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.

Pension Solutions Series Part 3 - Asset Exhaustion Test (AET)

Source: Pension Solutions Series Part 3 - Asset Exhaustion Test (AET)

Pension Solution: Asset Exhaustion Test (AET)

The primary pension objective is to secure promised benefits (Retired Lives) in a cost-effective manner (stable to lower contribution costs) with prudent risk. In our last Pension Solution blog, we explained that this is best accomplished through cash flow matching with fixed income… hopefully through our Liability Beta Portfolio™ (LBP). We recommend that our LBP should fund the first 10-years of NET Retired Lives (after Contributions). This buys time for the Alpha assets (performance assets) to grow without being diluted to fund any benefits. This leaves the residual liabilities to be monitored and funded through Alpha assets. As a result, the Alpha assets need to know their target ROA that will fully fund residual liabilities. This requires an Asset Exhaustion Test (AET).

Asset Exhaustion Test (AET)

GASB 67/68 requires an AET. We recommend this test for all pension plans. The AET requires projected contributions be subtracted from projected benefits to get a net liability schedule. The assets are then grown at an actuarial driven ROA to see if they fully fund these annual net liabilities. If the assets are exhausted, GASB requires the discount rate to be bifurcated and the area of future deficits to be discounted at the AA muni 20-year index rate. We have always recommended a market rate to discount all liabilities to calculate the true economic present value of liabilities so the economic funded status can be known. We also recommend that contributions be included as an asset or liability offset in the funded status calculation.

Ryan ALM modifies the GASB AET into a matrix that calculates the ROA needed to fully fund the net liabilities to be fully funded by the Alpha assets. Asset allocation needs to know its target ROA in order to function efficiently. A 5.27% ROA should have a different asset allocation than an 8.23% ROA. Since contributions are included in the ROA as an asset or liability offset, the calculated ROA is way lower than without contributions included. The point here is that assets need to know what their required hurdle rate is… or target ROA. Without this calculation, asset allocation is misaligned and may invite more risk into the equation than needed. A calculated ROA should be a requirement for asset allocation.

Ryan ALM, Inc. is an asset/liability manager specializing in cash flow matching thru a proprietary cost optimization model called the Liability Beta Portfolio™.

Becoming Liability Aware

Source: Becoming Liability Aware'

A Strategy For Improved Pension Funding

The Objective in managing a defined benefit plan is to fund benefit payments (liabilities) in a cost effective manner and to reduce risk over the long term.

The Process to improve funding starts with becoming more liability aware, and it includes the following steps / products to assist the sponsor in meeting the Objective.

Price your liability - ASC 715 Discount Rates

Provide a series of yield curves that conform to ASC 715. Price Waterhouse is a major subscriber. Ryan ALM discount rates consistently out-yield Citigroup’s rates.

Measure your liability - Custom Liability Index (CLI)

CLI provides all calculations needed to measure and monitor the PV risk/reward behavior of liabilities including: growth rate, statistical summary (YTM, Duration, etc.) and interest rate sensitivity. We will create both a gross and net CLI (after Contributions). The CLI is the proper benchmark for pensions.

Monitor your liability - Asset / Liability Summary

Based on the CLI calculations, we will create a summary page to clearly show the difference between gross and net CLI, the present value difference between discount rates, and the growth rate of the plan’s liabilities.

Will the plan go broke? - Asset Exhaustion Test (AET)

The AET will calculate when the current assets are exhausted and can no longer fund benefit payments. The AET includes all cash flows from current assets and the projected contributions. We will run a matrix of asset growth rates to calculate the proper ROA needed to fully fund liabilities.

Set the glide path - Allocation of Assets to Beta (insurance) and alpha (growth) The output from the CLI and AET will highlight that portion of the assets that can be allocated to beta versus alpha. This bifurcated approach is unique relative to single asset allocation strategies, and it is dynamic in its response to changes in the funded ratio / funded status.

Begin to de-risk the plan - Liability Beta Portfolio (LBP)

The LBP is a fixed income portfolio designed to cash flow match and fund the projected benefit payment schedule at the lowest cost to the plan. The LBP is a cost optimization model that should reduce funding costs versus the ASC discount rates using investment grade bonds.