Pension Strategy to Reduce Funding Costs by 20%+

Source: Pension Strategy to Reduce Funding Costs by 20%+

The true objective of a pension is to secure and fully fund benefits in a cost-efficient manner with prudent risk. It is a liability and cost objective… it is NOT a return objective! This objective is best accomplished through a cash flow matching strategy where an optimal bond portfolio will fully fund monthly benefits + administrative expenses net of contributions. Bonds are the only asset class with certainty of its cash flows. That is why bonds have been the asset choice to defease liabilities for over 50 years.

Cash flow matching (CFM) used to be called Dedication in the 1970s and 1980s. As the head of Fixed Income Research at Lehman in the 1970s and early 1980s, I was in charge of our Dedication model. When I created my initial firm in 1984 (Ryan Financial Strategy Group), I hired the two professors in charge of Dedication at I.P. Sharpe to build our model. At Ryan ALM, we have rebuilt a CFM model that best fits any liability objective. The Ryan ALM CFM strategy utilizes our proprietary cost optimization model that will fully fund monthly net liabilities and reduce funding costs by about 2% per year. If we CFM 1-10 years of net liabilities, we should be able to reduce funding costs by about 20%, 1-15 years = 30%, etc. In addition to reducing funding costs, CFM has several benefits that should be utilized and recognized. We strongly urge pensions to consider CFM as the core portfolio that best fits the true pension objective and provides many additional benefits as listed below:

Cash Flow Matching – Provides Liquidity

The intrinsic value of bonds is the certainty of their cash flows! If bonds were used to cash flow match and fund net liabilities (benefits - contributions) chronologically they would produce the liquidity needed to fully fund such net liabilities. Cash flow matching works best with longer coupon bonds where you use semi-annual interest income cash flows to partially fund liabilities. A 10-year bond has 20 interest cash flows + one principal cash flow all priced at a 10-year yield. This would eliminate the need to do a cash sweep of other asset classes which is a common liquidity procedure. According to S&P data, the S&P 500 has 48% of its historical returns from dividends and reinvestment since 1940 on a 10-year rolling period basis. Wouldn’t you want to reinvest dividends back into growth assets rather than spend it on funding benefits + expenses? Wouldn’t you want the ROA of growth assets enhanced?

Cash Flow Matching - Provides TIME

Ryan ALM, Inc. released a 2022 research report titled “Most Important Asset of a Pension… Time!”. By using bonds as the liquidity assets, the growth assets are left unencumbered to grow. The longer the cash flow matching period, the more time the growth assets have to compound their growth. This could significantly enhance the ROA. By cash flow matching net liabilities chronologically, Ryan ALM can buy the time a plan sponsor and their consultant feel is necessary for the growth assets to grow unencumbered… and recover from negative return years. When markets correct and go down (i.e. 2022) it may take several years to recover and achieve the average annual target ROA that was assigned to that asset class.

Cash Flow Matching – Provides Inflation Hedge

Ryan ALM released a 2020 research report and pension alert titled “Pension Inflation =/= CPI”. Pension inflation has three parts: a cost of living adjustment (COLA) lives; a salary increase factor for active lives and a forecast of administrative expenses. The COLA may be based on the CPI but with a floor and a cap or even a % of the CPI while the salary and administrative expense increases tend to be quite static @ 3% annual increase. As a result, pension inflation tends to be less volatile and more static than the CPI. The plan sponsor actuary includes pension inflation in their projected benefit + expenses payment schedule for both retired and active lives. This fact suggests clearly that the best way (and only way) to hedge pension inflation is to cash flow match the actuarial projected benefits + expenses. If you cash flow match the actuarial projections, you have defeased liabilities and hedged pension inflation.

Cash Flow Matching – Outyields Benchmark and Bond ROA

The Ryan ALM cash flow matching product (Liability Beta Portfolio or LBP) is heavily skewed to A/BBB corporate bonds while the BB Aggregate is heavily skewed to Government bonds. As a result, the LBP will outyield the BB Aggregate by a significant yield spread… usually 50 – 75 bps, which will enhance the ROA of bonds.

Higher Yields are Good for Cash Flow Matching… and Pensions

Ryan ALM released a topical 2022 research report titled “Why Higher Interest Rates are Good for Pensions”. Pension funds are highly interest rate sensitive! Certainly, fixed income assets are such that the longer their maturity and effective duration, the greater their interest rate sensitivity. But it is pension liabilities that are more interest rate sensitive. Liabilities behave like a 100% zero-coupon bond portfolio because the discount rate(s) chosen price liabilities as zero-coupon bonds. This causes liabilities to be longer in duration then the same maturity(s) coupon bonds. Many discount rates are a yield curve of rates (ASC 715, PPA, PBGC, IASB). As interest rates trend higher, bonds can cash flow match liabilities at lower and lower costs. Note that cash flow matching is focused on funding B + E which are future values. Future values are not interest rate sensitive. Bonds are the only asset class with the certainty of cash flows (future values). That is why bonds have always been used as the methodology for defeasance (cash flow matching) of liabilities. Moreover, if interest rates trend upward any reinvestment of cash flow can buy future value at a lower cost. As a result, cash flow matching sees higher interest rates as an opportunity to reduce funding costs. The Ryan ALM cash flow matching product can reduce funding costs by @ 20% for most pension liabilities out to 10 years. In contrast, bonds used as performance or growth assets could see negative returns… like 2022. Total return performance is not the value in bonds… the certainty of cash flow is the intrinsic value. We urge pensions to transfer their bond allocation from focusing on outperforming some generic bond index to focusing on cash flow matching liabilities chronologically, especially at today’s higher rates.

Reminder: The ROA is Plural… ROAs

Ryan ALM, Inc. released a topical 2022 research report titled “The Pension ROA is plural… ROAs” that details how the ROA is calculated. Each asset class is askby using their index benchmark as the target return proxy. However, for fixed income it is the YIELD of the index benchmark… not the total return like other asset classes. The Bloomberg Barclay Aggregate is most favored as the bond index benchmark. This index and almost all popular bond index benchmarks were designed at Lehman Bros. by me (Ron Ryan) when I was the head of Fixed Income Research & Strategy from 1977 to 1983. Please note… each asset class is NOT required to earn the pension fund ROA assumption (@ 6.50% today). This is an important fact to remember in asset allocation. We at Ryan ALM often hear the criticism and question… how can we invest in 4% bonds to earn our ROA? The answer is bonds do NOT need to earn the pension ROA… just their assigned ROA (yield of index benchmark) in the asset allocation model.

Pension Conundrum - Liquidity Risk

Source: Pension Conundrum - Liquidity Risk

Liquidity is a critical and necessary priority of a pension fund, since it must fund monthly benefits and expenses (B + E) on time. Many plan sponsors use a “cash sweep” or a fixed cash allocation to provide such cash flow. Both strategies are not optimal for a pension plan.

Cash Sweep

A cash sweep usually takes income or cash flow from all asset classes to fund the current monthly B+E. This can severely damage the ROA of such asset classes. According to a research report by Guinness Global found since 1940, dividends and dividends reinvested have accounted for 47% of the S&P 500 total return on a 10-year rolling period and 57% on a 20-year rolling period. So, this data questions the logic of a cash sweep that uses dividends to fund B+E.

As a solution, Ryan ALM recommends that you use a cash flow matching (CFM) strategy to fully fund B+E. Our CFM model will provide timely cash flows that will fully fund B+E at the lowest cost to our clients. The benefits of CFM are quite substantial:

• Allows growth (non-liquidity) assets to grow unencumbered. Should enhance their ROA significantly.

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

• CFM will provide certainty (barring a default) of cash flows which reduces or eliminates liquidity risk.

• CFM is an investment grade portfolio skewed to the longest maturities within the area it is funding (i.e. 1-3 years or 1-5 years) that should enhance the CFM yield versus the yield on cash reserves.

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

Asset Allocation (AA)

Most AA have a cash allocation somewhere between 2% to 5%. Why? Normally you hear it is for liquidity purposes or even diversification. Cash is usually the lowest yielding asset especially when there is a positive sloping yield curve. Due to its very short maturities, cash is usually costing the plan close to a 1:1 cost ratio of present value to future value. The present value of a 3-month T-Bill will be quite close to its future value or a 1:1 ratio. While a CFM portfolio with a 3-year average maturity yielding 4.00% would have a 0.88:1 ratio for a cost reduction = 12%.

As a solution, Ryan ALM recommends separating liquidity assets from growth assets in asset allocation. Let bonds in a CFM strategy be your liquidity assets for the advantages mentioned above. A CFM strategy will have a longer average duration than cash thereby reducing the cost ratio. In this way the liquidity assets and the growth assets are a team that will produce the optimal solutions:

• Enhance ROA by eliminating a cash sweep so growth assets grow unencumbered.

• Reduce or eliminate liquidity risk by fully funding B+E monthly with certainty.

• Enhance the ROA by outyielding cash

• Reduce funding costs

Things To Ask Your LDI Manager

Source: Things To Ask Your LDI Manager

LDI is the acronym for Liability Driven Investment. It is better explained as Asset Liability Management which we promote at Ryan ALM. It has developed into two main strategies either to fund liabilities through cash flow matching or to immunize the interest rate sensitivity of liabilities through duration matching. Below is a short list of questions we urge plan sponsors and pension consultants to ask to any LDI prospective asset manager. Please call us for more LDI guidance.

Are you a Duration Matching (DM) or a Cash Flow Matching (CFM)manager?

If Duration Matching… ask these questions:

1. What is the source of your liability duration calculation? (Actuaries usually do not provide such calculation)

2. What is the discount rate(s) you use for your duration calculation? Is it a single rate? (ASC 715 is best for accurate market value calculation which is a AA corporate yield curve)

3. Are you using an average duration, key rates, or matches along the yield curve?

4. Do you match total liabilities including those past 30 years?

5. How often do you rebalance?

6. Do you make or fund the liability payments (benefits + expenses)? (Most DM managers are not term structure matched so not aligned to pay liabilities)

If Cash Flow Matching… ask these questions:

1. What liabilities are you funding? Gross or Net?

2. How are you funding the annual actuarial projected liability cash flows?

3. How much of a funding cost savings do you expect to realize? (Major CFM benefit is the funding cost savings: FV of liabilities – PV of CFM = about 2% per year which is achieved as soon as the CFM portfolio is built)

4. How do you fund liabilities past 30 years?

5. How many years of experience do you have with CFM? (CFM may be the oldest LDI strategy starting with Dedication in the 1970s)

As our name implies, Ryan ALM Advisers is dedicated to Asset Liability Management specializing in Cash Flow Matching… our only LDI product. We strongly feel that CFM best fits any liability objective including Pensions, OPEB, Lotteries, NDA, and E&F. Our team has over 168 years of experience dating back to the 1970s with Dedication models. Our CFM product is called the Liability Beta Portfolio™ which will fully fund monthly net liabilities at a funding cost savings of about 2% per year (40% on 1-20 years of liabilities). We can fully fund and CFM up to 30 years with certainty. This term structure monthly cash flow matching approach also provides the best duration matching as each monthly liability payment is fully funded and duration matched. After 30 years we are compatible and synergistic with any derivative strategy a plan sponsor may want to use.

The Smartest Beta

Source: The Smartest Beta

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

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

Smart Beta

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

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

Liability Beta Portfolio (The Smartest Beta)

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

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

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

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

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

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

Ryan ALM, Inc. Celebrates 20th Anniversary

Source: Ryan ALM, Inc. Celebrates 20th Anniversary

Ryan ALM, Inc. Celebrates 20th Anniversary Mission: Protecting and Preserving Pensions

Ryan ALM, Inc. was incorporated in Delaware on June 15, 2004. Ronald J, Ryan, founder, says that “we created our company to be dedicated to asset liability management (ALM) as our name suggests. We are quite proud of our progress and achievements in ALM. We have built a turnkey system of products that are quite unique in the ALM industry that we treat as assets shown on our balance sheet, to include:

1. Custom Liability Index (CLI) – assets need to know what they are funding. Usually, it is monthly net liabilities (benefits + expenses – contributions). Such net liabilities are based on actuarial projections even though actuaries do not calculate net liabilities. The CLI is the proper benchmark for all LDI and ALM objectives. The CLI performs numerous calculations including present values, duration, growth rates, interest rate sensitivity, YTM, etc.

2. ASC 715 Discount Rates – Ryan ALM is one of few vendors providing ASC 715 discount rates in conformity to FASB. We produce four unique yield curves of AA zero-coupon corporate bonds. Usually, our discount rates are higher than our competitors providing for lower liability valuations and enhanced balance sheets.

3. Liability Beta Portfolio™ (LBP) – our asset management division, Ryan ALM Advisers, LLC, is entirely focused on cash flow matching as our only ALM product we call LBP. We feel strongly that our LBP provides the most benefits in harmony with the true pension objective of funding liabilities in a cost-efficient manner with prudent risk. Our LBP matches and funds monthly liability cash flows with certainty while reducing funding costs by 2% per year (20% on 1-10 year liabilities). Our LBP will outyield the CLI and enhance the ROA for bonds.

4. Performance Attribution Report (PAR) – given our CLI, we can calculate the relative risk/reward behavior of assets (as measured by our LBP) versus liabilities (as measured by the CLI). PAR calculates 14 risk/reward measurements including two graphs to clearly show the value added (or lost) of assets versus liabilities. This should be critical information for consultants and plan sponsors to understand how well the plan is being funded.

5. Asset Exhaustion Test (AET) – assets need to know the hurdle rate or ROA needed to fully fund net liabilities. The current ROA most pensions use is not an accurate calculation of a hurdle rate. Our AET clearly shows the annual difference of asset cash flows versus liability cash flows. We calculate a matrix of ROAs to arrive at the most applicable target ROA. Usually our calculated ROA (AET) is much different and lower than the current ROA since we focus on net liabilities not gross liabilities which reduces the liability cash flows assets need to fund (perhaps significantly).

We are very proud of our synergistic system and thankful for our team of experts with over 168 years of experience. Ryan ALM remains dedicated to achieving the true pension objective of funding liabilities with low cost and low risk.”

Magnificent 7: Caveat Emptor!

Source: Magnificent 7: Caveat Emptor!

As pension watchdogs, Ryan ALM is always interested and concerned about trends that may affect the funded status of pensions. Since the major asset holding of most pensions is the S&P 500, we are on the alert for anything that may affect this valuable asset. I recently attended a CFA dinner where Rob Arnott, founder and chairman of Research Affiliates a subdivision of PIMCO was the guest speaker. Rob is quite articulate and brilliant on his assessments and forecasts. He was concerned about the valuation of the Magnificent 7 and thought the P/E multiples may not be sustainable. I share Rob’s concerns for the following reasons.

Apple became the first $3 trillion market valuation in America’s history. The seven largest capitalized technology stocks (i.e. the Magnificent 7) have been the main driver of returns for the S&P 500 for several years and certainly in 2023 YTD. As of December 1, this group had a total return = 98.79% based on the Bloomberg Magnificent Seven equal weighted index. At the same time the S&P 500 has a YTD return of 20.96%. According to BOA Global Investment Research, the Mag 7 account for 29.6% of the S&P 500 market capitalization. The newly released Bloomberg Large Cap index without the Magnificent 7 (B500XM7T) posted a YTD return of 7.6% which is 36.4% of the YTD S&P 500 return of 20.96%. This means that the Mag 7 has a YTD weighted group return of 13.33% which accounts for 63.6% of the S&P 500 YTD return (as of 12/01/23).

The Mag 7 should continue to grow well given their product line, market share, higher sales growth, higher margins, strong balance sheet and greater re-investment ratio in their market. The main question is one of valuation. Although it may be hard to assess a proper P/E multiple for each of the Mag 7, the wide array of P/E multiples and comparison to the market seem quite overvalued… S&P 500 multiple = 24.2x current and 18.7x forward (source: Yardeni). Tesla at 76.9x current/61.7x forward seems hard to justify especially with earnings growth of -6.1% over the last 12 months. Alphabet, Apple, Meta and even Microsoft trailing 12 months EPS growth do not seem robust enough to merit their valuation either.

Stock Symbol	Company	PE current	PE forward	Market Capitalization	EPS Growth 5-year Avg.	EPS Growth Last 12 mos.
GOOG	Alphabet	25.38x	19.80x	$1.66 trillion	25.4%	3.4%
AMZN	Amazon	76.69x	41.03x	$1.52t	63.0%	74.1%
AAPL	Apple	31.55x	27.16	$3.01t	14.4%	0.3%
META	META	28.10x	18.17x	$0.82t	8.9%	3.1%
MSFT	Microsoft	36.08x	28.76x	$2.77t	18.4%	10.5%
NVDA	Nvidia	61.48x	22.61x	$1.15t	27.7%	264.5%
TSLA	Tesla	76.87x	61.72x	$0.76t	40.5%	-6.1%
	S&P 500	24.2x	18.7x	$37.7t

Goldman Sachs Global Investment Research is forecasting a 6% growth for 2024 for the S&P 500. This does not validate the P/E multiples of the S&P 500.

“Investors should be skeptical of history-based models. Beware of geeks bearing formulas”

Warren Buffett

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.