We remain concerned about the singular focus by plan sponsors on the return on asset assumption (ROA) to drive asset allocation. Why? First, the ROA is not reflective of a plan’s liability growth. Second, trying to create an asset allocation that achieves a 7.5% (average ROA) objective in this market is leading to excessive volatility.
It was once a fairly easy objective when interest rates provided a healthy 5%-6% return. However, in this low interest rate environment the standard deviation of returns around a 7.5% objective is roughly 17%-18%.
What does that mean for the plan sponsor and their asset consultant? It means that 68% of the time (1 standard deviation), the annual return for a DB plan will be anywhere from 25% to -10% (using 17.5% as the standard deviation). It also means that 95% of the time (19 out of 20 years) the return to the pension plan could be 42.5% to -27.5%. WOW!! You can drive multiple trucks through that gap. Is this range of results comforting to you? It shouldn’t be!
What is particularly troubling is the fact that there are well funded and less well funded plans using the same 7.5% objective and roughly the same asset allocation. How does this make sense? One would think that a plan with a 90% funded ratio would remove a significant portion of the above mentioned volatility from the asset allocation process. Either one plan’s asset allocation is too conservative or the others is way too aggressive.
We need to protect and preserve DB plans as the primary retirement vehicle. Injecting too much risk into the asset allocation process is destabilizing these plans. We need to rethink this approach before it is too late.