They Shouldn’t!

As we continue to answer questions from the most recent KCS Fireside Chat, today we address the following:

  • How could a 60% and a 90% funded plan have the same return on asset assumption (ROA)? Shouldn’t the asset allocation be based on the funded ratio?

They shouldn’t is the quick response, and yes, asset allocation should be predicated on the defined benefit plan’s funded ratio/status.

If two plans are striving for a 7.5% ROA, they are most likely going to have very similar asset allocations. In 1995, striving for a 7.5% annual return could be achieved through a mostly fixed income-oriented portfolio, and the standard deviation associated with that target return was only +/- 6%.  The plans with very different funded status wouldn’t necessarily be harmed in that environment.

However, according to Callan Associates Capital Market Projections, a 7.5% return objective in 2016 would come with a standard deviation of +/- 17.2%, and as markets continued to ramp up through 2017 that projected variability likely rose from that level. For the plan that is 90% funded (on a market-to-market basis), it has nearly won the battle. Subjecting the plan’s corpus to a traditional asset allocation with a standard deviation of more than 17% borders on being negligent.

But, how do you know what your return target should be since we know that the ROA is not a calculated number? Simply, every plan should undertake to have an asset exhaustion test run, which will determine the “true” return objective needed to ensure that the plan’s assets are never exhausted.

We recently did a review of two multi-employer plans that had the same ROA. After completing the asset exhaustion test, it was determined that one plan only needed a 6.85% return to ensure solvency, while the other fund needed a return greater than 11% / annum to accomplish that objective. Yet, they had been told that 7.5% was the objective for both, and each plan’s asset allocation reflected that pursuit.

Every defined benefit plan should be pursuing a de-risking strategy no matter what there funded status. Obviously, a plan that is poorly funded will have lessened ability to defease retired lives, but they should at least use the current highly interest rate sensitive fixed income to begin that process. Waiting for the next equity market crash before engaging in a de-risking strategy is very painful, and could prove terminal.

 

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