchmark should be based on the actuarial projections of:
benefits + expenses – contributions ((B+E) – C) = net liabilities.
Net liabilities are what pension assets must fund (not the gross liabilities)!
The CLI provides calculations needed for assets to be managed versus net liabilities:
monthly liability cash flows (term structure), duration, YTW, growth rate, and interest rate sensitivity (IRS).
Observation
The difference between net and gross liabilities is generally 20% to 50%. This suggests that the true funded status is much higher than what is reported. This should lead plans to lower the ROA needed to fully fund net liabilities allowing asset allocation to become less risky and more attainable.
2. ASC 715 Discount Rates
To understand the true economic valuation and growth rate of a pension you need to compare the market value (MV) of assets to the MV of liabilities. ASC 715 discount rates provide market valuation of liabilities. Ryan ALM is one of few vendors providing ASC 715 discount rates based on an AA zero-coupon corporate bond yield curve in conformity to ASC 715 (GAAP) accounting since FAS 87 and 158 were effective. Moody’s has adopted ASC 715 discount rates to assess the credit rating of municipalities.
Observation
The difference between discount rates based on the ASC 715 and the ROA is generally 150 to 250 basis points (5.00% versus 7.00%). This would increase the present value of liabilities around 15% to 30%.
3. Liability Beta Portfolio™ (LBP)
This is the core asset management product of Ryan ALM. The intrinsic value of bonds is the certainty of their cash flows. As a result, bonds have always been chosen as the way to defease and immunize liabilities. Our LBP is a cost optimization model composed of investment grade bonds skewed to A/BBB+ issues which calculates the lowest cost portfolio 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 as the target area to fund given the greater certainty of the liability cash flows and to buy time for the performance assets to grow unencumbered. The LBP will provide the liquidity needed to fully fund these net liabilities in a cost-efficient manner, so a cash sweep of performance assets is not needed. The LBP should also outyield traditional bond management which will enhance the ROA. The LBP should reduce funding costs by about 2% per year (1-10 years = 20% cost reduction) in this rate environment, reduce the volatility of the funded ratio and contributions, and reduce asset management costs (Ryan ALM’s max fee is 15 bps and then scales down).
Observation
It has been our experience for the last 20 years that our LBP reduces the funding cost of pension plans by about 2% per year (i.e. 20% for 1-10-year liabilities). Moreover, the LBP is fully funding the future value of net liabilities using a portfolio of A/BBB+ corporate bonds. As a result, there is no interest rate sensitivity with future values as well as we have defeased net liabilities with certainty. The yield difference of the LBP versus ASC 715 discount rates should be about 50 basis points. Depending on the average duration of the LBP (10 – 15 years) the LBP future value should be about 5% to 7.5% higher than the future value of net liabilities. This would improve the solvency of the pension plan.
4. Performance Attribution Report (PAR)
PAR compares the growth rate (total return) of the LBP to the CLI as a monthly report. PAR calculates 8 risk measurements, 4 return measurements, and 2 risk-adjusted measurements. Two historical graphs comparing these monthly returns is also provided.
Observation
Our 1-page PAR statistical report followed by our 2-page graphical comparisons of asset growth versus liability growth is quite succinct and tends to explain quite clearly the value added (or loss) from the LBP. Usually, the difference in yield is the return value added of the LBP with the same or similar risk behavior as the CLI.
Bonus: Asset Exhaustion Test (AET)
AET is required by GASB 67/68 as a test of solvency. Assets are grown at the ROA to see if they can fully fund projected benefits – projected contributions (net liabilities). Where they are exhausted, GASB requires a bifurcated discount rate using AA 20-year muni rates. Ryan ALM modifies the GASB AET to calculate the ROA needed to fully fundnet liabilities.
Observation
It has been our experience that our modified AET model using a calculated ROA (economic ROA) is much lower than the actuarial ROA suggesting the pension plan could reduce its allocation to risky assets.
Benefits
The benefits of the Ryan ALM turnkey system are numerous:
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 liabilities so no need for cash sweep
LBP reduces funding costs by roughly 2% per year = 20% on 1-10 years
Eliminates interest rate risk since it is funding benefits (future values)
AET calculates the economic ROA needed to fully fund net liabilities
LBP 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 and ASC 715 discount rates provided at no cost
Buys time for Alpha assets to grow unencumbered
The value added of the LBP model is the cost savings and risk reductions while fully funding liabilities chronologically (i.e. 1-10 years). The LBP is not interest rate sensitive since (IRS) since it is funding benefit payments (future values) which are not IRS. This eliminates interest rate sensitivity, which is the major risk factor for most performance based fixed income asset management. By cash flow matching we have fully funded a target area of liabilities thereby reducing the volatility of the total funded status and contribution costs. The LBP buys time for the growth or Alpha assets to perform without being encumbered to pay benefits. According to S&P data, 48% of the S&P 500 growth rate comes from dividends and reinvestment based on rolling 10-year periods since 1940. Buying time should enhance the ROA and funded status.
Please note:
That the LBP does not change any accounting or actuarial books.
Ryan ALM may have the longest experience with cash flow matching dating back to the late 1970s when Ron Ryan was the head of fixed income research at Lehman Bros.