Why Derisk? Less Volatility, Lower Costs

The U.S. DB pension industry has engaged in a returns-based “arms race” for the last 50+ years in an attempt to meet or exceed their ROA objective.  In many cases plan’s have achieved their stated return objective, but plan funding continues to deteriorate with funded ratios falling and contribution costs escalating.

There are many reasons for this phenomenon to have occurred, but the primary reason (for corporate plans) has been that liability growth has far outpaced asset growth during the 30+ year bond bull market.  If FASB and GASB had similar methodologies for valuing liabilities, public plan liabilities wouldn’t be as understated as they are.

For the past 5 years, we at KCS have been encouraging sponsors to begin derisking their plans despite moderate to low funded ratios.  Focusing exclusively on the return has injected far more risk into the asset allocation process than is necessary.  It is amazing that the last financial crisis didn’t sound the death knell for pensions, but the next one likely will.

Contribution costs as a percentage of payroll are nearing levels that are not sustainable.  The excess volatility found in today’s markets will only exacerbate this issue should another correction occur.  Return forecasts for the next 5 to 10 years are quite low, and reasonably so, given valuation levels for traditional bonds and equities.  Most DB pension plans generated a weak result in the 12 months ending June 20th (CalPERS was up just 0.61%), and this is with markets hitting all-time highs.

Our derisking methodology is quite simple (and logical). We suggest converting current fixed income holdings into a cash-flow matched portfolio to meet near-term retired and terminated vested lives (both known and easily calculated). The benefits are many! First, liquidity is improved to meet benefit payments (no longer have to sell illiquid assets) on a monthly basis net of contributions. Second, the conversion to a cash matched strategy significantly reduces interest rate sensitivity.  Finally, the investing horizon is extended for the growth assets, which benefit from time (capture the liquidity premium).

We recently undertook a project for a mid-sized public fund that asked us to restructure their fixed income.  This plan had all the fixed income bells and whistles, including high yield, bank loans, international and emerging markets, as well as a core plus manager. Through our derisking approach, we were able to shorten duration (by 0.34 years), improve the overall yield (>$750,000 / year), reduce management fees by $500,000 annually, while stabilizing contribution costs.

The cost savings and yield improvement are substantial. Obviously derisking doesn’t mean greater costs as some would have you believe.  Intrigued? Let us do a similar evaluation for you. We think that you’ll be pleasantly surprised by the results!

 

 

 

 

 

 

 

 

 

 

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