What Do Pension Sponsors Want For Christmas?

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

Bond Yields… Caveat Emptor

Source: Bond Yields… Caveat Emptor

Most bonds are priced and traded on some yield calculation. These yield calculations are based on assumptions that are difficult, if not impossible, to achieve. For example:

Yield to Maturity (YTM) assumes you will reinvest every six months at the purchase YTM until maturity of the bond. How could this happen? Yields are changing every day, and will you reinvest exactly every six months into the same maturity and same YTM? Sounds like Mission Impossible! In fact, the reinvestment rate on any bond is based on the total return of what you reinvested into. Yes, it is possible to have a negative reinvestment rate if you reinvested into a security with a negative total return. Moreover, the longer the bond maturity… the more the reinvestment rate of return determines the yield or return to maturity. In truth, the basic value of the YTM is to determine a price for the security.

All other yields (yield to call, yield to average life, yield to worst, etc.) are based on assumptions that are most difficult to occur, if not impossible. The intrinsic value of most bonds is the certainty of their cash flows. This is what the smart investor should focus on and utilize. Remove the uncertainty that is embedded in all bond yield calculations. Bonds are the only asset class with this certainty of their cash flows. That is why bonds have been the logical choice for Dedication and Defeasance using Cash Flow Matching (CFM) strategies since the 1970s. Only CFM is a best fit for any liability driven objective (Endowments & Foundations, Lotteries, Pensions, OPEB, etc.). The primary objective of a pension is to secure benefitsin a cost-efficient manner with prudent risk. CFM will secure and fully fund benefits by asset cash flows matching and fully funding monthly liability cash flows chronologically for as far out as the plan sponsor deems necessary.

We believe that a best practice is to separate liquidity assets (liability Beta assets) from growth assets (liability Alpha assets). The Beta assets should be the bond allocation to cash flow match the net liability cash flows (after contributions) chronologically for a target horizon (we recommend 10 years). This will provide the time for risky assets (Alpha) to grow unencumbered since you have the certainty of the Beta assets cash flows for as long a period as you want. It would also be wise to take the Cash and Fixed Income allocation and apply it to a CFM allocation. Several pension plans do a cash sweep of all assets’ income to fund the monthly benefits and expenses. A study of S&P 500 data by Guinness Global has determined that dividends and dividends reinvested account for about 47% of the S&P 500 total return on rolling 10-year periods and 57% for 20-year time horizons. So why would you want to dilute equity returns by spending the dividend income? Let the cash + bond allocation fund the current monthly liability cash flows through our CFM model (Liability Beta Portfolio™ or LBP). Our LBP would match and secure benefits chronologically for as far out as the allocation of funds allows. Since we are dealing with net liabilities (after contributions) a 15% LBP allocation may fund liabilities out to 10-years. The Ryan ALM cash flow matching model is well tested showing a funding cost savings of about 2% per year or more for longer maturity programs (20% for 1-10 years) depending on the liability term structure.

The Ryan ALM LBP model is funding benefits (future values) which are not interest rate sensitive. This eliminates the largest risk in bonds. Our LBP model will usually outyield active bond managers by over 50 bps, which will also reduce costs.

Observations and Benefits of LBP:

• No change in Cash and Bond allocation

• No dilution of Alpha assets to fund B + E

• Reduces funding costs by about 2% per year

• Mitigates interest rate risk (funding future values)

• Secures + fully funds monthly B+E chronologically

• Eliminates the need for a cash sweep which dilutes equity returns

• LBP will out yield current bond managers and enhance the ROA

• Cash flow matching buys time for Alpha assets to grow unencumbered

Logic

Let the performance assets (Alpha assets) perform by growing unencumbered as the liquidity assets (Beta assets) provide cash flow sufficient to fully fund benefits plus expenses chronologically.

Problem/Solution: Asset-only Focus

Source: Problem/Solution: Asset-only Focus

Problem: Asset Only Focus on Asset Allocation

Solution: Asset Liability Management (ALM)

Most, if not all asset allocation models are focused on achieving a total return target or hurdle rate… commonly called the ROA (return on assets). This ROA target return is derived from a weighting of all asset classes forecasted index benchmark returns except for bonds which uses the yield of the index benchmark. These forecasts are based on some historical average (i.e. last 20 years or longer). As a result, it is common that most pensions have the same or similar ROA.

This ROA exercise ignores the funded status. It is certainly obvious that a 60% funded plan should have a much higher ROA than a 90% plan. But the balancing item is contributions. If the 60% funded plan would pay more in contributions than the 90% plan (% wise) then it can have a lower ROA. I guess the question is what comes first. And the answer is the ROA with contributions as a byproduct of the ROA. The actuarial math is whatever the assets don’t fund… contributions will fund.

If the true objective of a pension is to secure and fully fund benefits and expenses (B+E) in a cost-efficient manner with prudent risk, then you would think that liabilities (benefits + expenses) would be the focus of asset allocation. NO, liabilities are usually missing in the asset allocation process. Pensions are supposed to be an asset/liability management (ALM) process not a total return process. Ryan ALM recommends the following asset allocation process:

Calculate the cost to fully fund (defease) the B+E of retired lives for the next 10 years chronologically using a cash flow matching (CFM) process with investment grade bonds. CFM will secure and fully fund B+E of retired lives for the next 10 years. Then calculate the ROA needed to fully fund the residual B+E with the current level of contributions. This is calculated through an asset exhaustion test (AET) which is a GASB requirement as a test of solvency. The difference is GASB requires it on the current estimated ROA before you do this ALM process. Ryan ALM can create this calculated ROA through our AET model. If the calculated ROA is too high then either you reduce the allocation to the CFM or increase contributions or a little bit of both. If the calculated ROA is low, then increasing the allocation to CFM is appropriate. Running AET iterations can produce the desired or most comfortable asset allocation answer.

Cash flow matching (CFM) will provide the liquidity and certainty needed to fully fund B+E in a cost-efficient manner with prudent risk. The Ryan ALM model (Liability Beta Portfolio™ or LBP) will reduce funding costs by about 2% per year or 20% for 1-10 years of liabilities. We will use corporate bonds skewed to A/BBB+ issues. There has never been a bond default in the 20-year history of Ryan ALM.

Assets are a team of liquidity (bonds) and growth assets to beat the liability opponent. They should work together in asset allocation to achieve the true pension objective.

Problem/Solution: Generic Indexes

Source: Problem/Solution: Generic Indexes

Problem: Find Pension Liabilities in any Generic Bond Index

Solution: Custom Liability Index (CLI)

Pension liabilities are unique to each plan sponsor… different salaries, benefits, expenses, contributions, mortality, inflation assumptions, plan amendments, etc. In an effort to capture and calculate the true liability objective, the Ryan team created the first Custom Liability Index (CLI) in 1991 as the proper pension benchmark for asset liability management (ALM). We take the actuarial projections of benefits and administrative expenses (B+E) for each client and then subtract Contributions to calculate the true liability cash flows that assets have to fund since contributions are the initial source to fund B+E. We then calculate the monthly liability cash flows as (B+E) – C. The CLI is a monthly report that includes the calculations of:

• Net future values broken out by term structure

• Net present values broken out by term structure

• Total returns broken out by term structure

• Summary statistics (yield, duration, etc.)

• Interest rate sensitivity

The Ryan ALM CLI should be installed as the index benchmark for any bond manager as well as total assets. This should be the first step in asset management and asset allocation. The CLI can be broken out into any time segment that bond assets are directed to fund (i.e. 1-3 years, 1-10 years, etc.). Moreover, total assets should be compared versus total liabilities to know if the funded ratio and funded status have improved over time. If all asset managers outperform their generic index benchmarks but lose to liability growth rate (total return)… the pension plan loses and must pay a higher contribution.

Since the CLI is a monthly report, plan sponsors can compare assets versus liabilities monthly. There should never be an investment update of just assets versus assets (generic index benchmarks) which is common. It is hard to understand in today’s sophisticated finance world, that liabilities are missing as an index. The reason must be that it is extra work for each client. But it should be clear that no generic bond index could ever properly represent the liability cash flows that assets are required to fund. It is apples versus oranges.

“Given the wrong index benchmark… you will get the wrong risk/reward”

How Bonds Can Enhance the ROA

Source: How Bonds Can Enhance the ROA

Given the volatility and uncertainty of the financial markets, bonds can provide Pension Plan Sponsors a strategy to mitigate some of that volatility. Bonds, through the certainty of their cash flows, prove to be a very effective tool. Most pensions focus on earning the return on asset (ROA) assumption as the goal of asset allocation. Because bonds yield less today than the ROA (7.00% average) the asset allocation to bonds tends to be lower than historic norms. But there exists a bond allocation that could enhance the probability of achieving the ROA. Here’s how:

1. Cash Flow Matching – if bonds were used to cash flow match and fund net liabilities (after contributions) chronologically they would produce the liquidity needed to fully fund such net liabilities. Cash flow matching works best with longer coupon bonds where you use semi-annual interest income to partially fund liabilities. A 10-year bond has 20 interest cash flows + one principal cash flowall priced at a 10-year yield. Having this liquidity wouldeliminate the need to do a cash sweep from other asset classes which is a common liquidity procedure. According to Guinness Global, the S&P 500 has 47% of its historical returns from dividends and reinvestment since 1940 on a 10-year rolling period basis. Wouldn’t you want to reinvest dividends back into growth assets rather than spend it on funding benefits + expenses? By using bonds as the liquidity assets, the growth assets are left unencumbered to grow. The longer the cash flow matching period, the more time the growth assets have to compound their growth. This strategy and practice could significantly enhance the ROA.

2. Yield on Bonds – the asset allocation models forecast the return of each asset class in the model, then weight each asset class to get the derived ROA for total assets. The ROA for most asset classes is based on the historical returns of each asset class index benchmark except for bonds. The currentyield on the bond index benchmark(s) is usually used as the forecast for bond returns. The Bloomberg Barclay Aggregate is most favored as the bond index benchmark. This index was designed at Lehman Bros. by Ron Ryan when he was the head of Fixed Income Research & Strategy from 1977 to 1983. The Aggregate is a very large and diversified portfolio of bonds with the following summary statistics as of March 31, 2025:

# of issues	13,770	Treasury	44.79%	AAA	3.06%
YTM	4.51%	Agency	1.29%	AA	47.86%
Duration	6.08 yrs.	Mtg. Backed	24.85%	A	11.38%
Avg. Maturity	8.38 yrs.	Corporates	24.06%	BBB	11.43%
				NR	25.60%

As a result, most asset allocation models would have a ROA for bonds of about 4.50%. If you can build a bond portfolio that outyields the Aggregate index, by definition, it should enhance the ROA for total assets. Ryan ALM Advisers, LLC has created a cash flow matching product we call the Liability Beta Portfolio™ (LBP). The LBP is a cost optimization model that cash flow matches liability cash flows chronologically at the lowest cost from a corporate bond portfolio skewed to A/BBB bonds. Based on the actuarial projections of each client we initially build a Custom Liability Index (CLI) to calculate net liabilities ((benefits + expenses) – contributions) chronologically. The CLI provides all the data needed for the LBP to function efficiently. Based on the allocation to the LBP will determine how far out the LBP can fully fund net liabilities. Usually, a 15% allocation to the LBP can fund 1-7 or even 1-10 years of net liabilities. The longer the term structure of the LBP, the higher the yield. The LBP will roughly outyield the Aggregate index by 50 bps (1-5 years) to over 100 bps (1-10 years) based on the LBP term structure. If the LBP outyields the AGG index by 50 to 100 bps, asset allocation can afford to overweight the bond allocation and still meet the target ROA for total assets. A 15% allocation to LBP is 7.5 to 15 bps value added to the ROA.

3.Cash – many pension plans have a cash allocation of around 2%+. Cash is usually the lowest yielding asset. Since the LBP becomes the liquidity assets to fully fund benefits + expenses chronologically, there is little need for cash to fund B+E. Cash might only be needed for capital calls on Private Equity and Alternative Investments. The LBP should significantly increase the yield margin versus cash since the LBP is using A/BBB+ coupon income from all maturities of the LBP. With the LBP fully funding B+E, the cash allocation can be reduced to <1%. Replacing most of the cash allocation to fund B+E with the LBP allocation is another ROA enhancement… it all adds up.

Pension Conundrum - Liquidity Risk

Source: Pension Conundrum - Liquidity Risk

Liquidity is a critical and necessary priority of a pension fund, since it must fund monthly benefits and expenses (B + E) on time. Many plan sponsors use a “cash sweep” or a fixed cash allocation to provide such cash flow. Both strategies are not optimal for a pension plan.

Cash Sweep

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 found 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 B+E.

As a solution, Ryan ALM recommends that you use a cash flow matching (CFM) strategy to fully fund B+E. Our CFM model will provide timely cash flows that will fully fund B+E at the lowest cost to our clients. The benefits of CFM are quite substantial:

• Allows growth (non-liquidity) assets to grow unencumbered. Should enhance their ROA significantly.

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

• CFM will provide certainty (barring a default) of cash flows which reduces or eliminates liquidity risk.

• CFM is an investment grade portfolio skewed to the longest maturities within the area it is funding (i.e. 1-3 years or 1-5 years) that should enhance the CFM yield versus the yield on cash reserves.

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

Asset Allocation (AA)

Most AA have a cash allocation somewhere between 2% to 5%. Why? Normally you hear it is for liquidity purposes or even diversification. Cash is usually the lowest yielding asset especially when there is a positive sloping yield curve. Due to its very short maturities, cash is usually costing the plan close to a 1:1 cost ratio of present value to future value. The present value of a 3-month T-Bill will be quite close to its future value or a 1:1 ratio. While a CFM portfolio with a 3-year average maturity yielding 4.00% would have a 0.88:1 ratio for a cost reduction = 12%.

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 than cash thereby reducing the cost ratio. In this way the liquidity assets and the growth assets are a team that will produce the optimal solutions:

• Enhance ROA by eliminating a cash sweep so growth assets grow unencumbered.

• Reduce or eliminate liquidity risk by fully funding B+E monthly with certainty.

• Enhance the ROA by outyielding cash

• Reduce funding costs

Magnificent 7: Caveat Emptor!

Source: Magnificent 7: Caveat Emptor!

As pension watchdogs, Ryan ALM is always interested and concerned about trends that may affect the funded status of pensions. Since the major asset holding of most pensions is the S&P 500, we are on the alert for anything that may affect this valuable asset. I recently attended a CFA dinner where Rob Arnott, founder and chairman of Research Affiliates a subdivision of PIMCO was the guest speaker. Rob is quite articulate and brilliant on his assessments and forecasts. He was concerned about the valuation of the Magnificent 7 and thought the P/E multiples may not be sustainable. I share Rob’s concerns for the following reasons.

Apple became the first $3 trillion market valuation in America’s history. The seven largest capitalized technology stocks (i.e. the Magnificent 7) have been the main driver of returns for the S&P 500 for several years and certainly in 2023 YTD. As of December 1, this group had a total return = 98.79% based on the Bloomberg Magnificent Seven equal weighted index. At the same time the S&P 500 has a YTD return of 20.96%. According to BOA Global Investment Research, the Mag 7 account for 29.6% of the S&P 500 market capitalization. The newly released Bloomberg Large Cap index without the Magnificent 7 (B500XM7T) posted a YTD return of 7.6% which is 36.4% of the YTD S&P 500 return of 20.96%. This means that the Mag 7 has a YTD weighted group return of 13.33% which accounts for 63.6% of the S&P 500 YTD return (as of 12/01/23).

The Mag 7 should continue to grow well given their product line, market share, higher sales growth, higher margins, strong balance sheet and greater re-investment ratio in their market. The main question is one of valuation. Although it may be hard to assess a proper P/E multiple for each of the Mag 7, the wide array of P/E multiples and comparison to the market seem quite overvalued… S&P 500 multiple = 24.2x current and 18.7x forward (source: Yardeni). Tesla at 76.9x current/61.7x forward seems hard to justify especially with earnings growth of -6.1% over the last 12 months. Alphabet, Apple, Meta and even Microsoft trailing 12 months EPS growth do not seem robust enough to merit their valuation either.

Stock Symbol	Company	PE current	PE forward	Market Capitalization	EPS Growth 5-year Avg.	EPS Growth Last 12 mos.
GOOG	Alphabet	25.38x	19.80x	$1.66 trillion	25.4%	3.4%
AMZN	Amazon	76.69x	41.03x	$1.52t	63.0%	74.1%
AAPL	Apple	31.55x	27.16	$3.01t	14.4%	0.3%
META	META	28.10x	18.17x	$0.82t	8.9%	3.1%
MSFT	Microsoft	36.08x	28.76x	$2.77t	18.4%	10.5%
NVDA	Nvidia	61.48x	22.61x	$1.15t	27.7%	264.5%
TSLA	Tesla	76.87x	61.72x	$0.76t	40.5%	-6.1%
	S&P 500	24.2x	18.7x	$37.7t

Goldman Sachs Global Investment Research is forecasting a 6% growth for 2024 for the S&P 500. This does not validate the P/E multiples of the S&P 500.

“Investors should be skeptical of history-based models. Beware of geeks bearing formulas”

Warren Buffett

Ryan ALM Pension Monitor 3Q’22

Source: Ryan ALM Pension Monitor 3Q’22

‍(Through September 30, 2022)

Pension plan liabilities need to be measured and monitored regularly. Without knowledge of plan liabilities, the allocation of plan assets cannot be done efficiently or appropriately.

The funded ratio/status of pension plans are present value calculations. Each type of plan is governed by accounting rules and actuarial practices, which determine the discount rate used to calculate the present value of liabilities. Single employer corporate plans are under ASC 715 (FASB) discount rates (AA corporate zero-coupon yield curve); multiemployer plans and public plans use the ROA (return on asset assumption) as the liability discount rate. The difference in liability growth between these plans can be quite significant, which will affect funded status and contribution levels. The table below compares these different liability growth rates (based on a 12-year average duration) versus the asset growth rate using the P&I asset allocation survey of the top 1,000 plans which is updated each year. The graph below shows the contrasting annual differences of asset versus liability growth for corporate and public plans since 2015. The impact of different accounting rules is massive, especially during 2022’s rising rate environment.

ASSET ALLOCATION	YTD Return	Corporate	Public	Union
Domestic Stock International Stock Global Equity Domestic Fixed Income Global Fixed Income Cash Private Equity Real Estate Equity* Other	-23.9% -27.1% -25.3% -14.6% -21.3% 0.2% 11.6% 8.6% 9.1%	11.1% 6.5% 10.4% 46.7% 1.3% 2.0% 8.5% 4.1% 9.4%	24.4% 16.3% 5.3% 20.2% 1.7% 2.0% 12.7% 7.9% 9.5%	24.7% 8.6% 11.4% 28.0% 0.9% 0.6% 8.2% 9.3% 8.3%
TOTAL ASSETS Growth Rate		-12.0%	-11.9%	-12.9%
LIABILITIES Growth Rate*		-25.9%	5.6%	5.6%
Asset Growth – Liability Growth		13.9%	-17.5%	-18.5%

Index Benchmarks: Domestic Stock = S&P 500; Int’l Stock = EAFE, Global Equity = All Country World; Domestic Fixed Income = BB Aggregate; Global Fixed Income = FTSE World Gov’t (unhedged); Cash = 3 mo. T-Bill; Private Equity =10-year return for the R2500 + 2%; *Real estate Equity =NFI-DP Index (delayed one month); Alternative Investments and Other = CPI-U & 3%.

*Liabilities = Ryan ALM Custom Liability Indexes (CLI)

Footnote: The measurement of asset growth to liability growth is an annual calculation beginning on December 31, 2015. For periods shorter than 1-year, the observation is a YTD calculation.