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