The Evolution of Asset/Liability Management

Source: The Evolution of Asset/Liability Management

CEO, Ryan ALM, Inc.

What Is Asset/Liability Management (ALM)?

The objective of most institutions in the United States with assets to invest is to fund some sort of liability, (banks, insurance companies, pension funds, etc.). As a result, asset/liability management (ALM) should be the investment focus and strategy for these institutions.

Banks and insurance companies have maintained this focus because it is required by the regulations under which they operate. The IAIS Standard No. 13 (2006), which is the basis for insurance company regulation in the United States, defines asset/liability management (ALM) as the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated.1 Oracle Financial Services (2008), in its white paper “Asset Liability Management: An Overview,” defines ALM for banks as a mechanism to address the risk faced by a bank because of a mismatch between assets and liabilities resulting from either differences in liquidity or changes in interest rates.

Indeed, as banks and insurance companies have practiced it, ALM is the management of assets so that asset cash flows are as similar as possible to that of the liability cash flows. Exley, Mehta, and Smith (1997) conclude in their paper “The Financial Theory of Defined Benefit Pension Schemes” that financial theory offers no good reason why ALM as practiced by pensions should differ from ALM by banks. They emphasize that the time has come to stop treating pensions as anything special. Pension liabilities are the same as any other liability. In a special LDI (liability-driven investing) issue of aiCIO Magazine, McDaniel (2011)

IAIS is the International Association of Insurance Supervisors. See http://www.iaisweb.com.

provides a well-documented history of LDI theory in his column “LDI’s Founding Document,” concluding that pension liabilities should be treated in the same way as bank and insurance liabilities, giving each a proper ALM focus.

The focus of this review will be the evolution of ALM for pensions. Pensions have no regulations requiring asset/liability management or the matching of assets cash flows to liability cash flows. This lack of regulation may be the most important cause of the spiraling pension deficits and decline of defined benefit plans since 1999.

Prehistory: Insurance Company Management of Pension Funds

In the decades before pension plan sponsors began to manage pension assets as quasi-independent investment organizations, it was typical for pension plan sponsors to simply pay an insurance company to assume the liabilities of the pension plan. The insurance company was then responsible for investing the assets while complying with then-current insurance regulations. By regulations, the insurance companies invested most of these assets in fixed-income securities, matching the cash flows from the assets to the cash required to be paid to the pension beneficiaries. This trend has existed from roughly 1875 when the first U.S. corporate pension plan (American Express) was established to today.

In the Beginning: Dedication

Dedication was the earliest form of ALM practiced by pension plans as quasi-independent investment organizations. It was in vogue during the historically high-interest-rate environment of the 1970s and early 1980s. Marty Leibowitz was the first to refer to cash flow matching as “dedication” because it required matching a stream of cash inflows (assets) to a stream of cash outflows (liabilities); each cash inflow was “dedicated” to paying a particular outflow. His work was initially published by Salomon Brothers in the 1970s, where he was managing director, and then (1986) as a series in the Financial Analysts Journal under the title “The Dedicated Bond Portfolio in Pension Funds.” Many authors have written about the pros and cons of dedication. Perhaps the most complete set of writings is offered by Frank Fabozzi (2005) in Dedicated Bond Portfoliosin The Handbook of Fixed Income Securities.

As interest rates rose in a long secular trend, the financial industry began to pay attention. Realizing that the high interest rates would allow them to lock in unprecedented rates of return, defined benefit pension fund managers embraced the concepts of dedication and then later immunization. Wall Street

broker/dealers, especially Salomon Brothers, with Marty Leibowitz as its intellectual leader, provided the complicated software models needed to execute dedication and immunization effectively. Many papers promoting and critiquing ALM strategies were written by quantitative scholars during this time. Times were also good for broker/dealers who could execute very large dedication and immunization portfolios. Perhaps the largest bond trades ever recorded were those done for dedication and immunization.

The dedication model assumed a 100% bond portfolio held to maturity. The quest was to find the least expensive collection of bonds that provided the needed cash flows over the time horizon of the liabilities to be funded. Dedication had several distinct advantages:

1. Simple asset allocation (100% bonds)

2. Mitigates interest rate risk since it is funding future values

3. Specificity (asset cash flows must match liability cash flows)

4. Predictable cash flows (when the bonds are held to maturity)

5. Structured management (more certain returns with lower fees)

6. Reduction of risk (interest rates, reinvestment, inflation, and liquidity)

Immunization Introduced as an ALM Strategy

In the 1980s when interest rates started a secular decline immunization became popular, which focuses on matching the interest rate movement of liabilities in present value dollars. The idea is to minimize the volatility of the surplus (the dollar value of assets minus liabilities) by having an asset duration equal to the liability duration. Duration is the present-value-weighted average time to receipt of the cash flows from a security or portfolio. Macaulay (1938), in his book entitled Some Theoretical Problems Suggested by] the Movement of Interest Rates, Bond Yields and Stock Prices in the United States since 1856,2 is credited with introducing the term “duration” and defining it as above. In 1942, Koopmans’s paper “The Risk of Interest Fluctuations in Life Insurance Companies” pointed out that if the duration of the bonds held in a portfolio were matched to the duration of the liabilities those bonds would fund, the effects of interest rate changes could be mitigated or nullified completely (i.e., the portfolio would be immunized).

This effort to define ALM strategies that would protect a portfolio from interest rate changes largely conducted by academics, culminated in a 1952 paper titled “Review of the Principles of Life-Office Valuations” by a nonacademic actuary, F.M. Redington, who worked for a British insurance company. He is credited with introducing the term “immunization” to signify the investment of assets in such a way that the existing business is immune to a general change in the interest rate.

As interest rates began to fall in early 1982, call risk surfaced as a serious impediment to immunization and dedication models, especially for those who ventured into mortgage-backed securities. This call (or prepayment) risk would alter cash flows and maturity structures, with resulting damage to the integrity of immunization and dedication models that depended on the certainty of these cash flows and maturity dates.

Accounting Rules Redirect Pension Asset Management

This FASB standard would help those designing immunization strategies to understand how to match the present value of liabilities. However, for pension expense purposes, the new statement allowed corporations to use the return on assets (ROA) assumption as follows: If the dollar growth in pension assets based on the ROA rate exceeded the pension expense amount, then pension expense would be negative—that is, it would become pension income which would directly enhance earnings. Because corporations are earnings led and not liabilities led, the ROA became the hurdle rate objective for pension assets.

When interest rates went below the ROA assumption rate (around 8%) in the late 1980s, dedication and immunization strategies fell out of vogue because they locked in a return that would not be sufficient to neutralize or overcome pension expense, resulting in a drain on EPS. As a consequence, dedication and immunization were largely replaced by surplus optimization strategies that aimed at the growth of pension assets to outpace liability growth, thereby creating a pension surplus that would reduce or even eliminate contribution costs. Contribution costs were a function of the funded status (the present value of assets minus the present value of liabilities). Any deficit or underfunding (a funded ratio less than 100%) was to be erased through contributions planned out over time so that the pension plan would be fully funded over the life of the liabilities.

The late 1980s and the decade of the 1990s were good times for pensions. With the switch to a surplus optimization strategy, asset allocation models were heavily skewed to equities over bonds because the ROA was now the “bogey,” or investment return benchmark. This asset allocation decision worked out well during this period; equities enjoyed several good years of double-digit returns, resulting in pension surpluses that enhanced EPS (returns above the ROA were an “actuarial gain” line item that increased EPS) and reduced contribution costs. During this period, ALM became a hard sell, given the level of interest rates, the historical return track record of equities, and the resulting financial statement benefits of an ROA hurdle rate. This focus on an absolute return (ROA) rather than on relative cash flows would soon haunt the pension industry and prove fatal to some plan sponsors.

The equity bear market that hit in 2000–2002 became a pension tsunami for several reasons. The correction was quite deep, amounting to a 49% fall in the S&P 500 Index, with the result that pension asset growth underperformed liability growth by as much as 75% on a cumulative basis over those three years. This event led to spiking contribution costs because of crashing funded ratios, an EPS drain from the pension assets underperforming the ROA (actuarial loss), and even insolvency of the plan sponsor, with several companies (notably airlines) filing for bankruptcy because pensions tend to be the largest liability of many firms.

The Society of Actuaries (SOA) became concerned that such an asset/liability disparity occurred as a result of accounting rules and it issued a research paper draft (2004) titled “Principles Underlying Asset Liability Management,” which warned that accounting measures can distort economic reality and produce reports that are inconsistent with economic results. It

further stated that entities that focus on economic value tend to achieve their financial objectives more consistently in the long run. In other words, the SOA promoted ALM on an economic basis (i.e., market value), rather than on an accounting basis, as the proper asset management style.

At that time, corporations were begging for relief from spiking pension contribution costs. Congress responded with the Pension Protection Act (PPA) of 2006. A number of pension experts provided testimony during the several-years-long process of writing the PPA. In my testimony before the ERISA Advisory Council on Employee Welfare and Pension Benefit Plans (2003), I recommended that liabilities should be priced at the market as a yield curve since liabilities are a term structure. In harmony with FAS 87 rules, I reminded them that the discount rate used should be one that settles the liabilities. I further proposed that as an acid test a rule should be created and enforced that reads, “If you cannot buy it, you cannot use it as a discount rate!”

1. a 24-month moving average of a three-segment yield curve and (

2. the current spot-rate yield curve. In both options, the yield curve was based on high-quality corporate bonds rather than Treasury bonds. In effect, the PPA raised discount rates which lowered the present value of liabilities, thereby enhancing the apparent funded ratio and lowering contribution requirements.

The FASB was also concerned that existing standards did not communicate the funded status on balance sheets, so in 2006 it issued Statement of Accounting Standards No. 158: Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (effective 2007). This communication, usually referred to as FAS 158, clarified that the discount rates used should correspond to the current market value of aportfolio of high-quality zero-coupon bonds whose maturity dates and amounts match the expected future benefit payments. This accounting standard also introduced Other Post-Employment Benefits (OPEB) liabilities onto the balance sheet, revealing that they are one of the largest liabilities facing U.S. institutions.

ALM Strategies Reborn as LDI

After the equity correction of 2000–2003, the stage was set for institutions to return to the basic practice of asset/liability management, because failure to do so had resulted in deteriorating funded ratios, large actuarial losses, spiking contribution costs and even bankruptcies. This time, however, ALM was more frequently referred to as liability-driven investing (LDI) to suggest a new, enhanced approach.

Because of the ongoing secular trend toward lower rates and the fact that the expected return on assets continued to be used to calculate pension expense, corporations continued to pursue an asset allocation away from bonds but with less equity concentration. This trend opened the asset allocation door to many new asset classes and strategies, including hedge funds, alternative investments, and new LDI strategies.

Frank Fabozzi, Ph.D. and I have written prolifically on ALM strategies and considerations. Fabozzi’s books are a mainstay for any ALM practitioner. His Bond Portfolio Management (especially the chapter “Managing Funds Against Liabilities”), published in 2001, and his Handbook of Fixed Income Securities (chapter on “Cash Flow Matching”), published in 2022, have become required reading. Fabozzi and I teamed up in 2005 to produce the article “Reforming Pension Reform,” proposing a solution to the growing pension crisis. Our solution starts with pricing liabilities at the market (economic value) and then building a custom liability index as the proper benchmark for pensions (or any liability-driven objective), because liabilities are unique to each pension plan. We later followed this article with “Liability Index Fund: The Liability Beta Portfolio” (2011), in which we argued that a liability index fund should bethe core portfolio and is the only correct beta portfolio for a pension with a liability objective. The liability beta portfolio is the proper form of ALM or LDI which cash flow matches liability cash flows at low cost. To create and maintain such a portfolio, a custom liability index is also required.

Waring and Siegel produced a detailed account of why saving defined benefit pension plans is a good idea in their 2007 paper “Don’t Kill the Golden Goose! Saving Pension Plans.” They conclude that the first element needed to manage a defined benefit plan is an “economic” view of the liability. The only risks that can be hedged through investment policy and strategy are those that are correlated with market returns of one kind or another. Accounting values are not hedgeable because they are smoothed and are not market values. In the face of a trend toward freezing defined benefit plans in favor of defined contribution plans, the authors argued that defined benefit plans are more cost effective and efficient than defined contribution plans.

Public pensions have the largest deficits and the lowest funded ratios, a result that may be attributable to the Governmental Accounting Standards Board (GASB) accounting rules, which smooth assets over five years and price liabilities at a ROA discount rate. Since 1999, this accounting practice has usually overvalued assets and undervalued liabilities versus economic values (market values). In my paper “The Public Pension Crisis” (2011), I described how the ROA discount rate misled pension trustees and consultants into making inappropriate asset allocation, benefit, and contribution decisions by thinking they were highly funded when they had true large economic deficits. All of these decisions are linked together. My solution to the public pension crisis starts with liabilities. I argued that until a Custom Liability Index (CLI) is installed as the proper benchmark priced as a yield curve of market rates, all asset allocation, budget, and contribution decisions are in jeopardy.

In conclusion, the true objective of a pension plan is to secure the benefits in a cost-efficient manner with prudent risk. This is best accomplished thru cash flow matching of the liability cash flows. A Custom Liability Index should also be installed as the proper benchmark so asset allocation can know the true economic funded status and performance measurement of asset growth versus liability growth can be accurately assessed.

“Insanity is doing the same thing over and over again and expecting different results” - Albert Einstein

Bibliography

Black, Fischer. 1980. “The Tax Consequences of Long-Run Pension Policy.” Financial Analysts Journal, vol. 36, no. 4 (July/August):21–28.

“I believe that every tax-paying firm’s defined benefit pension fund portfolio should be invested entirely in bonds (or insurance contracts). Although the firm’s pension funds are legally distinct from the firm, there is a close tie between the performance of the pension fund investments and the firm’s cash flows. Sooner or later, gains or losses in pension fund portfolios will mean changes in the firm’s pension contributions. Shifting from stocks to bonds in the pension funds will increase the firm’s debt capacity, because it will reduce the volatility of the firm’s future cash flows. Shifting from stocks to bonds will give an indirect tax benefit equal to the firm’s marginal tax rate times the interest on the bonds.” (p. 21)

Choie, Kenneth S. 1992. “Caveats in Immunization of Pension Liabilities.” Journal of Portfolio Management, vol. 18, no. 2 (Winter):54–69.

“Immunization requires that the value of assets and the present value of liabilities be the same, and that the interest rate sensitivity or duration of the assets be the same as that of the liabilities. The first issue in immunization is establishment of the appropriate discount rates to compute the present value and the duration of a liability schedule. The question of the appropriate discount rates for a given liability schedule has crucial ramifications for construction of an asset portfolio to immunize the liability stream.” (p. 54)

Collie, Bob. 2012. “LDI’s Journey toward Greater Customization.” aiCIO Magazine, vol. 4, no. 4 (LDI Special Issue):6–11.

“The basic initial steps of an LDI program are an increase in the portfolio’s sensitivity to interest rates and a reduction in equity holdings. These steps are similar no matter who is taking them. However, as the LDI program becomes more advanced and the link between the asset portfolio and the liabilities becomes stronger, a point is reached at which a greater degree of customization becomes necessary.” (p. 6)

Ehrentreich, Norman. 2009. “The Asset Return–Funding Cost Paradox: The Case for LDI.” Ehrentreich LDI Consulting & Research.

“Pension regulations of the 1980s have effectively removed incentives for corporate plan sponsors to overfund their pension plans. Now, equity based investing strategies sooner or later lead to large funding shortfalls, and the inability of most plan sponsors to close them immediately makes them persistent. Therefore, the most basic requirement for converting eventual higher asset returns into lower funding costs, i.e., having average funding levels of 100% or more, is regularly violated by most pension plans.” (p. 1)

Fabozzi, Frank. 2005a. “Dedicated Bond Portfolios.” In TheHandbook of Fixed Income Securities. 7th ed. New York: McGraw-Hill:1103–1117.

“The dedicated bond portfolio, as it is frequently called, is a strategy that matches monthly cash flows from a portfolio of bonds to a prespecified set of monthly cash requirements of liabilities. Cash matching or prefunding these liabilities leads to the elimination of interest-rate risk and the defeasance of the liability. Applications for the dedicated strategy include pension benefit funding, defeasance of debt service, municipal funding of construction takedown schedules, structured settlement funding, GIC matching and funding of other fixed insurance products.” (p. 1103)

Fabozzi, Frank, and Ronald Ryan. 2005. “Reforming Pension Reform.” Institutional Investor (January):84–88.

“Until pension liabilities are priced at the market, pension funds run the risk of an asset-liability disconnect. Liabilities should be priced off of a market yield curve. An ironclad pension accounting rule should be: If you cannot buy it, you cannot use it as a discount rate. Start with the Treasury zero-coupon yield curve. Use this yield curve to build custom liability indexes for each plan. Once a plan sponsor creates a custom index as a benchmark for liabilities, it can properly manage assets. Asset allocation and performance measurement models will be able to compare the growth and risk behavior of assets and liabilities by term structure. If assets are not measured against liabilities, they are likely to have the wrong index objective.” (p. 88)

Fabozzi, Frank, and Ronald Ryan. 2011. “Liability Index Fund: The Liability Beta Portfolio.” Journal of Financial Transformation, vol. 33 (December):29–33.

“For corporate defined benefit plans, only a CLI [custom liability index] is the appropriate asset benchmark for liability-driven objectives. With a CLI, Beta and Alpha portfolios are redefined and can work in harmony with the true objective. The asset management guidelines of a pension plan can then take into account the risk/reward behavior of the true economic objective in establishing investment policy, especially the liability Beta portfolio which should be installed as the core portfolio.” (p. 33)

“By definition, an index fund is the correct Beta portfolio that matches the index benchmark with such accuracy that the tracking error is nil with the Beta calculation at 1.00 and the correlation at or near 100. With a liability-driven objective, only a liability index fund could qualify as the Beta or matching portfolio. A liability index fund, by definition, requires an index that reflects a pension fund’s liability term structure. Since each liability structure is unique, this calls for the creation of a custom liability index (CLI). Until the asset portfolio’s cash flows match each monthly liability payment (i.e., liability term structure), the interest rate risk (systematic risk) that dominates the risk/reward behavior of pension liabilities cannot be hedged.” (p. 31)

Financial Accounting Standards Board. 1985. “Statement of Financial Accounting Standards No. 87: Employers’ Accounting for Pensions.” FASB

“Interest rates vary depending on the duration of investments; for example, U.S. Treasury bills, 7-year bonds, and 30-year bonds have different interest rates. … The disclosures required by this Statement regarding components of the pension benefit obligation will be more representationally faithful if individual discount rates to various benefit deferral periods are selected.” (paragraph 199)

“In making those estimates, employers may also look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits.” (paragraph 44)

Financial Accounting Standards Board. 2006. “Statement of Financial Accounting Standards No. 158: Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.”

“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 accumulated benefits when due. Notionally, that single amount, the accumulated post-retirement 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.” (paragraph 144a)

International Association of Insurance Supervisors. 2006. “Standard on Asset-Liability Management.” IAIS Standard No. 13

“This paper describes best practices for asset-liability management (ALM) that a well-managed insurer would be expected to follow and identifies 11 minimum requirements. Asset-liability management (ALM) is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. The objective of ALM is not to eliminate risk. Rather, it is to manage risks within a framework that includes self-imposed limits. The IAIS requires that insurers have in place effective procedures for monitoring and managing their asset-liability positions to ensure that their assets and investment activities are appropriate to their liability and risk profiles and their solvency positions.” (pp. 3, 5, 6)

Leibowitz, Martin L. 1986a. “The Dedicated Bond Portfolio in Pension Funds—Part I: Motivations and Basics.” Financial Analysts Journal, vol. 42, no. 1

“Dedicated bond portfolios allow a corporate pension fund to take advantage of favorable fixed income markets and the actuarial system’s willingness to provide special benefits for a minimum-risk investment approach. Purely as an investment approach, a dedicated portfolio serves as a least-risk asset, minimizing the risks involved in fulfilling a large class of nominal-dollar liabilities. Because the process is largely assumption-free, it provides the sponsoring corporation with an actuarially acceptable way to take advantage of available market interest rates to improve funding status.” (p. 68)

Leibowitz, Martin L. 1986b. “The Dedicated Bond Portfolio in Pension Funds—Part II: Immunization, Horizon Matching and Contingent Procedures.” Financial Analysts Journal, vol. 42, no. 2

“Immunization, horizon matching and various contingent schemes offer pension plan sponsors and managers an opportunity to minimize risk while retaining some degree of management discretion to pursue lower costs or higher returns. Immunization calls for the creation of a portfolio of bonds whose value coincides with the present value of a given schedule of liabilities and whose duration, or interest rate sensitivity, is the same as that of the liabilities. By specifying a minimum portfolio return somewhat below the available market rate, the manager can create a “cushion spread” that provides the basis for several contingent schemes. As long as the portfolio retains assets sufficient to meet the target return, it may be actively managed. When adverse market moves threaten this return, the portfolio must be converted into a dedicated mode that will assure the target return.” (p. 47)

Macaulay, Frederick R. 1938. Some Theoretical Problems Suggested by the Movement of Interest Rates, Bond Yields and Stock Prices in the United States since 1856. New York: National Bureau of Economic Research.

“The time to maturity is not an accurate or even a good measure of ‘duration.’ ‘Duration’ is a reality of which ‘maturity’ is only one factor. Whether one bond represents an essentially shorter or an essentially longer term loan than another bond depends not only upon the respective ‘maturities’ of the two bonds but also upon their respective ‘coupon rates’ and under certain circumstances, on their respective ‘yields.’ Only if maturities, coupon rates and yields are identical can we say, without calculations, that the ‘durations’ of two bonds are the same. The duration of a stream of payments may be thought of as the average life of the stream.” (p. 45)

McDaniel, Kip. 2011. “LDI’s Founding Document.” aiCIO Magazine, vol. 3, no. 2 (LDI Special Issue)

“The history of a formal LDI theory is littered, it seems, with false starts. Our conclusion is that, although historically a distinction has been drawn between asset and liability management by banks and pension funds, financial theory offers no good reason for this distinction. Time to stop treating pensions as anything special. They’re the same as any other liability—and time to show that on the balance sheet.” (pp. 8, 9)

Oracle Financial Services. 2008. “Asset Liability Management: An Overview.” Oracle White Papers (http://www.oracle.com/us/industries/financial-services/045581.pdf).

“Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating). The function of ALM is not just protection from risk. The safety achieved through ALM also opens up opportunities for enhancing net worth.” (p. 2)

Ryan, Ronald. 2003. “Testimony before the ERISA Advisory Council on Employee Welfare and Pension Benefit Plans.” U.S. Department of Labor

“Liabilities should be priced at the market as a yield curve. A rule should be created, or enforced, that reads: If you cannot buy it, you cannot use it as a discount rate! Bond indexes are market-weighted; they’re not liability weighted. Until a custom liability index is built for each pension plan, based upon the unique actuarial term structure of that plan, and priced off of real zero-coupon bonds, pensions are in jeopardy of managing to the wrong objective.” (p. 9)

Ryan, Ronald. 2011. “The Public Pension Crisis.” IMCA Investments and Wealth Monitor

“The solution to the public pension and budget crisis starts with liabilities. Until a custom liability index (CLI) is installed as the proper benchmark, all asset allocation, asset management, benefit and contribution decisions will be based upon erroneous and misleading calculations. The benchmark must be a CLI because no two pensions are alike due to different salaries, mortality and plan amendments.” (p. 30)

Society of Actuaries. 2004. “Principles Underlying Asset Liability Management.” SOA Exposure Draft

“Asset Liability Management is the ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities to achieve financial objectives, for a given set of risk tolerances and constraints. A consistent ALM structure can only be achieved for economic objectives. Various accounting measures are affected by rules that change the emergence of income and the reported book value of assets and liabilities. These measures can sometimes distort economic reality and produce results inconsistent with economic value. Because ALM is concerned with the future asset and liability cash flows, the natural focus of ALM is economic value. Entities that focus on economic value tend to achieve their financial objectives more consistently in the long term.” (p. 6)

Waring, M. Barton, and Laurence B. Siegel. 2007. “Don’t Kill the Golden Goose! Saving Pension Plans.” Financial Analysts Journal, vol. 63, no. 1

“The first element of ‘new’ technology needed to manage DB plan risk and cost is an economic view of the liability. The only risks that are helpful to know about are the risks that can be hedged through investing the assets. Such risks are those in the liability that are market related—that is, correlated with the returns of assets or indices available in the markets. Therefore, sponsors need to set aside the actuarial and accounting views of the liability and rediscount the cash flows at appropriate, market-related rates. Plus, they need to understand how these market-related values, economically sensible measures of periodic pension cost, and economically required contributions change as market interest rates change.” (p. 36)

Waring, Barton, and Duane Whitney. 2009. “An Asset–Liability Version of the Capital Asset Pricing Model with a Multi-Period Two-Fund Theorem.” Journal of Portfolio Management, vol. 35, no. 4 (Summer)

“The authors present a new capital asset pricing model (CAPM) that incorporates investors’ deferred spending plans, or ‘economic liabilities’—the underlying purpose behind all investments—and thus reveal a new risk-free asset, the investor’s liability-matching asset portfolio.” (p. 111)

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.

Pension Confusion - Find the Liabilities

Source: Pension Confusion - Find the Liabilities

Securing and funding liabilities in a cost-efficient manner with prudent risk is the true pension objective. Although liabilities should be the focus of pensions, it is hard to find liabilities in asset allocation, asset management and performance measurement… especially forPublic and Multiemployer Plans,as theseplans are asset only focused. Private plans are very much liability driven although they have opted out of pensions to buy Insurance BuyOut annuities as a major trend for over ten years.Given the 500 bps increase in the Fed Funds rate in the last two years, Private plans need to revisit the economics of BuyOut annuities versus a defeasance strategy (cash flow matching). I think they may find that a defeasance strategy has definite cost advantages today.

So, what’s the matter? There is an obvious disconnect between assets and liabilities because liabilities are missing from every critical asset function:

Asset Allocation (AA)

Liabilities are like snowflakes, you never find two alikeas each pension plan has a different labor force, salaries, mortality and plan amendments. There can never be a generic market index to replicate any plan sponsor’s unique liability cash flows. Liabilities are the domain of the actuary. They produce a very thorough annual report detailing and itemizing numerous liability calculations. The actuaries do an amazing job given the huge number of calculations. They have a tedious and most important function as the calculator and custodian of the liabilities. This voluminous work is usually presented as an annual report a few months after the end of the fiscal year. More importantly, the actuary calculates the funded status which should be the focus of asset allocation, asset management, and performance measurement.

Most pension asset allocations are based on earning a target ROA or hurdle rate. The ROA is calculated by weighing the expected return for a series of asset classes. Each asset class has its own ROA based on its index benchmark estimated return. Pension consultants are quite diligent in analyzing each asset class and assigning the proper weight to achieve the target ROA and risk behavior. Thorough quarterly reports are presented by the consultants to plan sponsors detailing the risk/reward of every asset manager versus the index benchmark assigned to that asset class as the bogey. As a result, generic market indexes are the driver and focus of asset allocation.

AA should be responsive to the funded status of each client. A 90% funded plan should have a much more conservative AA than a 60% funded plan. But most, if not all, asset allocation models ignore the funded status and focus on achieving the target ROA with the highest probability of success and prudent risk based on historical returns of a database that is almost 100% generic market indexes. The historical risk/reward behavior of numerous generic market indexes are

inputs into an AA optimization model that provides a baseline allocation of each asset class. The pension consultant will then massage those weights to best fit each client. Too often plan sponsors have similar asset allocations no matter what their funded status is because they have similar ROA targets. This has led to inappropriate AA especially in the late 1990s and early 2000s that were heavily skewed to risky assets although the pension plans were greatly overfunded then. Had pensions defeased their liabilities then through a cash flow matching strategy with investment grade bonds, they could have secured their surplus victory and stabilized low contribution costs. Instead, the equity correction of 2000-02 wrecked the funded status of almost all pensions causing spiking contribution costs which have not subsided even today.

Without knowledge of the economic funded status on a frequent and accurate basis, AA cannot function effectively. If the market value of assets is the most accurate measurement of asset valuation then the same is true for liabilities. The Society of Actuaries (SoA) delivered a research paper “Principles Underlying Asset Liability Management (ALM)” years ago that warns of erroneous accounting valuations and recommends that pensions create a set of economic books:

“A consistent ALM structure can only be achieved for economic objectives. Accounting measures can sometimes distort economic reality and produce results inconsistent with economic value. Because ALM is concerned with the future asset and liability cash flows, the natural focus of ALM is economic value.”

Ryan ALM Translation: Pension plans need to create a set of “economic books” so ALM can function effectively. It’s all about asset cash flows funding liability cash flows. A Custom Liability Index (CLI) is the method and proper benchmark to create economic books.

With a CLI in place, consultants and plan sponsors can now know monthly the true economic funded status and liability growth rate. With a CLI, consultants now possess pertinent and private information for each of their clients that no other consultant would have…. a significant advantage over competition. The CLI allows consultants to now customize the AA to best fit the clients dynamic funded status with timely adjustments. Although the actuaries don’t produce a CLI, it is based on the private actuarial projections of benefits, administrative expenses and contributions. Ron Ryan and his team created the first CLI in 1991 as the true benchmark of a pension. The Ryan ALM CLI provides all of the calculations needed for efficient AA, ALM, and performance measurement.

Asset Liability Management (ALM)

It would be hard, if not impossible, for an asset manager to manage assets versus a generic market index if it came out annually, months after the end of the fiscal year with no transparency (index constituents not shown) and it wasn’t priced at the market. Well welcome to the pension world of liabilities. Liabilities are an annual actuarial calculation that has little or no transparency (projections usually not shown) and is priced at the ROA (GASB) as the discount rate. The ROA discount rate is certainly not a market rate you can buy to settle the liabilities. The ROA discount rate is one of the accounting distortions of economic reality the SoA referenced.

This was the message from the SoA. You need to create a set of economic books for ALM to function effectively. This is why a CLI is the critical step in ALM. Assets need to know what they are funding. The answer is usually net liabilities defined as (benefits + expenses) – (contributions) since contributions are the first source to fund the liability cash flows. Because net liabilities are not calculated in the actuarial report, the CLI should be a requirement to understand the net liability cash flows that asset cash flows must fund. Such net liability cash flows are also monthly which is another calculation made by the CLI.

If the true pension objective is to secure benefits in a cost-efficient manner with prudent risk, then cash flow matching (CFM) must be the proper and best ALM strategy. CFM used to be called dedication and has been a stable approach to pension investing for over 50 years. Bonds are the only asset class with the certainty of its cash flows. That is the intrinsic value in bonds and the reason why CFM should be the core portfolio of any pension. As the funded ratio improves, a higher allocation should be given to CFM to secure more and more benefits while stabilizing the funded ratio and contributions.

Performance Measurement

Once the CLI is in place, it will provide monthly calculations of the net liability growth rate (returns). Total asset growth (returns) versus the total net liability growth rate is the critical performance measurement. If all of the asset managers outperformed their generic market index benchmarks but total asset growth underperformed total net liability growth rate… the plan loses. This lost shows up in higher pension expense (contribution costs) and a lower funded status.

With a liability objective, the terms Alpha and Beta now take on a different perspective. Liability Alpha is the excess return of asset growth rate versus the liability growth rate. Liability Beta is now the portfolio that matches the liability cash flows it is funding. With the CLI, liability Beta is now a Liability Index Fund. Without a CLI, performance measurement is comparing assets versus assets… this is in sharp contrast to the pension objective of assets versus liabilities.

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.

Ryan ALM Pension Alert Q2’23

Source: Ryan ALM Pension Alert Q2’23

Spread between ROA and Bonds Narrowest in 20+ Years

Most Asset Allocations for pensions are based on achieving the ROA. The ROA is an annual forecast of asset returns. Each asset class is assigned a ROA then weighted by the target allocation to get an average or target ROA. Currently, the ROA for most Public pensions is around 7.00%. Yields on A and BBB corporates have risen significantly in the last two years and are now fast approaching the ROA target return. With A and BBB corporate yields at 78.6% to 85.0% of the ROA, a strong argument should be made to increase the allocation to fixed income. The 2023 Milliman Public Funding Survey suggests that the ROA will continue its trend lower. With the Milliman 2024 estimate of a 6.75% ROA, A and BBB corporate bonds would approach 81.5% to 88.2% of the target return. Ryan ALM recommends using bonds for their intrinsic value… the certainty of their cash flows. Cash flow matching liabilities chronologically would be in harmony with the true objective of a pension… to secure the promised benefits in a cost-efficient manner with prudent risk.

Benefits of Higher Bond Allocation to Cash Flow Matching:

• Improve Liquidity

• Outyield ROA = liability Alpha

• Reduce Volatility (risk) of Funded Ratio

• Create CORE portfolio as anchor to earning ROA

• Reduce costs to fund Benefits + Expenses (B + E)

• Buy TIME for performance assets to grow unencumbered
  

Ryan ALM Pension Monitor YTD 2023

Source: Ryan ALM Pension Monitor YTD 2023

(Through June 30, 2023)

Pension plan liabilities need to be measured and monitored regularly. Without knowledge of plan liabilities, the allocation of plan assets cannot be done efficiently or appropriately. The funded ratio/status of pension plans are present value calculations. Each type of plan is governed by accounting rules and actuarial practices, which determine the discount rate used to calculate the present value of liabilities. Single employer corporate plans are under ASC 715 (FASB) discount rates (AA corporate zero-coupon yield curve); multiemployer plans and public plans use the ROA (return on asset assumption) as the liability discount rate. The difference in liability growth between these plans can be quite significant (see 2022’s differential of 31.5%), which will affect funded status and contribution levels.

The table below compares these different liability growth rates (based on a 12-year average duration) versus the asset growth rate based on the P&I asset allocation survey of the top 1,000 plans which is updated annually.

ASSET ALLOCATION	YTD 2023 Return	Corporate	Public	Union
Domestic Stock International Stock Global Equity Domestic Fixed Income Global Fixed Income Cash Private Equity Real Estate Equity* Other	16.9% 12.2% 14.3% 2.1% 1.7% 2.3% 5.8% -5.4% 3.6%	11.1% 6.1% 6.3% 44.4% 0.9% 2.2% 12.4% 5.5% 11.1%	22.1% 13.4% 4.5% 19.4% 1.6% 1.6% 15.1% 11.6% 10.7%	18.7% 9.1% 13.6% 28.9% 0.0% 0.7% 10.7% 9.4% 8.9%
TOTAL ASSETS Growth Rate		5.3%	7.1%	7.3%
LIABILITIES Growth Rate**		4.2%	3.6%	3.6%
Asset Growth – Liability Growth		1.1%	3.5%	3.7%

Index Benchmarks: Domestic Stock = S&P 500; Int’l Stock = EAFE, Global Equity = All Country World; Domestic Fixed Income = BB Aggregate; Global Fixed Income = FTSE World Gov’t (unhedged); Cash = Ryan ALM Cash Index; Private Equity =10-year return for the R2500 + 2%; *Real estate Equity =NFI-DP Index (one month lag); Alternative Investments and Other = CPI-U & 3%.
** Liabilities (corporate) = Ryan ALM ASC 715 discount rate and Liabilities (Public, Multiemployer) = 7.25% ROA

The graph below shows the contrasting annual differences of asset versus liability growth for corporate and public plans since 2015. The impact of different accounting rules (FASB vs. GASB) can create confusion, as reflected in the chart below.

Footnote: The measurement of asset growth to liability growth is an annual calculation beginning on December 31, 2015. For periods shorter than 1-year, the observation is a YTD calculation.

With regard to the first half of 2023, Corporate funding underperformed Public funding as declining interest rates YTD had a slightly greater impact on the present value of a plan’s future benefits. In addition, the much higher exposure to US fixed income within corporate pension plans (44.4%) versus both public (19.4%) and multiemployer (28.9%) and the far less exposure to US equities (11.1%) versus publics (24.4%) and multiemployer (21.8%) had a meaningful impact on the average total return for those plan types.

Ryan ALM Pension Monitor Q1’23

Source: Ryan ALM Pension Monitor Q1’23

‍(Through March 31, 2023)

Pension plan liabilities need to be measured and monitored regularly. Without knowledge of plan liabilities, the allocation of plan assets cannot be done efficiently or appropriately. The funded ratio/status of pension plans are present value calculations. Each type of plan is governed by accounting rules and actuarial practices, which determine the discount rate used to calculate the present value of liabilities. Single employer corporate plans are under ASC 715 (FASB) discount rates (AA corporate zero-coupon yield curve); multiemployer plans and public plans use the ROA (return on asset assumption) as the liability discount rate. The difference in liability growth between these plans can be quite significant (see 2022), which will affect funded status and contribution levels.

The table below compares these different liability growth rates (based on a 12-year average duration) versus the asset growth rate based on the P&I asset allocation survey of the top 1,000 plans which is updated each year. The graph below shows the contrasting annual differences of asset versus liability growth for corporate and public plans since 2015. The impact of different accounting rules can create confusion, as reflected in the chart below. Corporations underperformed as declining interest rates increased the present value of a plan’s future benefits.

ASSET ALLOCATION	Q1’23 Return	Corporate	Public	Union
Domestic Stock International Stock Global Equity Domestic Fixed Income Global Fixed Income Cash Private Equity Real Estate Equity* Other	7.5% 8.7% 6.8% 3.0% 3.5% 1.2% 3.0% -5.2% 1.8%	11.1% 6.1% 6.3% 44.4% 0.9% 2.2% 12.4% 5.5% 11.1%	22.1% 13.4% 4.5% 19.4% 1.6% 1.6% 15.1% 11.6% 10.7%	18.7% 9.1% 13.6% 28.9% 0.0% 0.7% 10.7% 9.4% 8.9%
TOTAL ASSETS Growth Rate		3.5%	4.0%	3.8%
LIABILITIES Growth Rate		7.2%	1.8%	1.8%
Asset Growth – Liability Growth		-3.7%	2.2%	2.0%

Index Benchmarks: Domestic Stock = S&P 500; Int’l Stock = EAFE, Global Equity = All Country World; Domestic Fixed Income = BB Aggregate; Global Fixed Income = FTSE World Gov’t (unhedged); Cash = Ryan ALM Cash Index; Private Equity =10-year return for the R2500 + 2%; *Real estate Equity =NFI-DP Index (one quarter lag); Alternative Investments and Other = CPI-U & 3%.

Footnote: The measurement of asset growth to liability growth is an annual calculation beginning on December 31, 2015. For periods shorter than 1-year, the observation is a YTD calculation.

Both Corporate and Public plans had average asset allocations that produced positive results during the first quarter. However, differences in the accounting rules between GASB and FASB led to Corporate plans showing a negative return when comparing assets versus liabilities.