Today was the day that I was supposed to be at FRA’s “Made In America” conference in Las Vegas. Ironically, the title of our panel discussion is “Digging Out Of Your Underfunded Status”. There certainly is a lot of digging our going on in the Northeast, but regrettably it has little to do with funded ratios or funded status for Pension America.
The basis of my presentation today was to focus on the need to first stabilize the plan through some fairly simple steps, but one’s that throw common pension orthodoxy out the window. So in that regard, not simple at all, as we are finding that there is great reluctance (inertia) to change one’s approach.
At KCS, we are espousing a three step approach to setting DB pension plans on the right course to improved funding. The process begins with a thorough analysis of the plan’s liabilities through the creation of a Custom Liability Index (CLI). This index utilizes readily available data from a plan’s actuary, but instead of getting an annual look at your liabilities through the actuarial report, a plan sponsor can get a monthly view through the CLI. The CLI will showcase the growth rate, interest rate sensitivity, and the term-structure of the plan’s liabilities.
With this output, we can determine how much alpha is needed relative to the liabilities, not the plan’s stated return on asset objective (ROA), in order to close the funding gap over the modified duration of the plan’s liabilities. Furthermore, we can determine how much of the plan’s assets can be placed in the beta portfolio (a cash matched or duration matched strategy) to begin to immunize near-term liabilities. The balance of the assets will be in the “alpha” portfolio with the goal, as stated before, of exceeding liability growth.
The final step in our process is to begin to implement our beta / alpha approach by converting the current fixed income portfolio, with all its credit and interest rate risk, into a more effective beta portfolio. With these three steps, the DB plan’s funded ratio will be stabilized, and the plan will now be on a glide path toward full funding, and contribution volatility will be lessened.
Unfortunately, current pension thinking would have one ratcheting up the ROA, jumping into new products / asset classes, trimming benefits, extending retirement age, lowering costs, etc., all in an attempt to stabilize the plan. Well, striving for the ROA has only lead to greater funding volatility, and given how the global markets have behaved so far in 2016, more volatility is not the medicine that we should be ingesting.