Managing a pension plan is difficult! Unfortunately, the task has been made more difficult by not having a complete picture of the plan’s true objective. What do I mean?
Well, as everyone knows, the big game is on Sunday, and much of the country will be glued to their seats watching Carolina and Denver play. Just think what a different experience it would be if there was no scoreboard, and you didn’t know who was winning or losing. Can you imagine a team trying to run an offense without the knowledge as to whether they should become more aggressive (more passing) or conservative (3 yards and a cloud of dust)? How about a defense not knowing whether to blitz on every play or use 5-6 defensive backs to stop the big play?
Well, unfortunately for most of our plan sponsors this is what they experience all the time – at least 364 of 365 days (non leap years). How is that possible? The most important piece of information that a plan sponsor can have is absent, missing, no where to be found! Plans only exist to meet a promise that has been made, yet that liability is only calculated once per year and usually received about 4 to 6 months in arrears.
Plans blindly manage asset allocation decisions versus a generic return on asset assumption (ROA), and I say generic because every liability stream is different, yet roughly 50% of public pensions use 7.5% as their objective. How can that be? Also, they assume that liabilities grow at the same rate as assets, but of course that isn’t correct. As we’ve seen during the last 15-16 years, liabilities have grown at nearly three times the rate as plan assets. Wonder why we have a funding crisis?
By not knowing what the plan’s liabilities are it is impossible to adjust a plan’s asset allocation to reflect either improvement or deterioration in the funded ratio. Plans experiencing improved funding should de-risk the portfolio (adopt that no hail Mary strategy), while plans struggling to improve funding might just need to get more aggressive. Clearly, a one-size-fits-all ROA objective of 7.5% can’t be right.
The standard deviation associated with a combination of assets that might get you 7.5% in this environment is roughly 17.5%. Are you comfortable living in an environment in which 68% of your annual observations ( 1 standard deviation) could have your plan up or down anywhere from 25% to – 10%? I don’t think so! Yet that is exactly what is happening.
I encourage you to get greater clarity on your liabilities so that asset allocation and management structure decisions are based on fact and not some generic ROA that doesn’t have anything to do with liabilities. With greater clarity comes a more likely victory! Get a Custom Liability Index (CLI) so that you have a monthly view on your promised benefits.