Asset allocation (AA) is the single most important asset decision. Pension consultants are usually in charge of AA and assign an index benchmark to each asset class as that asset class’ individual return objective. Based on the historical average total return (e,g. last 25 years) of these index benchmarks, the return on asset (ROA) target is determined for each asset class. The exception is the fixed income asset class where the yield on the index benchmark (e.g. the Aggregate) as of the preceding year-end is used as the ROA for bonds for the next year. These ROA targets for each asset class are then weighted by the asset allocation model creating the hurdle or target ROA for the entire plan.
the GOOD
Using index benchmarks for each asset class to calculate a ROA based on an average total return is a good and proper method for a successful total return-focused asset allocation. Weighting each asset class to determine the ROA for total assets is also a necessary approach to supply the plan’s actuary with the data needed to calculate the sponsor’s future contributions.
the BAD
Quite often the ROA calculation process seems to be forgotten or misunderstood when it comes to certain asset classes… especially fixed income. If the total assets ROA was calculated to be 7.00% and the yield on the fixed income index benchmark is 4.32% (the Agg index as of 12/31/25), some will ask how can an allocation to fixed income achieve the 7.00% target ROA? They seem to have forgotten how the 7.00% ROA was calculated. Fixed income’s target ROA is the 4.32% yield on its index not the 7.00% ROA on total assets.
the UGLY
If the true objective of a pension is to secure and fully fund benefits in a cost-efficient manner with prudent risk… then the appropriate focus of a plan’s assets should be on generating cash flows to fully fund benefits and expenses not returns relative to a ROA target.
Asset cash inflows need to fully fund liability cash outflows… period! The actuary calculates the liability cash flows for each year as far out until the plan is exhausted. These liability cash flows are future values. Since bonds are the only asset class where we know the future value (principal + interest income), bonds should be used as the funding or liquidity assets not performance assets. Some might argue that they already use bonds to fund liabilities but is it bond cash flows (principal + interest income) or just income? If bonds are managed versus a generic bond index they can never match liability cash flows. This mismatch usually requires more sources of income (cash sweep) to fund monthly liabilities. A cash sweep prevents the power of compounding, erodes the ROA of growth assets and should be avoided. Let bond cash flows fully fund the monthly liability cash flows. Importantly, asset allocation should separate liquidity assets (bonds) from growth assets.
Let the bond allocation be the liquidity supplier that fully funds the liability cash flows for the next 5 to 10 years. This will allow the growth assets to grow unencumbered instead of being eroded with a cash sweep or untimely asset sales.
Simply repurpose the allocation to bonds from a return objective to a cash flow objective. This is an uncommon approach to asset allocation but certainly in harmony with achieving the true pension objective. The synergy of utilizing liquidity assets and growth assets to fully fund liability cash flows is a prudent and wise approach to pension stewardship.
Asset Exhaustion Test (AET)
GASB requires a test of solvency where asset cash flows are calculated and matched versus liability cash flows to see if they fully fund each and every year of liabilities. If the asset cash flows become exhausted before they fully fund all liability cash flows, then the plan has failed the AET. At the point of asset exhaustion GASB requires the discount rate for future unfunded liabilities to be a long-dated, high-quality municipal bond interest rate.
GASB allows pension plans to use the ROA to calculate the asset cash flows. But this approach does not provide a good indication of what calculated ROA is needed to fully fund liability cash flows. Indeed a 10% ROA may easily fully fund liabilities but maybe a 5.75% ROA would also fully fund liabilities. Ryan ALM modifies the AET by first separating liquidity assets (bond allocation) and the liability cash flows the bond allocation can fully fund through our cash flow matching (CFM) process we call the Liability Beta Portfolio™ or LBP.
Our LBP uses A/BBB+ corporate bonds that will match and fully fund liability cash flows at a cost savings of 2% per year (20% for 10 years). Let’s assume the first iteration is using bonds to fully fund the next 10 years of liability cash flows. Next, we use a matrix of returns to calculate the residual or growth assets cash flows to fully fund the residual liability cash flows that our CFM did not fully fund. From this matrix we can determine an accurate calculated ROA for the growth assets that should fully fund liabilities. Most often, this calculated ROA is lower than the ROA asset allocation currently used. This would suggest a more conservative and less risky asset allocation can be used to fully fund the residual liability cash flows.
In this way, the pension plan has secured benefits for the next 10 years with near certainty through CFM at a cost savings of approximately 20% while reducing the ROA needed for growth assets which should allow for a less risky and less costly asset allocation.
