In an industry as exacting as the investment industry where trading is measured in milliseconds, a penny miss in earnings can tank a stock, and where performance results are measured to a minimum of hundredths, it is shocking that we still have so much guesswork involved in managing a pension plan.
We were recently asked to create a Custom Liability Index (CLI) for a defined benefit plan. Once that task was completed, we volunteered to do an Asset Exhaustion Test (AET) to help the plan sponsor calculate the return needed to ensure that the assets are not exhausted before all promised benefits were paid.
Unfortunately, the Return on Asset Assumption (ROA) that is used as a return objective and the discount rate in public and multi-employer plans, is nothing better than a guess. Given that it is nothing more than a guess, it is amazing that plans will have ROA targets as exact as 7.625%. Really?
In the case to which I am referring, the plan had “determined” that 7.5% should be the ROA objective. Why? Because! At KCS, we often refer to these ROAs as “Goldilocks” numbers because they are neither too hot nor too cold. But in this case, their target return was too high for we calculated that 6.8% is the return objective needed to keep the fund going.
Why does this matter? First, the ROA is instrumental in determining contributions into the fund. A number that is too low will necessitate larger contributions and vice versa. In addition, striving for a number greater than what is needed injects unnecessary risk into the asset allocation process. A plan with a 7.5% return target is likely going to have a lot more equity exposure than one needing only 6.85%.
As if this isn’t bad enough, because GASB allows public and multi-employer plans to discount their liabilities at the ROA, a significant majority (like all) are overstating their funded status. But, we’ll save this little ditty for another KCS Blog post.