What Do Pension Sponsors Want For Christmas?

Cash Flow Matching
Written By Ronald J. Ryan, CFA - Chairman

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

Ronald J. Ryan, CFA - Chairman

Ron Ryan is Chairman and Founder of Ryan ALM, Inc., which he established in 2004 to help pension plans reduce cost and risk through liability-focused solutions. A pioneer in fixed-income indexing, Ron previously founded Ryan Labs and Ryan Financial Strategy Group and served as Director of Fixed Income Research at Lehman Brothers Kuhn Loeb, where he helped design many of the firm’s widely used bond indexes. His career has been recognized with numerous industry honors, including the William F. Sharpe Indexing Lifetime Achievement Award. Ron is also the author of The U.S. Pension Crisis and holds the CFA® designation, an MBA, and a BBA from Loyola University.

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