As Promised, we will be posting answers to the questions that we posed in our most recent Fireside Chat, “Your Liability-Aware Cheat Sheet” during the next couple of weeks. Let’s begin:
- Is the primary pension objective an absolute return (ROA) or a relative return (liability growth) goal?
- Furthermore, is the ROA a calculated number?
The objective of a pension plan is not to generate the highest return, but to secure the promised pension benefit payments in a cost-efficient and prudent risk manner. When defined benefit plans first started, the current assets plus contributions were used to cash-flow match the plan’s benefit payments (i.e. liabilities). It wasn’t until the development of the asset consulting industry in the late 1960s and early 1970s did pension plans migrate to a return orientation from one focused on funding cost. Striving for a greater annual return ensures greater volatility of returns, but doesn’t ensure funding success, especially in an environment of stretched valuations for both equities and bonds.
What may come as a surprise to many in our industry is the fact that the return on asset assumption (ROA) is not a calculated number. The ROA is a discount rate for the plan’s liabilities and it determines the level of annual contributions that are required. Hitting the ROA objective does not guarantee funding success. A simple example proves the point. If you had assets of $60 and liabilities of $100 with an ROA of 7.50%, then don’t the assets need an ROA of 12.5% to earn $7.50, not the actuarial ROA of 7.50%! Performing an Asset Exhaustion test (an analysis of a plan’s solvency under GASB 67/68) will calculate the actual return needed to be generated by the fund that ensures that the fund’s assets will never be exhausted based on the contributions being forecast and will fully fund the benefits promised until the last participant has passed away.