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: 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”

The Smartest Beta

Source: The Smartest Beta

The term “beta” is credited to William F. Sharpe, Ph.D. in his 1964 work in development of the “Capital Asset Pricing Model (CAPM)”. It means (1) the covariance of the return on a security or portfolio with that of the market portfolio divided by (2) the variance of the return on the market portfolio. Professor Sharpe originally called this “market sensitivity” since you are comparing an investment to the market as defined by a market index. A beta of 1.0 suggests you have no residual risk in that you match the risk/reward behavior of the market index you are being compared against. Ideally, a market index fund should consistently have a market beta of 1.0.

Beta is a measurement based on a market or objective index. Without the index benchmark there is no applicable beta calculation. Traditionally, this has been the popular index benchmarks (i.e. S&P 500, Lehman Aggregate, etc.) but in truth it can be any index that best represents the objective of such funds (i.e. ETFs, index funds). Back in 1964 there was the absence of market indexes so beta was limited mainly to a measurement versus the S&P 500. The first bond index was introduced by Kuhn Loeb in 1973 (merged into Lehman in 1977). Since the advent of ETFs in 1993 there has been numerous new indexes created to feed the explosive growth of ETFs. Such new indexes are the stated objective of these many new ETFs.

Smart Beta

Smart beta is the optimization of the risk/reward behavior of a market index usually by changing the weights. Popular smart beta weighting schemes have been: fundamental weighting, equal-weighting, risk-clusters, and diversity weighting (combines equal and cap weighting). By changing the weights methodology the goal is to enhance returns or reduce volatility or both. Smart beta products have grown well in a short period of time but for the most part are still equity index derivatives. Rob Arnott and Research Affiliates, LLC have been a leader here introducing fundamental weighting for both bond and stock indexes as risk/reward value-added.

There is debate as to whether changing the weight methodology of a market index is really active management or an alpha strategy rather than a beta strategy or discipline. My recommendation is that the objective decides what is beta and alpha. What is important is to have the objective defined by a rules based index. If this reweighted index is the stated objective of an ETF, mutual fund or client then beta is the portfolio that matches the risk/reward of this objective index version. It also follows that alpha is the excess return versus this modified index objective. All comparisons to the traditional generic market index are just good information to know but do not determine the alpha and beta calculations.

Liability Beta Portfolio (The Smartest Beta)

The “smartest beta” portfolio is the portfolio that best matches and achieves the true client objective with the least amount of risk and cost. Risk is best measured as the uncertainty of achieving the objective. Cost is the amount required to fund the objective. The true objective of most institutions and even individuals is some type of liability (annuities, banks, insurance, lotteries, NDT, OPEB, pensions, etc.). The absolute level of volatility of returns is not risk given a liability objective. Indeed a 10-year liability payment is best matched and funded (defeased) by a 10-year Treasury STRIPS which has a certain future value. A three month T-bill would be very risky given this liability objective as it has 39 reinvestment moments of uncertainty. Although the 10-year Treasury STRIPS would be much more volatile in returns, such a return pattern would match the present value behavior of the 10-year liability and thus be low risk or even risk-free (defeasance).

Given a liability objective it is critical to create a custom liability index (CLI) as the proper benchmark. It must be a custom index since liabilities are like snowflakes… you will never find two alike. The CLI is a portfolio of liability payments weighted by the schedule of payments (term structure). Most institutional liabilities are calculated by actuaries who produce an actuarial projection of the liability payment schedule for each client. As such, the CLI is weighted by the actuarial projection in present value dollars. To calculate the present value of each liability payment you need to price liabilities based on a yield curve of discount rates. Depending on the type of liability there are accounting rules (ASC, FASB, GASB, IASB, PPA, etc.) that dictate the discount rate methodology.

Most, if not all, liabilities are priced as zero-coupon bonds since they produce a certain future value. Using U.S. corporate pensions, as an example, they are regulated by ASC 715 (formerly FAS 158) for GAAP accounting purposes. These rules suggest pricing liabilities as if they were AA corporate zero-coupon bonds. Since such bonds are not available in the bond market, they have to be manufactured as hypothetical zero-coupon bonds. As a result, liabilities behave like a yield curve of zero-coupon bonds weighted by the actuarial projections. This means that pension liabilities are extremely interest rate sensitive.

The CLI should calculate all of the necessary statistics to maintain and monitor a liability beta portfolio: term structure weights, total present value, YTM, duration, growth rate, interest rate sensitivity. The CLI is also the proper benchmark to measure liability alpha. If equity assets outperform the S&P 500 but underperform the CLI growth rate… did you earn alpha? In the eyes of the client you lost to liability growth which will damage the funded ratio (assets/liabilities), credit rating and increase contribution cost. Liability alpha is the excess return versus the CLI return (growth rate) and not versus a market index return. Based on Ryan ALM indexes, liability YTD returns through November 30 should be between 12.7% (10-year duration) and 22.2% (15-year duration). Hard to believe that any pension has earned liability alpha so far in 2014.

The key point here is that the client objective is truly the focus and determinant of relative risk and reward (beta and alpha). The client objective is to fund liabilities in such a way that risk and cost are reduced and stable over a long horizon. Given a long average life (duration) based on the liability payment schedule then the liability beta portfolio needs to match these term structure weights. An S&P 500 index fund or any generic market index fund could never represent the beta portfolio for a liability driven objective. Cash or a money market fund is a very risky investment for most liability objectives that have long average lives (duration).

The most appropriate and smartest beta portfolio is the one that matches the liabilities cash flow as measured by the CLI. In essence, the smartest beta portfolio is a custom liability index fund. Such a portfolio should be the core portfolio for any liability objective. By matching the liability term structure the uncertainty risk of matching liabilities is eliminated and interest rate sensitivity is neutralized. By matching the liability term structure with bonds that have higher yields and lower present values (price) than the discount rates used… you have reduced costs. Since the accounting rules (ASC 715, IASB, and PPA) use AA zero-coupon discount rates then a liability beta portfolio of A and BBB will produce higher yields and lower costs. This should provide significant cost savings of 10% to 15%. This matching process is called cash flow matching. Beware of duration matching strategies (i.e. immunization) which do not match the liability cash flows but just the average duration. This is not an accurate or cost effective way to match liabilities. The smartest beta portfolio is a liability cash flow matched portfolio!

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.

Liability Beta vs. Market Beta

Source: Liability Beta vs. Market Beta

Beta is a term first pioneered by PhD. William Sharpe in his 1970 book “Portfolio Theory and Capital Markets”. Here he introduced his famous capital asset pricing model (CAPM) which presented the idea that individual investments contain two types of risk: Systematic and Unsystematic risk.

Systematic risk was deemed to be market risk that cannot be diversified away while unsystematic risk was deemed to be the specific risk of that investment (i.e. credit, features, etc.) that can be diversified away through adding other investments to the portfolio. Modern portfolio theory (MPT) shows that unsystematic risks can be removed or reduced through portfolio diversification. The problem that remains is that of market risk.

The Notre Dame fixed income indexes study of 1986 proved that the market risk for bonds is interest rate risk which is quite dominate. Their calculations showed that interest rate risk explained or accounted for 96% plus of the total return for the major bond index aggregates. This study further proved that interest rate is best measured by a yield curve that is well diversified by maturity or duration (term structure). Any bond index that does not have a distinct term structure is not a good measurement of bond market risk.

Through time, it became obvious how difficult it was for active management to consistently outperform a market index as a benchmark (especially after fees). This led to Index Funds as a major asset management style. The growth in this form of asset management has been dramatic especially when including the explosive growth of exchange traded funds (ETFs).

With the advent of Portable Alpha as a strategy, assets are divided into two groups: Alpha and Beta. A Portable Alpha strategy transfers (ports) the excess return (Alpha) over to the Beta portfolio to secure the victory. The Beta portfolio is considered the portfolio that matches the objective as an index benchmark (i.e. Index Fund) and Alpha is considered the portfolio that outgrows (excess return) the index objective.

Given the currentasset liability management(ALM)or liability driven investment (LDI) trends, it has become obvious that the true objective of a pension is to fund a liability schedule unique to each plan sponsor. Since the objective of a pension (and most institutional objectives) is liability driven shouldn’t the terms Beta and Alpha be redefined for any LDI objective. After communication with PhD. William Sharpe years ago, he suggested I qualify my research as Liability Beta and Liability Alpha to distinguish it from market beta and market alpha. I agree, that makes good sense.

Market Beta and Alpha

Most asset managers are given an index bogey or objective that best represents the asset class risk/reward behavior that the client has chosen as the objective of such asset allocation. Asset consultants are quite diligent in selecting and monitoring the asset managers to perform under these index objectives. The goal could be to either match the risk/reward behavior (Beta portfolio or index fund) or outperform the return behavior (earn Alpha). A few good questions here are: if your asset managers earn market Alpha, does that mean they earned liability Alpha? If all asset managers outperformed their index bogey but total assets underperformed liability growth, did the client win or lose? Did asset allocation create value added (Alpha)?

Liability Beta and Alpha

Several strategies exist to match pension liabilities (cash flow matching, duration matching, derivatives, interest rate swaps, etc.). These liability Beta portfolios are to match the liability cash flow schedule (cash flow matching) or interest rate sensitivity of liabilities (duration matching) or both. Liability Alpha is rarely a consideration yet this is how a pension improves its funding status and reduces pension costs (i.e. contributions). In the end, total assets must outgrow total liabilities over time to earn liability Alpha thereby enhancing the funded status and reduce pension costs.

Custom Liability Index

Given any liability driven objective, the proper index benchmark should be a Custom Liability Index (CLI) that best measures the size, shape and risk/reward behavior of these client specific benefit payment schedules. The Ryan ALM CLI is a monthly report that calculates the present value, growth rate and interest rate sensitivity of liabilities. Client liabilities are like snowflakes… you will never find two alike. Only a CLI could accurately represent the true pension objective. It should be obvious thatthe true objective of a pension is to fund their liabilities in a cost-efficient manner with prudent risk. It is difficult, if not impossible, for asset liability management (ALM) to function effectively without proper knowledge of the liability cash flows. In sports, the scoreboard dictates the strategy. The CLI is the pension scoreboard for liabilities. When compared to assets, the plan sponsor knows every month if they are winning or losing the pension game.

Current accounting rules and actuarial practices price liabilities as a zero-coupon bond portfolio at a single discount rate on an annual basis, months delinquent where the liability cash flow schedule (annual projections of benefits) is rarely seen. Moreover, this single discount rate may not be a market rate (GASB for public plans uses the ROA). Could any asset manager perform versus a generic market index if it came out annually, months delinquent where the index portfolio was not transparent and all issues were priced at the same yield? Sounds ridiculous … well, welcome to the current pension liability world we live in.

The Society of Actuaries (SoA) in their 2004 research paper addressed this situation citing that current accounting rules distort economic reality and urged pensions to create a set of economic books that price liabilities at the market on a frequent and accurate basis. Such economic books are best created and maintained as a Custom Liability Index. Indeed, until a Custom Liability Index is installed, the asset side cannot function effectively towards a liability objective. How could an asset allocation model function without correct input as to the true economic Funded Ratio (assets/liabilities) and the size of the economic deficit or surplus (funded status)? How could performance measurement be calculated quarterly without knowledge of the true economic liability growth rate (total return)? How could you match and fund assets to liabilities without a Custom Liability Index?

I designed the CLI over 32 years ago as the best representation and benchmark for any liability objective. The CLI is a monthly report that prices liabilities at the market (using either the Ryan ALM ASC 715 (AA corporates) discount rates or US Treasury STRIPS). The CLI calculates the true economic present value of liabilities and their growth rate so the funded status and performance measurement of assets versus liabilities can both be ascertained.

Lehman Aggregate and Generic Bond Indexes

As the designer of many of the popular Lehman bond indexes (now Bloomberg Barclay’s), I am honored by the acceptance of these bond indexes. However, it should be obvious that they do not behave like liabilities. All of the popular generic bond indexes are rules based. Such rules only use coupon bonds and do not have zero-coupon bonds. Mathematically, the longest duration of any coupon bond is around 17 years today. As a result, such bond indexes could not be a proxy for long duration liabilities or match these liabilities as an index fund. Furthermore, most pensions are weighted to long durations with an average pension fund in the 10 to 15-year average duration area. The Bloomberg Barclay’s Aggregate’s average duration is usually between four to five years … a definite mismatch to pension liabilities cash flow. Even the long Corporate or Credit index cannot match liabilities. It has two distinct rules based problems. First, it has no issues shorter than 10 years in maturity which leaves out a large and most important segment of liability cash flows. Second, it has no issues with durations longer than 17 years. This is an inappropriate proxy for any pension’s liabilities. It is not the average duration you are trying to match and monitor but the entire liability term structure (liability cash flows). Once again only a Custom Liability Index is the proper fit as a liability benchmark.

Liability Beta Portfolio™ (LBP)

If the Beta portfolio is the portfolio that matches the index objective (Index Fund) then given a liability objective, the proper liability Beta portfolio is … the portfolio that matches the liability objective (Liability Index Fund). To be accurate, you must fund each monthly liability payment.

The Ryan ALM LBP is a cash flow matching portfolio that matches and funds monthly liability cash flows chronologically. Our LBP is a cost optimization model that will produce the optimal lowest cost portfolio to fund the target liability cash flows. Our LBP should reduce funding costs by about 2% per year (1-10 year liability schedule = 20% funding cost savings)! Moreover, the LBP will outyield the CLI thereby providing liability Alpha similar to the yield difference which enhances the funded status. The Ryan ALM LBP should also mitigate interest rate risk (similar duration and term structure matching) and reduce pension expense, the volatility of the funded status and contributions.

The intrinsic value in bonds is the certainty of their cash flows. We urge pensions to use bonds for their value… to match bond cash flows that fund liability cash flows. We do not view bonds as performance vehicles or Alpha assets. They are best as liquidity assets to fund liabilities as they come due. By bifurcating liquidity assets from growth assets (Beta vs. Alpha assets) you BUY TIME for the Alpha assets to grow unencumbered. Many pensions use a “Cash Sweep” where they take away income from all asset classes to fund benefits + expenses (B+E). According to S&P 500 data, dividends reinvested accounted for: 47% of rolling 10 years returns since 1940. So let the bond allocation (liquidity assets) fund B+E which will buy time for the Alpha assets to grow significantly more.

“An error is not a mistake until you refuse to correct it” John F. Kennedy

How To De-risk a Pension

Source: How To De-risk a Pension

Risk is best defined as the “uncertainty” of meeting the client objective. The pension objective is to fund liabilities in a cost-effective manner such that contribution costs remain low and stable. Pension plans also want to de-risk their plans over time. The lowest risk assets for a pension are those that match the liability benefit payment schedule with certainty. By definition, Treasury zero-coupon bonds (STRIPS) and annuities would be the lowest risk assets for pension since they have a known future value… but they tend to come at a high cost since they are low yielding (STRIPS) or have high fees (annuities). Given that the pension objective is to secure benefit payments in a cost-efficient manner, then solving for cost while matching and fully funding the liability payment schedule would be the ideal way to de-risk a pension.

A pension liability benefit payment schedule is a term structure or yield curve often referred to as the liability cash flow. In order to match or de-risk each pension liability payment requires a matching cash flow from assets. Only bonds (and annuities) produce a certain cash flow. That is why bonds have been used for decades as the best way to defease, immunize, and de-risk a pension plan.

Problems with Hedges

Duration-matching strategies (Immunization), Interest Rate Swaps, futures, derivatives, risk overlays, etc. are all hedging tools to help assets match the liability growth rate. They are NOT de-risking strategies since they do not match the liability cash flows. Duration matching has several difficult, if not erroneous, data gathering choices it uses:

1. Average duration of liabilities
   Where do you get the average duration of liabilities? Most, if not all, actuarial reports do not provide this calculation. Moreover, they usually do not provide the projected liability benefit payment schedule which you would need to calculate duration. In addition, actuarial reports are, at a minimum, annual reports usually three to six months delinquent so there would be serious delayed information. The duration calculation is at a precise moment in time… like a balance sheet. As time and interest rates change… so will duration. Only A Custom Liability Index (CLI) based on each pension’s unique liability benefit payment schedule could provide an accurate and monthly duration profile.

2. Discount Rates
   Since the duration of liabilities changes with interest rates (discount rates) this calculation needs to be refreshed and updated on a frequent and accurate basis. According to pension accounting rules (FAS 158, GASB 67) and federal funding standards (PPA – MAP 21 and spot rates) there is an assortment of discount rates required to price liabilities. Which one is best? The FASB accounting language says it best… you are use a discount rate that settles the liability payments. This means discount rates you can buy to settle or defease the liability payment schedule. ASC 715 comes the closest by using an AA corporate bond yield curve. Treasury STRIPS would be ideal, but no one seems to favor this approach since STRIPS are low yielding causing the present value of liabilities to be higher. The yield difference in these discount rates could be significant. Any difference in yield creates a difference in the calculation of duration and liability growth rates.

3. Generic Bond Indexes
   A common proxy for the average duration of liabilities is to use a generic bond market index… usually the Barclay’s long corporate index. Such a proxy creates several erroneous data issues. This index has no bonds shorter than 10 years and no durations longer than 16 years. This certainly does not represent any pension liability schedule even if the average durations were similar. Accounting standards and actuarial practices price liabilities as a portfolio of zero-coupon bonds with a single average discount rate based on the present value of this zero-coupon liability portfolio. There are no generic bond indexes that use zero-coupon bonds as their portfolio. There are no generic bond indexes that use pension discount rates in accordance with FASB, GASB and PPA guidelines. Each pension plan’s liabilities are different and unique to that plan due to a different labor force, salaries, mortality, and plan amendments. There is no way any generic bond market index could represent any pension plan liability term structure.

   Only a Custom Liability Index could properly represent and measure any pension plan’s liabilities providing all of the critical data calculations needed to de-risk the plan. In 1991, Ron Ryan designed the first Custom Liability Index (CLI). Based on each client’s unique projected liability benefit payment schedule, Ryan ALM produces monthly CLI reports on:
   
   Structure (Present Value, Average Duration, YTM, Price, etc.)

   Growth Rate (Liability growth for month, year, and since inception)

   Interest Rate Sensitivity (PV change in % and $ given rate changes)

4. Interest Rate Sensitivity

   Every 1 year of duration difference between the liability proxy and the actual duration of each plan’s benefit payment schedule would represent a 1% mismatch in liability growth for every 100 bps of discount rate change. In truth, the duration mismatch is more likely to be three to five years rather than one year. Given that pension cost for the actuary, administration, asset managers, and consultant are usually less than 50 bps a year; such a duration mismatch could be very costly representing years of pension cost.

5. Funding Liabilities

   Imagine a 12-year average duration liability benefit payment schedule. It could have many different term structure shapes to come up with an average 12-year average duration. Imagine 100% of the assets in a 12-year duration bond portfolio. If interest rates rose 50 basis points in one-year, total assets and liabilities supposedly would both have a -6% price return (interest rate movement x duration (as a negative number). If they had the same income return = 5% they would match again. However, if the duration matching assets are used to fund liabilities as they come due then a -1% loss (-6% + 5% = -1%) on assets could be funding a short liability which will have a small positive growth rate. So, the assets could be taking a loss each year to fund the next liability payment if interest rates continue to rise. This could get to be a serious costly mismatch if interest rates continue their secular trend to higher rates for the next few years. But the point is……there is no cash flow match here, only a duration match so there is both a funding and interest rate risk!

6. Derivatives

   Interest rate swaps and futures are contracts not assets. There is no cash flow or funds available to make the liability cash flow payments. They are certainly NOT de-risking strategies but hedges vs. the liability growth rate. In fact, these strategies introduce more risk: counter party risk, interest rate risk, non-matching risk of assets purchased (usually equities) vs. liabilities, and leverage. In addition, interest rate swaps and futures have all of the problems associated with a liability proxy data gathering… as listed with duration matching.

Solution: Cash Flow Matching

As stated in the beginning, matching the liability benefit payment schedule (liability cash flow) at the lowest cost is the ideal way to de-risk a pension plan. Ryan ALM built a liability cash flow matching product, named the Liability Beta Portfolio™ (LBP), as a cost optimization model that matches the liability benefit payment schedule at the lowest cost given the investment policy restrictions of our clients.

The LBP provides about a 2% per year funding cost savings (1-15 years = 30%). This is a serious cost reduction and should be a major consideration of any de-risking strategy. Yes, the LBP model has some credit risk but very small since we are using investment grade corporate bonds with a credit filter (no bonds on negative watch list) plus the cost savings provides a large value-added cushion.

The funded ratio should dictate the allocation to bonds. A surplus should have a high allocation to bonds matched to liabilities and vice versa for a deficit funded status. Unfortunately, asset allocation did not respond to the surplus status in the 1990s which led to the US pension crisis. With funded ratios at 120% and above then, why didn’t pensions immunize and secure this victory? Amazingly, instead of increasing their bond allocation in response to a growing funded ratio they reduced it consistently because of low interest rates to the lowest bond allocations in modern history by 1999.

The allocation to bonds should determine how much of the liabilities we can cash flow match (i.e. a 25% bond allocation might fund the next seven years of gross liabilities). Ryan ALMrecommends: funding the next 10 years of Retired Lives on a net liability basis (after contributions). Indeed, current assets fund the net liabilities not the gross liabilities. Our LBP model will calculate with precision the cost to fund liabilities (gross or net) in a cost-effective manner either as a % of total liabilities or liabilities chronologically, as both methods will de-risk the plan gradually. There are advantages for each method.

Since liabilities are funded initially by contributions, using the LBP model to cash flow match net liabilities chronologically may be able to fund more liabilities than you think. Assume that a 20% bond allocation could match the next 10 years of net liability payments chronologically. Based on the Ryan ALM Liability Beta Portfolio™ (LBP) model we show a cost savings of about 20% on cash flow matching the first 10 years of liabilities, in this interest rate environment.

Matching liabilities chronologically should also buy time for the non-bond assets (Alpha assets) to perform and outgrow liabilities. Given time (7-10 years) most non-bond asset classes tend to outperform bonds. Since liabilities behave like bonds there is a high probability that non-bond asset classes could outperform vs. liability growth over an extended time horizon.

Since the pension objective is a cost focus, cash flow matching a % of total liabilities would produce the optimal cost savings since the longer the bond the less it costs given the same future value. Our LBP model is back tested since 2009. Every $1 billion in bonds used in our LBP model could save about $200 million in cost savings on a 1-10 year liability schedule and $400 million on a 1-20 year liability schedule.

Asset Allocation (AA)

Pension consultants and plan sponsors should consider installing an LBP as the core portfolio in asset allocation and as the liquidity assets to fund liability cash flows chronologically. The intrinsic value in bonds is the certainty of their cash flows. Bonds are usually not considered performance assets (Alpha assets) especially vs. pension liabilities which behave like bonds. Cash flow matching liabilities chronologically will buy time for the Alpha assets (non-bonds) to perform vs. liability growth, thereby enhancing the funded ratio. Such excess returns should be transferred over to the Liability Beta Portfolio™ (LBP) to de-risk more and more liabilities… Portable Alpha. Had this portable Alpha discipline been in place during the decade of the 1990s when funded ratios grew to their highest historical levels with true economic surpluses… there would be no U.S. pension crisis today!

Nota Bene (Note Well)

Please note that the definition of risk used in this article is in sharp contrast to the traditional approach produced by the Nobel Prize winner Ph.D. William F. Sharpe back in 1966. Professor Sharpe proposed that risk is the volatility of total returns and that the three-month T-Bill was the default risk-free rate. He developed the Sharpe Ratio as a means of calculating the risk-adjusted return by subtracting the return of the three-month T-Bill from the mean return of the asset(s) being analyzed and dividing the net return by the volatility of the return of the asset(s) in review. For many decades the Sharpe Ratio was the standard measurement of risk-adjusted returns. In 1994 Prof. Sharpe called me and invited me to Stanford to discuss our unique Custom Liability Index data and reports. I had the unique pleasure to meet and debate with one of the finest intellects I have ever met.

I proposed that risk is not a generic measurement but based on each client’s objective. I referenced pensions where every client’s liabilities are different (like snowflakes). As proof, I asked Professor Sharpe what is the risk-free asset for a 10-year liability payment? Professor Sharpe answered… a 10-year Treasury zero-coupon bond. Prof. Sharpe identified that the three-month T-Bill would have 39 reinvestment moments of uncertainty, so there is no way the three-month T-Bill could match a 10-year liability future value with any certainty and would become a risky asset. Our discussion led to Prof. Sharpe re-inventing the Sharpe Ratio in 1994 to include the benchmark objective instead of the three-month T-Bill in the numerator and denominator such that the average return of the asset portfolio is reduced by the average return of the objective (numerator). This net average return is then divided by the standard deviation of the asset portfolio excess return vs. the objective return. This is commonly called today… the Information Ratio.

Cash Flow Matching Overview

Source: Cash Flow Matching Overview

Pension Objective	Fund benefits in a cost-efficient manner with prudent risk
Pension Needs	Liquidity to fund benefits Reduce Contribution costs Reduce Volatility of Funded Status
Strategy	Cash flow match liability cash flows (benefits + expenses)
Value in Bonds	Certainty of cash flows (only asset class with such value) Maturity selection = yield curve (term structure) Cash flows every month as portfolio
Methodology	Ryan ALM creates a Custom Liability Index (CLI) Provides all calculations needed for ALM Based on actuarial projections of B+E Discount rates = ASC 715 and ROA Ryan ALM creates Liability Beta Portfolio (LBP) Cost Optimization Model Investment grade bond portfolio Target area of liabilities to fund chronologically Cash flow matches + duration matches liabilities
LBP Benefits	Fully funds B+E and secures benefits with certainty Reduces funding costs by 2% per year (1-10 years = 20%) Eliminates cash sweep of growth assets (Alpha assets) Buys time for Alpha assets to grow unencumbered Reduces volatility of funded ratio/status Outyields liabilities creating alpha Enhances funded status and ROA Reduces Contribution costs Mitigates interest rate risk Hedges pension inflation Low fee
Note:	LBP does not change any accounting, actuarial and asset allocation (AA) actions. LBP is a less risky & less costly alternative to active bond management. LBP is a best fit to the true pension objective.
Interest Rate Risk (IRR)	Biggest and dominant risk on bonds present values (PV) Benefits + expenses = future values (FV) B+E are not interest rate sensitive LBP funds Benefits + Expenses LBP mitigates IRR
Pension Inflation	Actuarial projections unique to each pension plan Inflation assumptions =/= CPI
Generic Bond Indexes	Not a proper benchmark Do not represent pension liabilities Liabilities are like snowflakes, unique to each plan sponsor Only a Custom Liability Index could measure/monitor liabilities
Value Added	Ryan ALM offers clients a series of synergistic values: Experience More than 160 years with more than 40 years in cash flow matching Model Proprietary cost optimization model unique in the bond business Educators Wealth of fixed income research produced over the last 50 years Indexes Separate division to create Custom Liability Indexes (CLI) Focus Dedicated to only one asset management product Team Four asset managers working as a team Fees Very low at 15 bps (includes CLI) Expertise Award winning bond expertise
Awards	Gold Medal Winner – The U.S. Pension Crisis book of the year Bernstein, Fabozzi, Jacob Levy – Research Paper of the year William F. Sharpe Index Lifetime Achievement Money Management Letter Lifetime Achievement Capital Link – Most Innovative ETF IMN - ETF of the year

Pension Solutions Series Part 4 - Performance Measurement

Source: Pension Solutions Series Part 4 - Performance Measurement

Pension Solution: Performance Measurement

Most pension assets are managed versus a market index as the objective or benchmark. However, the true objective of a pension is to fund the pension liabilities (benefit payments) at the lowest cost to the plan with prudent risk. No market index could ever represent the liability objective of any pension. Just like snowflakes, no two pension liabilities are alike due to each plan having a different labor force, salaries, mortality and plan amendments. As pensions have experienced too often, given the wrong index objective … you will get the wrong risk/reward profile!

This has been the pattern for most pension plans as their Funded Ratios have been on a roller coaster for several decades. Until the true liability objective of a pension plan (and any liability driven objective) is measured and monitored frequently and accurately, pension assets are in jeopardy of being managed to the wrong index objective(s). Until a Custom Liability Index is built and put in place as the proper benchmark, all asset decisions are in danger of being mismanaged. Given the wrong index objective(s), performance measurement will then provide inappropriate risk/reward measurements. It is rare that pension assets are ever compared to pension liabilities in performance measurement reports. It follows that if you outperform the S&P 500 or any market index but lose to liability growth …the pension plan loses!

Traditional generic bond indexes do a good job of measuring the risk/reward behavior of a market sector but have nothing to do with pension liabilities. Only a Custom Liability Index (CLI) could ever measure and monitor the risk/reward behavior of any pension liability cash flow schedule. Since contributions are the initial source to fund benefits, current assets fund net liabilities (benefits – contributions). Assets need to know what they are funding… net liabilities!

Solution: Performance Measurement

Once the Liability Beta Portfolio™ is installed to cash flow match net Retired Lives chronologically, you now need the Alpha assets to outgrow net residual liability growth (benefits – contributions of 10-year + Retired Lives and Active Lives)) to enhance the funded status. The CLI will provide the growth rate of net residual liabilities just like any index benchmark so performance measurement of Alpha assets versus net residual liabilities (as measured by the CLI) can be easily assessed. If Alpha assets can outgrow net residual liabilities, then the funded status will be enhanced and contribution costs should be reduced. The Ryan ALM Performance Attribution Report (PAR) will calculate:

eight measurements of risk

four measurements of reward

two measurements of risk-adjusted returns