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.

Cash… A Risky and Costly Investment For Pensions

Source: Cash…A Risky and Costly Investment For Pensions

Pension funds tend to have a cash portfolio, which is usually held by the custodian bank and often has an average maturity/duration of about 3 months. That cash “bucket” is meant to fund monthly benefits (and expenses). Any deficiency in the cash account to fund monthly benefits creates a cash sweep of other assets, including dividends and interest. This practice causes cash to be a risky and costly investment decision for the following reasons:

1. Reinvestment Risk – Pension liabilities (benefits and expenses) are monthly payments. It is rare that the allocation to cash matches the characteristics of the liability cash flows for the next 3 months. There could be either excess cash or an inadequate cash allocation. Excess cash has some reinvestment risk. A cash shortage usually requires the plan sponsor to sweep liquid assets from growth assets, including dividends and interest income, thereby creating a reinvestment drag or risk on future returns (ROA) of growth assets.

2. Opportunity Cost – Cash is usually the lowest yielding asset since the portfolio has a Treasury bias and maturities are short. This creates an opportunity cost when compared to cash flow matching (CFM) given the longer maturities and much higher yields.

3. Funding Cost – Funding liabilities with cash creates a pay-as-you-go strategy, which tends to be the highest cost strategy to fund liabilities. This is in direct contrast to a defeasance strategy using CFM to fully fund liabilities.

Solution: Cash Flow Matching (CFM)

CFM is designed to fully fund net liability cash flows in a cost-efficient manner. CFM skews the assets to the longer maturities within the maturity range it is funding. The Ryan ALM model (we call the Liability Beta Portfolio™ or LBP) is an investment-grade portfolio skewed to A/BBB+ securities. Bond math tells us that the longer the maturity and the higher the yield, the lower the cost. For example, if CFM is funding liabilities out to 10 years, it will have skewed the weights to the 5-10-year area. This means that 0-1 year liabilities are being partially funded by the cash flows of the longer maturities. The benefits of CFM as the liquidity assets are numerous:

1. Higher yield than cash, enhancing the probability of achieving the ROA.

2. Buys time for the alpha assets to grow unencumbered.

3. Reduces the cost of funding liabilities by about 2% per year.

4. Eliminates a cash sweep that significantly diminishes the ROA of growth assets.

5. Neutralizes interest rate risk since it is funding liability cash flows (FV numbers).

6. Enhances funded ratio/status since it outyields cash and traditional bond portfolios.

CFM should be the core portfolio and liquidity assets of a pension since it best represents the true client objective: funding benefits in a cost-efficient manner with prudent risk.

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

Pension Doctor: Specialist or Generalist?

Source: Pension Doctor: Specialist or Generalist?

When a person gets sick or has an injurythey go see a doctor. Usually, they prefer to see a Specialist who is the recognized expert on the ailment they have rather than a Generalist who has less expertise related to this particular medical condition. Well, the same should be true for pensions. If a pension plan needs a certain strategy to help enhance (cure) the funded status, they call in a specialist for that strategy.

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 advisors should be dialing up a risk mitigation specialist, such as Ryan ALM. For more than 50 years, our cash flow matching (CFM) strategy is the best fit and proven strategy for the pension objective. CFM provides an accurate and timely match of monthly asset cash flows to fully fund monthly liability cash flows. The CFM is a portfolio of investment grade bonds. 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 cash flow matching product is a cost optimization model that fully funds monthly liability cash flows at a cost savings of about 2% per year in this interest rate environment. We call our CFM model the Liability Beta Portfolio (LBP). The LBP should be the core portfolio of any DB pension and replace active fixed income management, which is highly susceptible to changes in rates. By matching and funding liabilities chronologically, the LBP buys time for the Alpha or performance assets (non-bonds) to grow unencumbered. By working in harmony with the Alpha assets the plan can gradually enhance its funded status and stabilize contribution costs. 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 (1-10 years)

• Buys time for performance assets to grow unencumbered

• Outyields active bond management… enhances 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

We urge pensions to use CFM as the core portfolio strategy to achieve their true objective. To our knowledge Ryan ALM is the only firm that specializes in CFM… our only product.

When is a Pension Fully Funded?

Source: When is a Pension Fully Funded?

The Funded Ratio tends to be the acid test and benchmark for funded status… but is it? We have written several research white papers (www. RyanALM/Research/White Papers) about the glaring issues with the Funded Ratio. Here are just a few of the inconsistencies with the Funded Ratio:

Actuarial Value versus Market Value

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. Market values are the better measurement of economic reality since you can’t spend actuarial dollars. As a result, this valuation difference can seriously distort the FR and FS calculation.

Present Value versus Future Value

Notably, the FR and FS are present value calculations. But pension liability cash flows (benefits + expenses (B+E)) are future value (FV) projections. Since the FV of most assets is not known this becomes a true pension conundrum. Bonds are the only asset class with a known and certain future value. That is why bonds have been the chosen asset class for defeasance, immunization and cash flow matching for several decades. The disconnect between PVs and FVs haunts pensions. The true objective of a pension is to secure and fully fund liability cash flows in a cost-efficient manner with prudent risk. As a result, the objective should be for asset cash flows to match and fully fund liability cash flows.So, when is a pension fully funded... when asset cash flows (future values) fully fund liability cash flows (future values). This is best accomplished thru cash flow matching and is best measured by the Asset Exhaustion Test.

Contributions = MIA

The FR and FS both ignore contributions as an asset. The truth is that contributions are future assets and should be a high consideration in any asset liability management (ALM). We recommend using the Ryan ALM modified Asset Exhaustion Test (AET) as the best way to measure the solvency and funding status of a pension. We take asset cash flows (based on a ROA) and compare them to NET liability cash flows (benefits + expenses – contributions) to understand if assets can fully fund the liability cash flows. We use a matrix of ROAs to determine what ROA is the best fit. This calculated ROA is in sharp contrast to the current ROA that is based on an asset allocation model that ignores the FR and FS. It is common that a pension plan with a 60% funded ratio and another funded at 90% have the same or similar ROA. How is this possible? Shouldn’t the 60% funded plan need assets to work harder? Yes, but that does not have anything to do with the current ROA calculation. Whatever shortfall there is in asset cash flows to fund liability cash flows (B+E) must be paid by higher contributions… this is not in the best interests of a pension plan and the sponsor’s budget. Clearly, the current ROA is not a calculated return based on the FR and FS that will guarantee a fully funded

status if achieved long-term… nor will it guarantee that contributions will go down. This has been a sad and costly trend for the last 25+ years.

Discount Rates

A most troubling issue is what discount rate to use. FASB and GASB tend to disagree on this.

FASB = high quality AA corporate zero-coupon yield curve

GASB = ROA

Since the ROA is a much higher rate (usually 100 to 200 bps) then liabilities would be priced at a much lower PV (12% to 24%). This would enhance the FR by 8% to 22%. Market rates are best in determining the market or economic value of liabilities. FASB 144 says it well:

“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 pension benefits when due. Notionally, that single amount, the projected 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. The determination of the assumed discount rate is separate from the determination of the expected rate of return on plan assets”

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 plan sponsor. 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 can 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 (AET) 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 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 and is a better fit than the current ROA. This would suggest 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 be the asset allocation model focus. We urge all pensions to incorporate this modified 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 (Alpha) 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 a 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 and replace active fixed income management. 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 should be 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 vs. 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.

What’s It All About? Liabilities!

Source: What’s It All About? Liabilities!

Most institutional assets are required to fund some type of liability objective (Pensions, OPEB, Lottery, Endowment & Foundation) yet liabilities tend to be missing in every function related to assets:

Asset Allocation – is focused on achieving an absolute rate of return (ROA) which has nothing to do with a liability objective. The proof: how could a 60% and a 90% funded pension plan have the same or similar ROA? Wouldn’t the 60% funded plan have to work harder? This common focus is really assets versus assets (as measured by some index benchmarks) and not assets versus liabilities.

Asset Management – most asset classes are given some generic index benchmark as their return focus. Obviously no generic index could ever represent the unique liability cash flows of each client.

Performance Measurement – once again we have assets versus assets (generic index benchmarks). If an asset class outperforms its generic index benchmark does that mean assets have outgrown liability growth? Of course not! This is again a complete disconnect which plaques most institutional comparisons.

Solutions:

Ryan ALM has developed a turnkey system of products that are a best fit to achieving the true liability objective of institutions:

Custom Liability Index (CLI) – In 1991, the Ryan team developed the CLI as the proper benchmark for any liability objective. The CLI is a monthly report that calculates what liability cash flows assets must fund. For pensions, this is usually the net monthly liability cash flows (after contributions). The CLI is in harmony with clients’ actuarial projections since that is the data used to construct the CLI.

Liability Beta Portfolio™ (LBP) – The LBP is our proprietary cash flow matching (CFM) model which will fully fund monthly net liability cash flows at a low cost to our clients. Usually, the LBP will reduce funding costs by roughly 2% per year (20% for 1-10 years). Our LBP is a good fit as the liquidity assets so there is no need for a cash sweep that takes income from all asset classes to fund benefits + expenses (B+E). Since the LBP is focused on liability cash flows (future values or FV) it mitigates interest rate risk as well because FVs are not interest rate sensitive.

Performance Attribution Report (PAR) – Our proprietary PAR product provides 14 risk/reward calculations of the LBP versus the CLI, providing even more evidence of value added (in addition to cost savings + mitigation of interest rate risk) since our LBP should outyield and outgrow the CLI.

Asset Exhaustion Test (AET) – Our AET will calculate the true ROA needed to fully fund net liability cash flows. Quite often this calculated ROA is much lower than the current ROA used for asset allocation. Developing an AET should be a first step in the asset allocation process in determining the allocation to the liquidity bucket (LBP assets).

Observations:

The intrinsic value in bonds is the certainty of their cash flows. Bonds are the only asset class with 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. The primary objective of a pension is to secure benefitsin a cost-efficient manner. Our CFM product (LBP) will secure and fully fund benefits by matching asset cash flows monthly versus liability cash flows. This matching process is done chronologically for as far out as the plan sponsor deems necessary.

Furthermore, it would be wise 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. This will buy time for the risky assets (Alpha) to grow unencumbered since you have certainty of the Beta assets’ cash flows for as long a period as you want. A study of S&P data by Guinness Global highlights that dividends and dividends reinvested account for about 47% of the S&P 500 total return on rolling 10-year periods dating back to 1940 and 57% for 20-year horizons. So why would you want to dilute equity returns with a cash sweep? Since we are dealing with net liabilities (after contributions) a 15% LBP allocation may fund liabilities out to 10-years or more, especially given the higher U.S. interest rate environment.

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

• Generic bond indexes cash flows look nothing like the projected benefit payment schedule

• This leads to a mismatch of cash flows and risk/reward behaviors… serious issues over time

• Alpha assets need time to perform without any dilution of their cash flows to pay benefits so they shouldn’t be a source of liquidity. Use CFM as the liquidity assets.

Logic:

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

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.

Operation Home Run

Source: Operation Home Run

Pension Solution:Operation Home Run

The true objective of a pension is to secure and fully fund benefits in a cost-efficient manner with prudent risk. This is best accomplished through a cash flow matching (CFM) strategy using investment grade bonds to fully fund and match monthly benefit payments at low cost. CFM has several advantages of which we label four as “Operation Home Run”:

1.Liquidity

Liquidity is a critical and necessary priority of a pension since it must fund monthly benefits + expenses (B + E) on time. Many plan sponsors use a “cash sweep” or a cash allocation strategy to provide such cash flow. Both strategies are not optimal for a pension plan. 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 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 benefits + expenses (B+E). A cash allocation is usually low yielding + is close to a 1:1 relationship between present value and future value which is high cost. CFM will fully fund monthly B+E in a cost-efficient manner with yields of the average duration of the CFM.

2.Security

Pensions need to secure the benefit payments as a high priority. This is best accomplished through CFM which has the certainty of asset cash flows that fully fund liability cash flows on time with the correct amount. To our knowledge only bonds and annuities have certain cash flows. This is why bonds have been chosen as the appropriate securities to defease liability cash flows for decades.

3.Time

The greatest asset of a pension is time. Most pensions have long average lives. The best way to buy time is with a CFM strategy that will defease liabilities for as long a period of time as the plan sponsor wants. S&P data proves that the longer the time horizon the higher the total return of stocks… and most risky investments. Ryan ALM recommends a CFM strategy to fund at least 1-7 years.

4.Cost

The pension objective is a liability objective and cost objective. Since liabilities are future value costs, only a CFM or annuity strategy could fund liability cash flows with certainty. The Ryan ALM CFM model will reduce funding costs by about 2% per year (20% for 1-10 years of liabilities).

Conclusion

As a best-fit to achieve the true pension objective, Ryan ALM recommends our cash flow matching (CFM) strategy to fully fund B+E in a cost-efficient manner. Our CFM model will provide timely cash flows that will fully fund B+E at the lowest cost to our clients. The benefits of our CFM model are quite substantial:

• CFM will provide certainty of cash flows which eliminates liquidity risk.

• CFM secures the benefit payments through the certainty of its cash flows.

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

• CFM is a cost optimization model that reduces funding costs by about 2% per year.

• CFM is an investment grade portfolio skewed to the longest maturities within the area it is funding (i.e. 1-5 years or 1-10 years) that should enhance the CFM yield versus the yield on cash reserves and active bond management.

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

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 and higher yield than cash thereby reducing the cost to fund B+E. In this way the liquidity assets and the growth assets are a team that will produce the optimal solutions.