When is a Pension Fully Funded?

Source: When is a Pension Fully Funded?

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

Actuarial Value versus Market Value

The Funded Ratio (FR) of a pension is usually based on the actuarial value of assets / actuarial value of liabilities. The Funded Status (FS) is the actuarial value of assets – actuarial value of liabilities. Actuarial values are different than market values… sometimes quite different. Market values are the better measurement of economic reality since you can’t spend actuarial dollars. As a result, this valuation difference can seriously distort the FR and FS calculation.

Present Value versus Future Value

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

Contributions = MIA

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

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

Discount Rates

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

FASB = high quality AA corporate zero-coupon yield curve

GASB = ROA

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

“The objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the pension benefits when due. Notionally, that single amount, the projected benefit obligation, would equal the current market value of a portfolio of high-quality zero coupon bonds whose maturity dates and amounts would be the same as the timing and amount of the expected future benefit payments. The determination of the assumed discount rate is separate from the determination of the expected rate of return on plan assets”

Ryan ALM Solutions:

Custom Liability Index (CLI): The first step in prudent pension management is to calculate the liability cash flows that assets must fund. This should be a net liability cash flow (benefits + expenses – contributions). Until liabilities are monitored and priced as a Custom Liability Index (CLI) the asset side is in jeopardy of managing to the wrong objectives (i.e. ROA and generic market indexes). Only a CLI best represents the unique liability cash flows of a plan sponsor. Just like snowflakes, no two pension liability schedules are alike due to different labor forces, salaries, mortality and plan amendments. How could a static ROA or genericmarket indexes ever properly represent the risk/reward behavior of such a diverse array of pension liabilities? Once the CLI is installed, the pension can now know the true economic Funded Ratio and Funded Status which should dictate the appropriate Asset Allocation, Asset Management and Performance Measurement.

Asset Exhaustion Test (AET): GASB requires a test of solvency (AET) to document that the asset cash flows (at the ROA) will fully fund the net liability cash flows (benefits + expenses – contributions). GASB correctly understands that assets are funding net liabilities after contributions… and that contributions are future assets. This net liability is rarely focused on by the asset side in asset allocation. Ryan ALM enhances the asset exhaustion test by calculating the ROA that will fully fund net liability cash flows. Usually, we find that a lower ROA can accomplish this goal and is a better fit than the current ROA. This would suggest a more conservative asset allocation and a heavier allocation to fixed income to defease liability cash flows chronologically. This is a common and serious issue. This calculated ROA should be the asset allocation model focus. We urge all pensions to incorporate this modified AET before acting on asset allocation.

Liability Beta Portfolio™ (LBP):The intrinsic value in bonds is the certainty of its cash flows. That is why bonds have been used for decades to defease liability cash flows. The core or Beta portfolio for a pension should be in investment grade bonds that cash flow match and fully fund liabilities chronologically thereby buying time for the growth (Alpha) assets to outgrow liabilities and erase the deficit. The proper Beta portfolio for any liability objective should be… a Liability Beta Portfolio™. Ryan ALM has developed a LBP which will cash flow match liabilities chronologically and reduce funding costs by about 2% per year (1-10 years = 20%) as well as reduce the volatility of the Funded Status and contribution costs. The LBP should be the core portfolio of any pension and replace active fixed income management. By matching and funding liabilities chronologically, the LBP buys time for the growth or Alpha assets (non-bonds) to perform. By working in harmony with the Alpha assets the plan can gradually enhance its funded status and reduce contribution costs.

Liability Alpha Assets: The non-bond assets should be managed vs. the CLI to exceed liability growth (earn liability Alpha) and enhance the economic Funded Status. The goal here is outgrow liabilities in $s (relative returns) by enough to erase the deficit over a time horizon equal to the average life (duration) of liabilities (calculated by the CLI). As the Alpha assets achieve the required annual Alpha, any excess returns vs. liability growth should be ported over to the Liability Beta Portfolio™ to secure the victory. Had this been in place during the decade of the 1990s when pensions had surpluses… there would be no pension deficits today.

What’s It All About? Liabilities!

Source: What’s It All About? Liabilities!

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

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

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

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

Solutions:

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

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

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

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

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

Observations:

The intrinsic value in bonds is the certainty of their cash flows. Bonds are the only asset class with certainty of their cash flows. That is why bonds have been the logical choice for Dedication and Defeasance using Cash Flow Matching (CFM) strategies since the 1970s. Only CFM is a best fit for any liability driven objective. The primary objective of a pension is to secure benefitsin a cost-efficient manner. Our CFM product (LBP) will secure and fully fund benefits by matching asset cash flows monthly versus liability cash flows. This matching process is done chronologically for as far out as the plan sponsor deems necessary.

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

Observations and Benefits of LBP:

• No change in Cash and Bond allocation

• No dilution of Alpha assets to fund B + E

• Reduces funding costs by about 2% per year

• Mitigates interest rate risk (funding future values)

• Secures + fully funds monthly B+E chronologically

• Eliminates the need for a cash sweep which dilutes equity returns

• LBP will out yield current bond managers and enhance the ROA

• Cash flow matching buys time for Alpha assets to grow unencumbered

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

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

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

Logic:

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

Problem/Solution: Asset-only Focus

Source: Problem/Solution: Asset-only Focus

Problem: Asset Only Focus on Asset Allocation

Solution: Asset Liability Management (ALM)

Most, if not all asset allocation models are focused on achieving a total return target or hurdle rate… commonly called the ROA (return on assets). This ROA target return is derived from a weighting of all asset classes forecasted index benchmark returns except for bonds which uses the yield of the index benchmark. These forecasts are based on some historical average (i.e. last 20 years or longer). As a result, it is common that most pensions have the same or similar ROA.

This ROA exercise ignores the funded status. It is certainly obvious that a 60% funded plan should have a much higher ROA than a 90% plan. But the balancing item is contributions. If the 60% funded plan would pay more in contributions than the 90% plan (% wise) then it can have a lower ROA. I guess the question is what comes first. And the answer is the ROA with contributions as a byproduct of the ROA. The actuarial math is whatever the assets don’t fund… contributions will fund.

If the true objective of a pension is to secure and fully fund benefits and expenses (B+E) in a cost-efficient manner with prudent risk, then you would think that liabilities (benefits + expenses) would be the focus of asset allocation. NO, liabilities are usually missing in the asset allocation process. Pensions are supposed to be an asset/liability management (ALM) process not a total return process. Ryan ALM recommends the following asset allocation process:

Calculate the cost to fully fund (defease) the B+E of retired lives for the next 10 years chronologically using a cash flow matching (CFM) process with investment grade bonds. CFM will secure and fully fund B+E of retired lives for the next 10 years. Then calculate the ROA needed to fully fund the residual B+E with the current level of contributions. This is calculated through an asset exhaustion test (AET) which is a GASB requirement as a test of solvency. The difference is GASB requires it on the current estimated ROA before you do this ALM process. Ryan ALM can create this calculated ROA through our AET model. If the calculated ROA is too high then either you reduce the allocation to the CFM or increase contributions or a little bit of both. If the calculated ROA is low, then increasing the allocation to CFM is appropriate. Running AET iterations can produce the desired or most comfortable asset allocation answer.

Cash flow matching (CFM) will provide the liquidity and certainty needed to fully fund B+E in a cost-efficient manner with prudent risk. The Ryan ALM model (Liability Beta Portfolio™ or LBP) will reduce funding costs by about 2% per year or 20% for 1-10 years of liabilities. We will use corporate bonds skewed to A/BBB+ issues. There has never been a bond default in the 20-year history of Ryan ALM.

Assets are a team of liquidity (bonds) and growth assets to beat the liability opponent. They should work together in asset allocation to achieve the true pension objective.

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.

NIRS Innovative Pension Funding Strategies

Source: NIRS Innovative Pension Funding Strategies

The NIRS pension objectives for this paper are:

1. Reduce contribution volatility

2. Promote intergenerational equity

3. Keep plan on sound funding trajectory

Cash Flows (Future Values versus Present Values)

Pensions are all about cash flows: asset cash flows versus liability cash flows. It is the future value of these cash flows that are the most meaningful and need to be monitored. Asset cash flows are pension assets (A) to grow at some ROA forecasted rate + projected contributions (C). Liability cash flows are projected benefit payments (B) + projected administrative expenses (E). The formula of: (A + C) – (B + E) is what dictates the soundness and solvency of any pension. However, funded ratios and status are based on the present value of A/B or A – B. Contributions and expenses are not included in the funded ratio/status. Contributions are the first source to fund B + E. Accordingly, assets fund net liabilities not gross. This is the first innovative funding strategy: subtract contributions from B + E to calculate net liabilities. Have assets focus on fully funding net liabilities. Indeed, GASB requires an asset exhaustion test (AET) as a test of solvency which takes cumulative projected A + C minus projected B + E on an annual basis to determine how far out is the plan solvent. The AET is truly the battlefield that the pension asset/liability game is played on and should play a major role in asset allocation.

Present values may help us understand if we are on track like a scoreboard but can be very misleading. Take for example, two portfolios: one is 100% in Treasuries yielding 1.75% and the second portfolio is 100% in corporate bonds yielding 2.50%. They have the same present values, but their future values are much different by as much as 20% to 30% depending on maturities. They have the same funded ratio and status, but they are certainly different in pension solvency. The same problem exists with asset smoothing and actuarial valuations. Only a market valuation will tell you the true or accurate economic value. Imagine your bank telling you that they cannot provide your current balance but only the five-year average balance. Would you be comfortable writing a check on that information? Asset liability management (ALM) requires accurate and frequent information in order to be successful.

Return on Asset Assumption (ROA)

Assets need to know what they are funding… net not gross liabilities. The AET can be modified to calculate the ROA needed for assets to fully fund net liabilities. This is the second innovative funding strategy: calculate the ROA based on the AET and not asset allocation. Currently, the ROA is calculated based on what asset allocation tells us is a high probability of achieving a target return given a certain asset allocation. This in no way tells us if this ROA is capable of achieving accurate full funding, which is the true goal of the assets. The ROA may be too high creating surpluses and higher contribution costs (too often the result). The AET can be used to calculate what ROA will fully fund residual net liabilities. This accurately determined ROA will now be the hurdle rate for asset allocation.

Assure Plan Remains on Sound Funding Trajectory

It is the future value of A + C versus B + E that counts. That is what the AET focuses on and what assets should focus on. Since we only know the future value of bonds with certainty then bonds should be the core or Beta portfolio. This is the third innovative funding strategy: install a Beta portfolio to cash flow match net liabilities chronologically. The Beta assets are the liquidity assets to fund B + E chronologically and buy time for the Alpha or growth assets to grow unencumbered. Asset allocation should initially focus on the weighting of Beta + Alpha assets that produce the highest probability of fully funding B + E net of C. The question of how much is allocated to the Beta assets is based on the how well funded the plan is. The higher the funded ratio, the greater the allocation to Beta assets. Logically, you want the Beta assets to fund the next 10-years since history tells us that the alpha assets need time to perform and grow. This will allow the Alpha assets to reinvest their dividends and income streams. Historically, about 48% of the S&P 500 growth on a 10-year rolling basis since 1950 comes from dividends and reinvestment.

This is not how asset allocation has worked for decades. Instead, asset allocation is based on achieving a target ROA which favors a high allocation to riskier (Alpha) assets no matter what the funded status is. Two plans, one at 40% funded and the other at 80% funded should have distinctly different asset allocations. But if they have the same ROA, they will have the same or similar asset allocations. This was the asset allocation mistake made in the 1990s when public pension plans had surpluses. Why didn’t they secure B + E and the surplus with a high allocation to Beta assets that would have cash flow matched B + E for many years? Instead, they reduced their allocation to bonds to achieve a ROA target return as interest rates were going down in a secular trend over 38 years. The equity correction of 2000-02 sent funded ratios into deep deficits and spiking contribution costs which public pensions have not yet cured.

Reduce Contribution Cost Volatility

Cash flow matching (CDI) with bonds reduces contribution cost volatility by definition. It will fully fund B + E chronologically thereby reducing contribution cost volatility in the area it is funding (i.e., 1-10 years). CDI is based on matching and funding future values not present values. This eliminates the actuarial noise from actuarial valuations. It also mitigates interest rate risk which is the dominant risk factor in bonds. The future value of B + E is not very volatile especially on shorter projections (i.e., 1-10 years). Moreover, CDI will rebalance whenever actuarial projections change to always be cash flow matched to projected B + E. It also assures that the pension plan remains on a strong fiscal path. The certainty of their cash flows is the value of bonds and why bonds have always been used for cash flow matching, defeasance, dedication and immunization. A cash flow matching portfolio should be the anchor or core portfolio for prudent pension ALM.

Intergenerational Equity

The AET will calculate the residual or remaining assets based on fully funding B + E after C. As a result, you want AET to show an increase in assets or, at least, show the initial assets as the remainder so intergenerational equity has improved its asset position or no dilution of assets. The AET is certainly the best measurement for intergenerational equity and should be monitored annually.

Hypothetical Pension Plan

Applying our innovative funding strategies to the NIRS hypothetical pension plan, we first calculated net liabilities (B + E) – C by using the projected B + E provided by NIRS and taking contributions (normal cost) of $184.75 million and growing it at 3% for payroll inflation which creates a constant 12% of payroll contribution cost. We ran three asset exhaustion test (AET) versions (see link _____________________):

1. Keeping Contributions as a constant 12% of payroll with 3% inflation grows contribution costs to exceed B + E by 1/01/64. As a result, a ROA of less than 3% will fully fund all projected B + E thru 12/31/99.

2. Removing Contributions after 1/01/64 (crossover point where C > B + E) would result in a ROA of 4.63% to fully fund all projected B + E thru 12/31/99.

3. Freezing Contribution costs at the initial amount would result in a ROA of 6.19% to fully fund all projected B + E thru 12/31/99.

The major point of this exercise is to show and prove that the ROA is not a calculated number based on the funded status. If the mission of pension assets is to fully fund B + E in a cost-efficient manner with prudent risk, then assets need to know the correct ROA needed to accomplish this mission. But that is not what happens today with the ROA and asset allocation. A rounded ROA hurdle rate is commonly used based on the asset allocation model with no regards to the funded status. As a result, a surplus funded status and a significant deficit funded status could have the same ROA if that they had the same or similar asset allocation. This is not logical or in the best interest of the plan solvency. Again, my example of what happened in the 1990s which led to spiking contribution costs in the early 2000s and beyond should never be repeated.

Today, most public plans have seen an improvement in their funded status but little or no change in their asset allocation. To be true to the pension objective, asset allocation needs to be responsive to the economic funded status based on valuing assets and liabilities on market valuations not actuarial valuations. We ran a Custom Liability Index (CLI) to compare and calculate the present value of B + E before and after C based on both a 7% ROA and an ASC 715 discount rate of 2.61%. Here are the calculations:

‍Custom Liability Index

Assets	$7,665,500,000	$7,665,500,000
Gross Liabilities (w/o Contributions)	$40,998,000,000	$40,998,000,000
PV of Gross CLI (w/o Contributions)	$9,259,823,437	$19,351,264,070
Funded Ratio	82.78%	39.61%
PV of Net CLI (C @ 3% growth to 1/1/64)	$5,349,624,369	$11,215,430,808
Net Funded Ratio (with C)	143.29%	68.35%

Noticeably, there is a significant difference in PV based on the two discount rates (ROA vs. ASC 715). Which one provides the best calculation of the true economic funded ratio/status? Which one should asset allocation be focused on? Certainly, the ASC 715 is based on reality… current market rates. FASB accounting rules clearly state that the discount rate should be a rate that can settle the liabilities… a rate you can buy to defease liabilities. The ROA discount rate is eliminated here since it is a rate that you can NOT buy.

Cash flow matching (CDI) with bonds focuses on future values and eliminates this confusion over discount rates and the correct present value of liabilities and funded ratio/status. Our third innovative funding strategy is to install CDI as the core portfolio or liquidity assets to fully fund B + E (net after contributions) for as far out as makes sense. Logically, the CDI allocation should allow for the asset allocation to achieve the new calculated ROA. Based on the AETs we ran, it looks like a 4.63% ROA is the proper hurdle rate if C are used to initially fund B + E up to 1/01/64 leaving net liabilities to be funded by the assets. This would suggest that 47% invested in CDI yielding 2.00% + and 53% invested in residual assets earning 7.00% would earn the 4.63% hurdle rate. This is the prudent approach to a calculated ROA and a responsive asset allocation to fully funding (B + E) – C. It is also a far more conservative asset allocation than that of most plans that should lead to significantly reduced volatility of returns, contribution expenses, and the plan’s funded status while keeping the plan on a sound funding trajectory.

‍Resume
Ronald J. Ryan, CFA

——

CEO and founder of Ryan ALM, Inc. in 2004. Ryan ALM provides a turnkey system for pensions that reduces cost and risk based on three synergistic and proprietary models:

• ASC 715 Discount Rates

• Custom Liability Index (CLI)

• Liability Beta Portfolio™ (LBP)

The CLI and LBP cash flow matching model are both unique in the pension industry. The index division of Ryan ALM also provides custom indexes for ETFs.

Prior to creating Ryan ALM, Mr. Ryan founded Ryan Labs, Inc. in 1988 which became one of the largest Enhanced Bond Index Fund managers in America. In 1982, he founded the Ryan Financial Strategy Group (RFSG) which was a fixed income quantitative firm focused on helping bond managers outperform bond Indexes. At RFSG, he and his team created many unique financial models and index innovations. Mr. Ryan is the former Director of fixed income research at Lehman Bros. Kuhn Loeb from 1977–1982 where he designed most of the popular Lehman bond indexes.Prior to Lehman, he was the head of fixed income for the First in Dallas from 1973-1977, the largest bank holding company in Texas. From 1966-1973 he was a security analyst at Pan-American Life Insurance company, the largest institutional investor in Louisiana.

Mr. Ryan has a CFA degree, and a MBA and BBA from Loyola University.

Becoming Liability Aware

Source: Becoming Liability Aware'

A Strategy For Improved Pension Funding

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

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

Price your liability - ASC 715 Discount Rates

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

Measure your liability - Custom Liability Index (CLI)

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

Monitor your liability - Asset / Liability Summary

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

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

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

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

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

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