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

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.

Operation Home Run

Source: Operation Home Run

Pension Solution:Operation Home Run

The true objective of a pension is to secure and fully fund benefits in a cost-efficient manner with prudent risk. This is best accomplished through a cash flow matching (CFM) strategy using investment grade bonds to fully fund and match monthly benefit payments at low cost. CFM has several advantages of which we label four as “Operation Home Run”:

1.Liquidity

Liquidity is a critical and necessary priority of a pension since it must fund monthly benefits + expenses (B + E) on time. Many plan sponsors use a “cash sweep” or a cash allocation strategy to provide such cash flow. Both strategies are not optimal for a pension plan. A cash sweep usually takes income or cash flow from all asset classes to fund the current monthly B+E. This can severely damage the ROA of such asset classes. According to a research report by Guinness Global since 1940, dividends and dividends reinvested have accounted for 47% of the S&P 500 total return on a 10-year rolling period and 57% on a 20-year rolling period. So, this data questions the logic of a cash sweep that uses dividends to fund benefits + expenses (B+E). A cash allocation is usually low yielding + is close to a 1:1 relationship between present value and future value which is high cost. CFM will fully fund monthly B+E in a cost-efficient manner with yields of the average duration of the CFM.

2.Security

Pensions need to secure the benefit payments as a high priority. This is best accomplished through CFM which has the certainty of asset cash flows that fully fund liability cash flows on time with the correct amount. To our knowledge only bonds and annuities have certain cash flows. This is why bonds have been chosen as the appropriate securities to defease liability cash flows for decades.

3.Time

The greatest asset of a pension is time. Most pensions have long average lives. The best way to buy time is with a CFM strategy that will defease liabilities for as long a period of time as the plan sponsor wants. S&P data proves that the longer the time horizon the higher the total return of stocks… and most risky investments. Ryan ALM recommends a CFM strategy to fund at least 1-7 years.

4.Cost

The pension objective is a liability objective and cost objective. Since liabilities are future value costs, only a CFM or annuity strategy could fund liability cash flows with certainty. The Ryan ALM CFM model will reduce funding costs by about 2% per year (20% for 1-10 years of liabilities).

Conclusion

As a best-fit to achieve the true pension objective, Ryan ALM recommends our cash flow matching (CFM) strategy to fully fund B+E in a cost-efficient manner. Our CFM model will provide timely cash flows that will fully fund B+E at the lowest cost to our clients. The benefits of our CFM model are quite substantial:

• CFM will provide certainty of cash flows which eliminates liquidity risk.

• CFM secures the benefit payments through the certainty of its cash flows.

• CFM buys time. The longer the time, the greater the ROA for the growth assets.

• CFM is a cost optimization model that reduces funding costs by about 2% per year.

• CFM is an investment grade portfolio skewed to the longest maturities within the area it is funding (i.e. 1-5 years or 1-10 years) that should enhance the CFM yield versus the yield on cash reserves and active bond management.

• CFM reduces reinvestment risk if interest rates trend downward (as many expect).

As a solution, Ryan ALM recommends separating liquidity assets from growth assets in asset allocation. Let bonds in a CFM strategy be your liquidity assets for the advantages mentioned above. A CFM strategy will have a longer average duration and higher yield than cash thereby reducing the cost to fund B+E. In this way the liquidity assets and the growth assets are a team that will produce the optimal solutions.