Pension Conundrum: Same or Similar ROA

Source: Pension Conundrum: Same or Similar ROA

The Funded Ratio (FR) of a pension is usually based on the actuarial value of assets / actuarial value of liabilities. The Funded Status (FS) is the actuarial value of assets – actuarial value of liabilities. Actuarial values are different than market values… sometimes quite different. Notably, the FR and FS are present value calculations. But pension liability cash flows (benefits + expenses (B+E)) are future value (FV) projections. The disconnect between PVs and FVs haunts pensions. We have written several research papers about this glaring issue.

The return on assets (ROA) assumption is not based on the funded ratio or funded status. Instead, it is based on the expected return from the pension plan’s asset allocation. The same or similar asset allocation will produce the same or similar ROA focus. This brings up the question from my title – how could 60% and 90% pension funded plans have the same ROA? Shouldn’t the 60% funded plan require assets to work harder? Yes, but that does not have anything to do with the ROA calculation. Whatever shortfall there is in asset cash flows to fund liability cash flows (B+E) must be paid through higher contributions. As a result, the ROA is not a calculated return that will guarantee a fully funded status if achieved long-term… nor will it guarantee that contributions will go down.

Ryan ALM Solutions:

Custom Liability Index (CLI): The first step in prudent pension management is to calculate the liability cash flows that assets must fund. This should be a net liability cash flow (benefits + expenses – contributions). Until liabilities are monitored and priced as a Custom Liability Index (CLI) the asset side is in jeopardy of managing to the wrong objectives (i.e. ROA and generic market indexes). Only a CLI best represents the unique liability cash flows of a pension plan. Just like snowflakes, no two pension liability schedules are alike due to different labor forces, salaries, mortality and plan amendments. How could a static ROA or genericmarket indexes ever properly represent the risk/reward behavior of such a diverse array of pension liabilities? Once the CLI is installed, the pension fund will now know the true economic Funded Ratio and Funded Status, which should dictate the appropriate Asset Allocation, Asset Management, and Performance Measurement.

Asset Exhaustion Test (AET): GASB requires a test of solvency (asset exhaustion test) to document that the asset cash flows (at the ROA) will fully fund the net liability cash flows (benefits + expenses – contributions). GASB correctly understands that assets are funding net liabilities after contributions… and that contributions are future assets. This net liability is rarely shown or focused on by the asset side in asset allocation. Ryan ALM enhances the asset exhaustion test by calculating the ROA that will fully fund net liability cash flows. Usually, we find that a lower ROA can accomplish this goal than the current ROA target. This would support a more conservative asset allocation and a heavier allocation to fixed income to defease liability cash flows chronologically. This is a common and serious issue. This calculated ROA should drive asset allocation decisions. We urge all pensions to incorporate the AET before acting on asset allocation.

Liability Beta Portfolio™ (LBP):The intrinsic value in bonds is the certainty of its cash flows. That is why bonds have been used for decades to defease liability cash flows. The core or Beta portfolio for a pension should be in investment grade bonds that cash flow match and fully fund liabilities chronologically thereby buying time for the growth assets to outgrow liabilities and erase the deficit. The proper Beta portfolio for any liability objective should be… a Liability Beta Portfolio™. Ryan ALM has developed an LBP which will cash flow match liabilities chronologically and reduce funding costs by about 2% per year (1-10 years = 20%), as well as reduce the volatility of the Funded Status and contribution costs. The LBP should be the core portfolio of any pension fund and replace active fixed income management, which is subject to great interest rate risk. By matching and funding liabilities chronologically, the LBP buys time for the growth or Alpha assets (non-bonds) to perform. By working in harmony with the Alpha assets the plan can gradually enhance its funded status and reduce contribution costs.

Liability Alpha Assets: The non-bond assets are managed vs. the CLI to exceed liability growth (earn liability Alpha) and enhance the economic Funded Status. The goal here is outgrow liabilities in $s (relative returns) by enough to erase the deficit over a time horizon equal to the average life (duration) of liabilities (calculated by the CLI). As the Alpha assets achieve the required annual Alpha, any excess returns versus liability growth should be ported over to the Liability Beta Portfolio™ to secure the victory. Had this been in place during the decade of the 1990s when pensions had surpluses… there would be no pension deficits today.

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”

Ryan ALM, Inc. Celebrates 20th Anniversary

Source: Ryan ALM, Inc. Celebrates 20th Anniversary

Ryan ALM, Inc. Celebrates 20th Anniversary Mission: Protecting and Preserving Pensions

Ryan ALM, Inc. was incorporated in Delaware on June 15, 2004. Ronald J, Ryan, founder, says that “we created our company to be dedicated to asset liability management (ALM) as our name suggests. We are quite proud of our progress and achievements in ALM. We have built a turnkey system of products that are quite unique in the ALM industry that we treat as assets shown on our balance sheet, to include:

1. Custom Liability Index (CLI) – assets need to know what they are funding. Usually, it is monthly net liabilities (benefits + expenses – contributions). Such net liabilities are based on actuarial projections even though actuaries do not calculate net liabilities. The CLI is the proper benchmark for all LDI and ALM objectives. The CLI performs numerous calculations including present values, duration, growth rates, interest rate sensitivity, YTM, etc.

2. ASC 715 Discount Rates – Ryan ALM is one of few vendors providing ASC 715 discount rates in conformity to FASB. We produce four unique yield curves of AA zero-coupon corporate bonds. Usually, our discount rates are higher than our competitors providing for lower liability valuations and enhanced balance sheets.

3. Liability Beta Portfolio™ (LBP) – our asset management division, Ryan ALM Advisers, LLC, is entirely focused on cash flow matching as our only ALM product we call LBP. We feel strongly that our LBP provides the most benefits in harmony with the true pension objective of funding liabilities in a cost-efficient manner with prudent risk. Our LBP matches and funds monthly liability cash flows with certainty while reducing funding costs by 2% per year (20% on 1-10 year liabilities). Our LBP will outyield the CLI and enhance the ROA for bonds.

4. Performance Attribution Report (PAR) – given our CLI, we can calculate the relative risk/reward behavior of assets (as measured by our LBP) versus liabilities (as measured by the CLI). PAR calculates 14 risk/reward measurements including two graphs to clearly show the value added (or lost) of assets versus liabilities. This should be critical information for consultants and plan sponsors to understand how well the plan is being funded.

5. Asset Exhaustion Test (AET) – assets need to know the hurdle rate or ROA needed to fully fund net liabilities. The current ROA most pensions use is not an accurate calculation of a hurdle rate. Our AET clearly shows the annual difference of asset cash flows versus liability cash flows. We calculate a matrix of ROAs to arrive at the most applicable target ROA. Usually our calculated ROA (AET) is much different and lower than the current ROA since we focus on net liabilities not gross liabilities which reduces the liability cash flows assets need to fund (perhaps significantly).

We are very proud of our synergistic system and thankful for our team of experts with over 168 years of experience. Ryan ALM remains dedicated to achieving the true pension objective of funding liabilities with low cost and low risk.”

The Evolution of Asset/Liability Management

Source: The Evolution of Asset/Liability Management

CEO, Ryan ALM, Inc.

What Is Asset/Liability Management (ALM)?

The objective of most institutions in the United States with assets to invest is to fund some sort of liability, (banks, insurance companies, pension funds, etc.). As a result, asset/liability management (ALM) should be the investment focus and strategy for these institutions.

Banks and insurance companies have maintained this focus because it is required by the regulations under which they operate. The IAIS Standard No. 13 (2006), which is the basis for insurance company regulation in the United States, defines asset/liability management (ALM) as the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated.1 Oracle Financial Services (2008), in its white paper “Asset Liability Management: An Overview,” defines ALM for banks as a mechanism to address the risk faced by a bank because of a mismatch between assets and liabilities resulting from either differences in liquidity or changes in interest rates.

Indeed, as banks and insurance companies have practiced it, ALM is the management of assets so that asset cash flows are as similar as possible to that of the liability cash flows. Exley, Mehta, and Smith (1997) conclude in their paper “The Financial Theory of Defined Benefit Pension Schemes” that financial theory offers no good reason why ALM as practiced by pensions should differ from ALM by banks. They emphasize that the time has come to stop treating pensions as anything special. Pension liabilities are the same as any other liability. In a special LDI (liability-driven investing) issue of aiCIO Magazine, McDaniel (2011)

IAIS is the International Association of Insurance Supervisors. See http://www.iaisweb.com.

provides a well-documented history of LDI theory in his column “LDI’s Founding Document,” concluding that pension liabilities should be treated in the same way as bank and insurance liabilities, giving each a proper ALM focus.

The focus of this review will be the evolution of ALM for pensions. Pensions have no regulations requiring asset/liability management or the matching of assets cash flows to liability cash flows. This lack of regulation may be the most important cause of the spiraling pension deficits and decline of defined benefit plans since 1999.

Prehistory: Insurance Company Management of Pension Funds

In the decades before pension plan sponsors began to manage pension assets as quasi-independent investment organizations, it was typical for pension plan sponsors to simply pay an insurance company to assume the liabilities of the pension plan. The insurance company was then responsible for investing the assets while complying with then-current insurance regulations. By regulations, the insurance companies invested most of these assets in fixed-income securities, matching the cash flows from the assets to the cash required to be paid to the pension beneficiaries. This trend has existed from roughly 1875 when the first U.S. corporate pension plan (American Express) was established to today.

In the Beginning: Dedication

Dedication was the earliest form of ALM practiced by pension plans as quasi-independent investment organizations. It was in vogue during the historically high-interest-rate environment of the 1970s and early 1980s. Marty Leibowitz was the first to refer to cash flow matching as “dedication” because it required matching a stream of cash inflows (assets) to a stream of cash outflows (liabilities); each cash inflow was “dedicated” to paying a particular outflow. His work was initially published by Salomon Brothers in the 1970s, where he was managing director, and then (1986) as a series in the Financial Analysts Journal under the title “The Dedicated Bond Portfolio in Pension Funds.” Many authors have written about the pros and cons of dedication. Perhaps the most complete set of writings is offered by Frank Fabozzi (2005) in Dedicated Bond Portfoliosin The Handbook of Fixed Income Securities.

As interest rates rose in a long secular trend, the financial industry began to pay attention. Realizing that the high interest rates would allow them to lock in unprecedented rates of return, defined benefit pension fund managers embraced the concepts of dedication and then later immunization. Wall Street

broker/dealers, especially Salomon Brothers, with Marty Leibowitz as its intellectual leader, provided the complicated software models needed to execute dedication and immunization effectively. Many papers promoting and critiquing ALM strategies were written by quantitative scholars during this time. Times were also good for broker/dealers who could execute very large dedication and immunization portfolios. Perhaps the largest bond trades ever recorded were those done for dedication and immunization.

The dedication model assumed a 100% bond portfolio held to maturity. The quest was to find the least expensive collection of bonds that provided the needed cash flows over the time horizon of the liabilities to be funded. Dedication had several distinct advantages:

1. Simple asset allocation (100% bonds)

2. Mitigates interest rate risk since it is funding future values

3. Specificity (asset cash flows must match liability cash flows)

4. Predictable cash flows (when the bonds are held to maturity)

5. Structured management (more certain returns with lower fees)

6. Reduction of risk (interest rates, reinvestment, inflation, and liquidity)

Immunization Introduced as an ALM Strategy

In the 1980s when interest rates started a secular decline immunization became popular, which focuses on matching the interest rate movement of liabilities in present value dollars. The idea is to minimize the volatility of the surplus (the dollar value of assets minus liabilities) by having an asset duration equal to the liability duration. Duration is the present-value-weighted average time to receipt of the cash flows from a security or portfolio. Macaulay (1938), in his book entitled Some Theoretical Problems Suggested by] the Movement of Interest Rates, Bond Yields and Stock Prices in the United States since 1856,2 is credited with introducing the term “duration” and defining it as above. In 1942, Koopmans’s paper “The Risk of Interest Fluctuations in Life Insurance Companies” pointed out that if the duration of the bonds held in a portfolio were matched to the duration of the liabilities those bonds would fund, the effects of interest rate changes could be mitigated or nullified completely (i.e., the portfolio would be immunized).

This effort to define ALM strategies that would protect a portfolio from interest rate changes largely conducted by academics, culminated in a 1952 paper titled “Review of the Principles of Life-Office Valuations” by a nonacademic actuary, F.M. Redington, who worked for a British insurance company. He is credited with introducing the term “immunization” to signify the investment of assets in such a way that the existing business is immune to a general change in the interest rate.

As interest rates began to fall in early 1982, call risk surfaced as a serious impediment to immunization and dedication models, especially for those who ventured into mortgage-backed securities. This call (or prepayment) risk would alter cash flows and maturity structures, with resulting damage to the integrity of immunization and dedication models that depended on the certainty of these cash flows and maturity dates.

Accounting Rules Redirect Pension Asset Management

This FASB standard would help those designing immunization strategies to understand how to match the present value of liabilities. However, for pension expense purposes, the new statement allowed corporations to use the return on assets (ROA) assumption as follows: If the dollar growth in pension assets based on the ROA rate exceeded the pension expense amount, then pension expense would be negative—that is, it would become pension income which would directly enhance earnings. Because corporations are earnings led and not liabilities led, the ROA became the hurdle rate objective for pension assets.

When interest rates went below the ROA assumption rate (around 8%) in the late 1980s, dedication and immunization strategies fell out of vogue because they locked in a return that would not be sufficient to neutralize or overcome pension expense, resulting in a drain on EPS. As a consequence, dedication and immunization were largely replaced by surplus optimization strategies that aimed at the growth of pension assets to outpace liability growth, thereby creating a pension surplus that would reduce or even eliminate contribution costs. Contribution costs were a function of the funded status (the present value of assets minus the present value of liabilities). Any deficit or underfunding (a funded ratio less than 100%) was to be erased through contributions planned out over time so that the pension plan would be fully funded over the life of the liabilities.

The late 1980s and the decade of the 1990s were good times for pensions. With the switch to a surplus optimization strategy, asset allocation models were heavily skewed to equities over bonds because the ROA was now the “bogey,” or investment return benchmark. This asset allocation decision worked out well during this period; equities enjoyed several good years of double-digit returns, resulting in pension surpluses that enhanced EPS (returns above the ROA were an “actuarial gain” line item that increased EPS) and reduced contribution costs. During this period, ALM became a hard sell, given the level of interest rates, the historical return track record of equities, and the resulting financial statement benefits of an ROA hurdle rate. This focus on an absolute return (ROA) rather than on relative cash flows would soon haunt the pension industry and prove fatal to some plan sponsors.

The equity bear market that hit in 2000–2002 became a pension tsunami for several reasons. The correction was quite deep, amounting to a 49% fall in the S&P 500 Index, with the result that pension asset growth underperformed liability growth by as much as 75% on a cumulative basis over those three years. This event led to spiking contribution costs because of crashing funded ratios, an EPS drain from the pension assets underperforming the ROA (actuarial loss), and even insolvency of the plan sponsor, with several companies (notably airlines) filing for bankruptcy because pensions tend to be the largest liability of many firms.

The Society of Actuaries (SOA) became concerned that such an asset/liability disparity occurred as a result of accounting rules and it issued a research paper draft (2004) titled “Principles Underlying Asset Liability Management,” which warned that accounting measures can distort economic reality and produce reports that are inconsistent with economic results. It

further stated that entities that focus on economic value tend to achieve their financial objectives more consistently in the long run. In other words, the SOA promoted ALM on an economic basis (i.e., market value), rather than on an accounting basis, as the proper asset management style.

At that time, corporations were begging for relief from spiking pension contribution costs. Congress responded with the Pension Protection Act (PPA) of 2006. A number of pension experts provided testimony during the several-years-long process of writing the PPA. In my testimony before the ERISA Advisory Council on Employee Welfare and Pension Benefit Plans (2003), I recommended that liabilities should be priced at the market as a yield curve since liabilities are a term structure. In harmony with FAS 87 rules, I reminded them that the discount rate used should be one that settles the liabilities. I further proposed that as an acid test a rule should be created and enforced that reads, “If you cannot buy it, you cannot use it as a discount rate!”

1. a 24-month moving average of a three-segment yield curve and (

2. the current spot-rate yield curve. In both options, the yield curve was based on high-quality corporate bonds rather than Treasury bonds. In effect, the PPA raised discount rates which lowered the present value of liabilities, thereby enhancing the apparent funded ratio and lowering contribution requirements.

The FASB was also concerned that existing standards did not communicate the funded status on balance sheets, so in 2006 it issued Statement of Accounting Standards No. 158: Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (effective 2007). This communication, usually referred to as FAS 158, clarified that the discount rates used should correspond to the current market value of aportfolio of high-quality zero-coupon bonds whose maturity dates and amounts match the expected future benefit payments. This accounting standard also introduced Other Post-Employment Benefits (OPEB) liabilities onto the balance sheet, revealing that they are one of the largest liabilities facing U.S. institutions.

ALM Strategies Reborn as LDI

After the equity correction of 2000–2003, the stage was set for institutions to return to the basic practice of asset/liability management, because failure to do so had resulted in deteriorating funded ratios, large actuarial losses, spiking contribution costs and even bankruptcies. This time, however, ALM was more frequently referred to as liability-driven investing (LDI) to suggest a new, enhanced approach.

Because of the ongoing secular trend toward lower rates and the fact that the expected return on assets continued to be used to calculate pension expense, corporations continued to pursue an asset allocation away from bonds but with less equity concentration. This trend opened the asset allocation door to many new asset classes and strategies, including hedge funds, alternative investments, and new LDI strategies.

Frank Fabozzi, Ph.D. and I have written prolifically on ALM strategies and considerations. Fabozzi’s books are a mainstay for any ALM practitioner. His Bond Portfolio Management (especially the chapter “Managing Funds Against Liabilities”), published in 2001, and his Handbook of Fixed Income Securities (chapter on “Cash Flow Matching”), published in 2022, have become required reading. Fabozzi and I teamed up in 2005 to produce the article “Reforming Pension Reform,” proposing a solution to the growing pension crisis. Our solution starts with pricing liabilities at the market (economic value) and then building a custom liability index as the proper benchmark for pensions (or any liability-driven objective), because liabilities are unique to each pension plan. We later followed this article with “Liability Index Fund: The Liability Beta Portfolio” (2011), in which we argued that a liability index fund should bethe core portfolio and is the only correct beta portfolio for a pension with a liability objective. The liability beta portfolio is the proper form of ALM or LDI which cash flow matches liability cash flows at low cost. To create and maintain such a portfolio, a custom liability index is also required.

Waring and Siegel produced a detailed account of why saving defined benefit pension plans is a good idea in their 2007 paper “Don’t Kill the Golden Goose! Saving Pension Plans.” They conclude that the first element needed to manage a defined benefit plan is an “economic” view of the liability. The only risks that can be hedged through investment policy and strategy are those that are correlated with market returns of one kind or another. Accounting values are not hedgeable because they are smoothed and are not market values. In the face of a trend toward freezing defined benefit plans in favor of defined contribution plans, the authors argued that defined benefit plans are more cost effective and efficient than defined contribution plans.

Public pensions have the largest deficits and the lowest funded ratios, a result that may be attributable to the Governmental Accounting Standards Board (GASB) accounting rules, which smooth assets over five years and price liabilities at a ROA discount rate. Since 1999, this accounting practice has usually overvalued assets and undervalued liabilities versus economic values (market values). In my paper “The Public Pension Crisis” (2011), I described how the ROA discount rate misled pension trustees and consultants into making inappropriate asset allocation, benefit, and contribution decisions by thinking they were highly funded when they had true large economic deficits. All of these decisions are linked together. My solution to the public pension crisis starts with liabilities. I argued that until a Custom Liability Index (CLI) is installed as the proper benchmark priced as a yield curve of market rates, all asset allocation, budget, and contribution decisions are in jeopardy.

In conclusion, the true objective of a pension plan is to secure the benefits in a cost-efficient manner with prudent risk. This is best accomplished thru cash flow matching of the liability cash flows. A Custom Liability Index should also be installed as the proper benchmark so asset allocation can know the true economic funded status and performance measurement of asset growth versus liability growth can be accurately assessed.

“Insanity is doing the same thing over and over again and expecting different results” - Albert Einstein

Bibliography

Black, Fischer. 1980. “The Tax Consequences of Long-Run Pension Policy.” Financial Analysts Journal, vol. 36, no. 4 (July/August):21–28.

“I believe that every tax-paying firm’s defined benefit pension fund portfolio should be invested entirely in bonds (or insurance contracts). Although the firm’s pension funds are legally distinct from the firm, there is a close tie between the performance of the pension fund investments and the firm’s cash flows. Sooner or later, gains or losses in pension fund portfolios will mean changes in the firm’s pension contributions. Shifting from stocks to bonds in the pension funds will increase the firm’s debt capacity, because it will reduce the volatility of the firm’s future cash flows. Shifting from stocks to bonds will give an indirect tax benefit equal to the firm’s marginal tax rate times the interest on the bonds.” (p. 21)

Choie, Kenneth S. 1992. “Caveats in Immunization of Pension Liabilities.” Journal of Portfolio Management, vol. 18, no. 2 (Winter):54–69.

“Immunization requires that the value of assets and the present value of liabilities be the same, and that the interest rate sensitivity or duration of the assets be the same as that of the liabilities. The first issue in immunization is establishment of the appropriate discount rates to compute the present value and the duration of a liability schedule. The question of the appropriate discount rates for a given liability schedule has crucial ramifications for construction of an asset portfolio to immunize the liability stream.” (p. 54)

Collie, Bob. 2012. “LDI’s Journey toward Greater Customization.” aiCIO Magazine, vol. 4, no. 4 (LDI Special Issue):6–11.

“The basic initial steps of an LDI program are an increase in the portfolio’s sensitivity to interest rates and a reduction in equity holdings. These steps are similar no matter who is taking them. However, as the LDI program becomes more advanced and the link between the asset portfolio and the liabilities becomes stronger, a point is reached at which a greater degree of customization becomes necessary.” (p. 6)

Ehrentreich, Norman. 2009. “The Asset Return–Funding Cost Paradox: The Case for LDI.” Ehrentreich LDI Consulting & Research.

“Pension regulations of the 1980s have effectively removed incentives for corporate plan sponsors to overfund their pension plans. Now, equity based investing strategies sooner or later lead to large funding shortfalls, and the inability of most plan sponsors to close them immediately makes them persistent. Therefore, the most basic requirement for converting eventual higher asset returns into lower funding costs, i.e., having average funding levels of 100% or more, is regularly violated by most pension plans.” (p. 1)

Fabozzi, Frank. 2005a. “Dedicated Bond Portfolios.” In TheHandbook of Fixed Income Securities. 7th ed. New York: McGraw-Hill:1103–1117.

“The dedicated bond portfolio, as it is frequently called, is a strategy that matches monthly cash flows from a portfolio of bonds to a prespecified set of monthly cash requirements of liabilities. Cash matching or prefunding these liabilities leads to the elimination of interest-rate risk and the defeasance of the liability. Applications for the dedicated strategy include pension benefit funding, defeasance of debt service, municipal funding of construction takedown schedules, structured settlement funding, GIC matching and funding of other fixed insurance products.” (p. 1103)

Fabozzi, Frank, and Ronald Ryan. 2005. “Reforming Pension Reform.” Institutional Investor (January):84–88.

“Until pension liabilities are priced at the market, pension funds run the risk of an asset-liability disconnect. Liabilities should be priced off of a market yield curve. An ironclad pension accounting rule should be: If you cannot buy it, you cannot use it as a discount rate. Start with the Treasury zero-coupon yield curve. Use this yield curve to build custom liability indexes for each plan. Once a plan sponsor creates a custom index as a benchmark for liabilities, it can properly manage assets. Asset allocation and performance measurement models will be able to compare the growth and risk behavior of assets and liabilities by term structure. If assets are not measured against liabilities, they are likely to have the wrong index objective.” (p. 88)

Fabozzi, Frank, and Ronald Ryan. 2011. “Liability Index Fund: The Liability Beta Portfolio.” Journal of Financial Transformation, vol. 33 (December):29–33.

“For corporate defined benefit plans, only a CLI [custom liability index] is the appropriate asset benchmark for liability-driven objectives. With a CLI, Beta and Alpha portfolios are redefined and can work in harmony with the true objective. The asset management guidelines of a pension plan can then take into account the risk/reward behavior of the true economic objective in establishing investment policy, especially the liability Beta portfolio which should be installed as the core portfolio.” (p. 33)

“By definition, an index fund is the correct Beta portfolio that matches the index benchmark with such accuracy that the tracking error is nil with the Beta calculation at 1.00 and the correlation at or near 100. With a liability-driven objective, only a liability index fund could qualify as the Beta or matching portfolio. A liability index fund, by definition, requires an index that reflects a pension fund’s liability term structure. Since each liability structure is unique, this calls for the creation of a custom liability index (CLI). Until the asset portfolio’s cash flows match each monthly liability payment (i.e., liability term structure), the interest rate risk (systematic risk) that dominates the risk/reward behavior of pension liabilities cannot be hedged.” (p. 31)

Financial Accounting Standards Board. 1985. “Statement of Financial Accounting Standards No. 87: Employers’ Accounting for Pensions.” FASB

“Interest rates vary depending on the duration of investments; for example, U.S. Treasury bills, 7-year bonds, and 30-year bonds have different interest rates. … The disclosures required by this Statement regarding components of the pension benefit obligation will be more representationally faithful if individual discount rates to various benefit deferral periods are selected.” (paragraph 199)

“In making those estimates, employers may also look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits.” (paragraph 44)

Financial Accounting Standards Board. 2006. “Statement of Financial Accounting Standards No. 158: Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.”

“The objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due. Notionally, that single amount, the accumulated post-retirement benefit obligation, would equal the current market value of a portfolio of high-quality zero-coupon bonds whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments.” (paragraph 144a)

International Association of Insurance Supervisors. 2006. “Standard on Asset-Liability Management.” IAIS Standard No. 13

“This paper describes best practices for asset-liability management (ALM) that a well-managed insurer would be expected to follow and identifies 11 minimum requirements. Asset-liability management (ALM) is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. The objective of ALM is not to eliminate risk. Rather, it is to manage risks within a framework that includes self-imposed limits. The IAIS requires that insurers have in place effective procedures for monitoring and managing their asset-liability positions to ensure that their assets and investment activities are appropriate to their liability and risk profiles and their solvency positions.” (pp. 3, 5, 6)

Leibowitz, Martin L. 1986a. “The Dedicated Bond Portfolio in Pension Funds—Part I: Motivations and Basics.” Financial Analysts Journal, vol. 42, no. 1

“Dedicated bond portfolios allow a corporate pension fund to take advantage of favorable fixed income markets and the actuarial system’s willingness to provide special benefits for a minimum-risk investment approach. Purely as an investment approach, a dedicated portfolio serves as a least-risk asset, minimizing the risks involved in fulfilling a large class of nominal-dollar liabilities. Because the process is largely assumption-free, it provides the sponsoring corporation with an actuarially acceptable way to take advantage of available market interest rates to improve funding status.” (p. 68)

Leibowitz, Martin L. 1986b. “The Dedicated Bond Portfolio in Pension Funds—Part II: Immunization, Horizon Matching and Contingent Procedures.” Financial Analysts Journal, vol. 42, no. 2

“Immunization, horizon matching and various contingent schemes offer pension plan sponsors and managers an opportunity to minimize risk while retaining some degree of management discretion to pursue lower costs or higher returns. Immunization calls for the creation of a portfolio of bonds whose value coincides with the present value of a given schedule of liabilities and whose duration, or interest rate sensitivity, is the same as that of the liabilities. By specifying a minimum portfolio return somewhat below the available market rate, the manager can create a “cushion spread” that provides the basis for several contingent schemes. As long as the portfolio retains assets sufficient to meet the target return, it may be actively managed. When adverse market moves threaten this return, the portfolio must be converted into a dedicated mode that will assure the target return.” (p. 47)

Macaulay, Frederick R. 1938. Some Theoretical Problems Suggested by the Movement of Interest Rates, Bond Yields and Stock Prices in the United States since 1856. New York: National Bureau of Economic Research.

“The time to maturity is not an accurate or even a good measure of ‘duration.’ ‘Duration’ is a reality of which ‘maturity’ is only one factor. Whether one bond represents an essentially shorter or an essentially longer term loan than another bond depends not only upon the respective ‘maturities’ of the two bonds but also upon their respective ‘coupon rates’ and under certain circumstances, on their respective ‘yields.’ Only if maturities, coupon rates and yields are identical can we say, without calculations, that the ‘durations’ of two bonds are the same. The duration of a stream of payments may be thought of as the average life of the stream.” (p. 45)

McDaniel, Kip. 2011. “LDI’s Founding Document.” aiCIO Magazine, vol. 3, no. 2 (LDI Special Issue)

“The history of a formal LDI theory is littered, it seems, with false starts. Our conclusion is that, although historically a distinction has been drawn between asset and liability management by banks and pension funds, financial theory offers no good reason for this distinction. Time to stop treating pensions as anything special. They’re the same as any other liability—and time to show that on the balance sheet.” (pp. 8, 9)

Oracle Financial Services. 2008. “Asset Liability Management: An Overview.” Oracle White Papers (http://www.oracle.com/us/industries/financial-services/045581.pdf).

“Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating). The function of ALM is not just protection from risk. The safety achieved through ALM also opens up opportunities for enhancing net worth.” (p. 2)

Ryan, Ronald. 2003. “Testimony before the ERISA Advisory Council on Employee Welfare and Pension Benefit Plans.” U.S. Department of Labor

“Liabilities should be priced at the market as a yield curve. A rule should be created, or enforced, that reads: If you cannot buy it, you cannot use it as a discount rate! Bond indexes are market-weighted; they’re not liability weighted. Until a custom liability index is built for each pension plan, based upon the unique actuarial term structure of that plan, and priced off of real zero-coupon bonds, pensions are in jeopardy of managing to the wrong objective.” (p. 9)

Ryan, Ronald. 2011. “The Public Pension Crisis.” IMCA Investments and Wealth Monitor

“The solution to the public pension and budget crisis starts with liabilities. Until a custom liability index (CLI) is installed as the proper benchmark, all asset allocation, asset management, benefit and contribution decisions will be based upon erroneous and misleading calculations. The benchmark must be a CLI because no two pensions are alike due to different salaries, mortality and plan amendments.” (p. 30)

Society of Actuaries. 2004. “Principles Underlying Asset Liability Management.” SOA Exposure Draft

“Asset Liability Management is the ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities to achieve financial objectives, for a given set of risk tolerances and constraints. A consistent ALM structure can only be achieved for economic objectives. Various accounting measures are affected by rules that change the emergence of income and the reported book value of assets and liabilities. These measures can sometimes distort economic reality and produce results inconsistent with economic value. Because ALM is concerned with the future asset and liability cash flows, the natural focus of ALM is economic value. Entities that focus on economic value tend to achieve their financial objectives more consistently in the long term.” (p. 6)

Waring, M. Barton, and Laurence B. Siegel. 2007. “Don’t Kill the Golden Goose! Saving Pension Plans.” Financial Analysts Journal, vol. 63, no. 1

“The first element of ‘new’ technology needed to manage DB plan risk and cost is an economic view of the liability. The only risks that are helpful to know about are the risks that can be hedged through investing the assets. Such risks are those in the liability that are market related—that is, correlated with the returns of assets or indices available in the markets. Therefore, sponsors need to set aside the actuarial and accounting views of the liability and rediscount the cash flows at appropriate, market-related rates. Plus, they need to understand how these market-related values, economically sensible measures of periodic pension cost, and economically required contributions change as market interest rates change.” (p. 36)

Waring, Barton, and Duane Whitney. 2009. “An Asset–Liability Version of the Capital Asset Pricing Model with a Multi-Period Two-Fund Theorem.” Journal of Portfolio Management, vol. 35, no. 4 (Summer)

“The authors present a new capital asset pricing model (CAPM) that incorporates investors’ deferred spending plans, or ‘economic liabilities’—the underlying purpose behind all investments—and thus reveal a new risk-free asset, the investor’s liability-matching asset portfolio.” (p. 111)

Optimizing Asset Allocation

Source: Optimizing Asset Allocation

The asset allocation decision is the single most important asset decision since it affects all assets and the funded status of a pension plan. Strategic asset allocation (AA) takes a long-term view and establishes weights for each asset class in order to achieve the highest probability of earning the target return on assets (ROA). These weights tend to be static and not responsive to the funded status. Tactical AA is a short-term view that changes the strategic weights due to a market opportunity it is trying to capture. Responsive AA is when AA responds to the ever-changing funded ratio and funded status. Since the true objective of a pension is to secure benefits (liabilities) in a cost-efficient manner with reduced risk over time… responsive AA is the more appropriate methodology.

It should be obvious that a 60% and a 90% funded plan should have two very different asset allocations. But if they have the same or similar ROA they will have the same or similar strategic or tactical asset allocations. Focusing on the ROA has misled most plan sponsors down a return objective path instead of a liability objective direction. This ROA focused road has been a roller coaster of volatile funded ratios and spiking contribution costs.

Responsive AA requires accurate and current knowledge of the true economic funded status (assets MV / liabilities MV and assets MV – liabilities MV). This is difficult due to annual accounting and actuarial reports that are usually months delinquent and don’t calculate the economic market value of liabilities (i.e., GASB accounting). Assets need to know what they are funding (benefits + expenses). Assets need to outgrow liabilities to enhance the funded status, so assets need to know the market value and growth rate of liabilities. Assets need a scoreboard of asset growth vs. liability growth that is updated frequently to help them play the pension game.

Custom Liability Index (CLI)

The solution to the accounting and actuarial delinquent information is a Custom Liability Index (CLI). In 1991, Ron Ryan and his team invented the first CLI as the best representation of the true client objective. Although funding liabilities is the true objective, liabilities tend to be missing in action in asset allocation, asset management, and performance measurement. The reason for this disconnect is the absence of a Custom Liability Index (CLI) that monitors the present value, term structure, and risk/reward behavior of liabilities. Once a CLI is installed as the proper benchmark, then and only then can the asset side function effectively on asset allocation, asset management, and performance measurement.

Liabilities are like snowflakes… you will never find two alike. Pension liabilities are unique to each plan sponsor. As a result, only a Custom Liability Index could ever properly represent or measure these unique liabilities of any plan sponsor. A CLI should be calculated accurately and frequently so the plan sponsor and its consultant can be informed with timely data that can support the asset allocation decision. Assets need to know what they are funding. The economic truth is… assets fund the net liabilitiesafter contributions. Our CLI will provide both a gross and net liability valuation based on market rates (ASC 715 and Treasury STRIPS) as well as the discount rates that apply (ROA, ROA bifurcated with 20-year munis, PPA spot rates, and PPA 3-segment). The CLI will provide a monthly or quarterly calculation of the current present value of liabilities so the funded ratio and funded status can be updated… and a monthly or quarterly calculation of the liability growth rate so performance measurement of total assets vs. total liabilities can be assessed.

Since current assets fund net liabilities after contributions, current assets need to know the projected benefits, expenses, and contributions for every year as far-out as the actuary calculates such projections. Noticeably, contributions are a missing asset in the calculation of the funded ratio / funded status and usually play no role in the asset allocation strategy of most plan sponsors. Given the size of contributions today, it is critical that contributions should be a major consideration in the asset allocation strategy.

Asset Exhaustion Test (AET)

We commend GASB accounting for requiring a test of solvency whereby the plan’s actuary must calculate and present proof that projected benefits + expenses (B+E) will be fully funded from both a return on asset (ROA) assumption + projected contributions. If the assets fail this test, then the GASB ROA discount rate is bifurcated at the time that assets are exhausted, and liabilities are then discounted at a 20-year AA muni rate going forward. Ryan ALM modifies the AET to calculate the ROA needed to fully fund (B+E) – C. This calculated ROA should help AA understand the minimum ROA or target return needed to fully fund net liabilities. Asset allocation needs to know the hurdle rate that has to be achieved to fully fund B+E with help from contributions. Our experience has been that this calculated ROAis always much different than the normal ROA used today. Usually, it is a much lower ROA rate for plans that pass this solvency test since contributions are a major contributor while it could be much higher for plans that fail this test. We highly recommend that all pensions apply this modified AET test of solvency to provide AA with the proper ROA target return rate.

Asset Allocation (AA)

As stated previously, Asset allocation is the single most important asset decision as it controls the risk/reward behavior of 100% of the assets. Since it will greatly affect the funded ratio and funded status, the success or failure of the asset allocation strategy is the single most important asset decision. Pension consultants are very diligent in their AA recommendation for each client to achieve the ROA hurdle rate. It is our recommendation that the asset allocation strategy should be based on the funded ratio (present value of assets/liabilities), funded status (present value of assets – liabilities) and the modified AET with a calculated ROA. Logically, a large deficit status should have a more aggressive asset allocation strategy than one with a surplus or fully funded status. Unfortunately, the funded ratio tends to play little or no role in many asset allocation strategies today. Most often the asset allocation focus is on achieving the return on asset (ROA) assumption… an absolute return target.

Since the true plan objective is to secure benefits in a cost-efficient manner with reduced risk over time, asset allocation needs to be in harmony with this objective. We recommend that asset allocation separate assets into liability Beta and liability Alpha assets. The liability Beta assets are to secure benefits by cash flow matching liabilities through a structured bond portfolio (defeasance). This should be the core portfolio of the pension plan since it best represents the true objective. The liability Alpha assets job is to outgrow liabilities in $s to enhance the funded status such that contribution costs are reduced over the life of the plan. In order for contributions to be reduced, pension assets must outgrow pension liabilities in $s. A simple example might explain this better:

	Begin	Growth Rate %	Growth Rate $	End
Assets	$700m	7.50%	$52.5m	$752.5m
Liabilities	$1 billion	6.00%	$60.0m	$1.06b
Funded Ratio	70.0%			71.0%
Funded Status	-$300m			-$307.5m

In this example assets outgrew liabilities in % return (7.50% vs. 6.00%). But because the funded ratio/status was a big deficit of 30%, the asset $ growth was less than the liability $ growth ($52.5m vs. $60.0m). This created a larger deficit that requires a larger contribution. In order to maintain the funded status at -$300m would require asset growth of $60.0m or an 8.57% return.

Only with a CLI can the plan know the true economic funded status on a routine basis. With the synergy of liability Beta and Alpha assets, AA now has the proper structure to achieve the true objective. Based on the economic funded status AA can now determine the allocation between these two asset groups. With a modified AET, AA now knows the calculated ROA needed to fully fund net

liabilities. The plan return objective should be for assets to outgrow liabilities in $s… it is the relative $ returns that count not an absolute % return (ROA). Asset allocation models need to focus on enhancing the funded status by creating liability Alpha in $s… not an absolute % return target (ROA).

Asset allocation needs to be responsive to this ever-changing net funded ratio/status. Strategic and Tactical asset allocation do not respond to the funded status. A responsive asset allocation responds to the funded status through a process called Portable Alpha. If the liability Alpha assets exceed liability growth in $s (as measured by the CLI), a prudent discipline is to transfer (port) this excess $ return over to the liability Beta assets. This will secure more benefits and reduce more volatility on the funded status. Just like the gambler in Las Vegas… take your winnings off the table to reduce your risk of losing! Asset allocation needs to recognize and respond to the funded status. A Portable Alpha strategy does this as a procedure or discipline thereby protecting the plan, so it doesn’t become too risky or chase the wrong ROA objective.

Performance Measurement

In harmony with the true pension objective, assets need to be measured vs. the risk/reward behavior of the CLI. This should be the acid test of asset allocation. Total asset growth must outperform total liability growth in $s for the funded ratio and funded status to be enhanced. Without a CLI, such a measurement would be difficult and certainly not timely. Total asset growth should be measured and monitored vs. total liability growth routinely (quarterly) for every investment review meeting. However, liability growth and the current funded status are usually MIA. The CLI will correct this error of omission. A simple warning is applicable here: If you outperform the S&P 500 and any generic market index benchmark but lose to liability growth… the plan sponsor loses!

Obviously, there is no victory or liability Alpha earned if asset growth underperforms liability growth although traditional performance measurements vs. generic market indexes could suggest otherwise. All liability Beta and liability Alpha assets need to be in sync with the true objective of enhancing the funded ratio, the funded status, and reducing contribution costs.

Conclusion

Traditional asset allocation models are focused on achieving the ROA assumption. This is not the true or proper pension objective. Until a Custom Liability Index (CLI) is installed as the proper benchmark and an AET is performed, asset allocation will be disconnected from the true liability objective. Contributions should be a major consideration in the asset allocation process since they are a large future asset that enhances the funded status. Contributions are the first source to pay the current liabilities due each year, thereby reducing the liabilities current assets need to fund. This net liability needs to be calculated and monitored by the CLI on a frequent basis. Since full funding is the goal, asset allocation needs to know the annual hurdle rate or calculated ROA needed to reach this funding status. The modified AET will provide the calculated ROA needed to fully fund net liabilities (B+E) – (C). A Portable Alpha strategy will then rebalance the asset allocation accordingly by taking the excess returns over net liability growth as measured by the CLI (liability Alpha) and porting them over to the liability Beta assets. Performance measurement will then monitor total asset vs. total liability growth to verify that the pension plan is on the proper road to full funding.