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.