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.

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.

How Bonds Can Enhance the ROA

Source: How Bonds Can Enhance the ROA

Given the volatility and uncertainty of the financial markets, bonds can provide Pension Plan Sponsors a strategy to mitigate some of that volatility. Bonds, through the certainty of their cash flows, prove to be a very effective tool. Most pensions focus on earning the return on asset (ROA) assumption as the goal of asset allocation. Because bonds yield less today than the ROA (7.00% average) the asset allocation to bonds tends to be lower than historic norms. But there exists a bond allocation that could enhance the probability of achieving the ROA. Here’s how:

1. Cash Flow Matching – if bonds were used to cash flow match and fund net liabilities (after contributions) chronologically they would produce the liquidity needed to fully fund such net liabilities. Cash flow matching works best with longer coupon bonds where you use semi-annual interest income to partially fund liabilities. A 10-year bond has 20 interest cash flows + one principal cash flowall priced at a 10-year yield. Having this liquidity wouldeliminate the need to do a cash sweep from other asset classes which is a common liquidity procedure. According to Guinness Global, the S&P 500 has 47% of its historical returns from dividends and reinvestment since 1940 on a 10-year rolling period basis. Wouldn’t you want to reinvest dividends back into growth assets rather than spend it on funding benefits + expenses? By using bonds as the liquidity assets, the growth assets are left unencumbered to grow. The longer the cash flow matching period, the more time the growth assets have to compound their growth. This strategy and practice could significantly enhance the ROA.

2. Yield on Bonds – the asset allocation models forecast the return of each asset class in the model, then weight each asset class to get the derived ROA for total assets. The ROA for most asset classes is based on the historical returns of each asset class index benchmark except for bonds. The currentyield on the bond index benchmark(s) is usually used as the forecast for bond returns. The Bloomberg Barclay Aggregate is most favored as the bond index benchmark. This index was designed at Lehman Bros. by Ron Ryan when he was the head of Fixed Income Research & Strategy from 1977 to 1983. The Aggregate is a very large and diversified portfolio of bonds with the following summary statistics as of March 31, 2025:

# of issues	13,770	Treasury	44.79%	AAA	3.06%
YTM	4.51%	Agency	1.29%	AA	47.86%
Duration	6.08 yrs.	Mtg. Backed	24.85%	A	11.38%
Avg. Maturity	8.38 yrs.	Corporates	24.06%	BBB	11.43%
				NR	25.60%

As a result, most asset allocation models would have a ROA for bonds of about 4.50%. If you can build a bond portfolio that outyields the Aggregate index, by definition, it should enhance the ROA for total assets. Ryan ALM Advisers, LLC has created a cash flow matching product we call the Liability Beta Portfolio™ (LBP). The LBP is a cost optimization model that cash flow matches liability cash flows chronologically at the lowest cost from a corporate bond portfolio skewed to A/BBB bonds. Based on the actuarial projections of each client we initially build a Custom Liability Index (CLI) to calculate net liabilities ((benefits + expenses) – contributions) chronologically. The CLI provides all the data needed for the LBP to function efficiently. Based on the allocation to the LBP will determine how far out the LBP can fully fund net liabilities. Usually, a 15% allocation to the LBP can fund 1-7 or even 1-10 years of net liabilities. The longer the term structure of the LBP, the higher the yield. The LBP will roughly outyield the Aggregate index by 50 bps (1-5 years) to over 100 bps (1-10 years) based on the LBP term structure. If the LBP outyields the AGG index by 50 to 100 bps, asset allocation can afford to overweight the bond allocation and still meet the target ROA for total assets. A 15% allocation to LBP is 7.5 to 15 bps value added to the ROA.

3.Cash – many pension plans have a cash allocation of around 2%+. Cash is usually the lowest yielding asset. Since the LBP becomes the liquidity assets to fully fund benefits + expenses chronologically, there is little need for cash to fund B+E. Cash might only be needed for capital calls on Private Equity and Alternative Investments. The LBP should significantly increase the yield margin versus cash since the LBP is using A/BBB+ coupon income from all maturities of the LBP. With the LBP fully funding B+E, the cash allocation can be reduced to <1%. Replacing most of the cash allocation to fund B+E with the LBP allocation is another ROA enhancement… it all adds up.

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!

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