Rethinking Traditional Fixed Income In A DB Plan

Ron Ryan, Ryan ALM, and the KCS team would like to encourage plan sponsors and their consultants to re-think the use of traditional fixed income in a defined benefit plan, especially given where rates are after a 3o+ year bull market for bonds.  It is truly unfortunate that most plans have dramatically underweight fixed income during the last 15+ years, and as a result they’ve created a significant asset / liability mismatch, while missing one of the greatest performance periods for U.S. fixed income.

First, we’d like for you to ask yourselves what is the value in having Bonds in your portfolio? As mentioned above, yields are historically low suggesting below average potential returns. Historically, the PIPER study shows that active bond management adds little to no value versus their index benchmark based on the median bond manager versus the Barclay’s Gov/Corp index. But, it gets worse, as this comparison is shown “before fees”.

After fees the median manager would lose consistently to the index benchmark.
So, what is the value in bonds? Answer: Cash Flows. Bonds are the only asset class with a known cash flow. That is why bonds have been used for defeasance, dedication, immunization and de-risking strategies. The most cost effective way to de-risk a pension is “cash flow matching”, as opposed to duration matching liability driven investing. For example, a Liability Beta Portfolio (LBP) model (produced by Ryan ALM) will cash flow match liabilities at a cost savings of 4% on 1-10 year and 10% on 1-30 year liabilities given its yield advantage.  That is tremendous savings on a $200 million portfolio ($8 to $20 million).

Second, pension liabilities are “Interest Rate Sensitive” just like bonds. Since they have on average longer durations than bond indexes they are more interest rate sensitive, and by a factor of 2, maybe 3 times. Since 1982 (the beginning of the great bond bull market) interest rates have been in a secular decline, which has created significant growth in the present value of DB pension liabilities.

When interest rates go up as a trend, the opposite effect will happen. The present value growth of pension liabilities will be very low, and importantly, perhaps even negative. This will provide the best chance for DB Plan Funded Ratios to recover to a fully funded status. Pension assets will need little positive growth to outgrow liabilities and create significant liability Alpha.  As we’ve stated many times, the ROA isn’t the objective for a DB plan, but that plan’s liabilities certainly are!

By converting your current fixed income from a performance oriented portfolio to one that is used to cash flow match, we set the plan on a de-risking path, remove interest rate sensitivity, and begin to stabilize contribution costs. Let us know how we can help you!

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