We’ve often spoken about the fallacy of the return on asset assumption (ROA), as not being the appropriate objective for a pension plan, but we’ve never introduced the idea that the funded ratio is not a good indicator of a plan’s financial health until today.  We think that a plan can hide behind the funded ratio, which can mask the true economics of that plan. How is that possible? Let us given you an example. But, first some facts.

• During the last 5 years (ending 12/31/14) the average public pension plan (TUCS universe) has generated a 9.95% annualized return, which would be considered very good relative to most plan’s stated ROA (8%).
• Also, during the last 5 years, liabilities (according to Ryan ALM) have grown by 10.14% annualized.
• Given the fact that asset growth easily eclipsed the ROA, and kept pace with liabilities, one would think that the funded ratio would remain fairly stable, and you’d be right.  So what is the issue?

Let’s look at pension math. Let’s assume that your plan has $375 million in assets as of December 31, 2009, and a funded ratio of 75% (S&P stated that the average plan was 72% funded at that time). That would suggest that your liabilities amounted to $500 million.  If you grow assets by the 9.95% and liabilities by the 10.14%, your funded ratio only falls from 75% to 74.4%.

On the surface, everything seems to be stable, if not improving.  However, the funding gap in terms of the plan’s unfunded actuarial accrued liability (UAAL) has ballooned. In our example, assets grew to $602.6 million, while liabilities increased to $810.4 million. The UAAL went from $125 million, as of 2009, to $207.8 million in just five years, increasing by a whopping 65.8%.

So, do you still think that the ROA, which was easily eclipsed, and the funded ratio, relatively stable at roughly 74 -75%, are the key pension metrics? Managing a pension plan shouldn’t be about return, but about providing a stated benefit at the lowest cost possible. How many budgets can afford the volatility witnessed in our example? We suspect that few can! This is why a plan’s liabilities need to be at the forefront of asset allocation and manager structure decisions, and not a bit player, as they are today.