Yesterday we wrote about CalPERS, and the request by Dane Hutchings, legislative representative to the League of California Cities, imploring the CalPERS team to “think outside the Box” in order to generate a fund return that exceeded their 7% annual return on assets objective (ROA). We were wondering what magic potion they might discover that would altar the long-term return expectations for a variety of asset classes.

However, managing a pension plan isn’t about generating the highest return, but it is very much about providing the promised benefit at the lowest cost. As we’ve stated many times before, the true objective for a pension system is that plan’s specific liabilities, and not some made up ROA. We would like to further explain.

1. Liabilities are highly interest rate sensitive. If rates go up (as most believe that they will) there is a good chance liability growth in present value dollars will be negative, just as the return on long bonds would be negative in that scenario, too.
2. A pension plan’s true growth objective is to have asset growth exceed liability growth so the economic funded ratio/status is enhanced. Earning the ROA is not the goal here.
3. The true economic funded ratio for a public pension plan is not currently known, as plans are not using a mark-to-market discount rate to value their liabilities. Yes, a discount rate of 4% (AA Corporate under FASB) or Treasury rate (3%) would increase the value of plan liabilities and reduce the plan’s funded ratio, but it would create the base case from which appropriate action can and then should be taken.

Let’s look at the scenario below. Clearly, assets do not need to achieve the 7.5% ROA objective to witness meaningful improvement in the plan’s funded status provided that asset growth exceeds liability growth. In our scenario, with liability growth of -2.56% annually, a 5% asset growth rate produces 7.6% annual alpha for assets relative to liabilities, and it improves the funded ratio from 60% to 87.8% in just 5 years. If markets cooperate, and the annual return achieved is 7%, then the funded ratio dramatically rises to 96.5%. Knowing the true economic reality of a plan’s liabilities can lead to better decision making, while eliminating the need for pixie dust to be thrown at the “problem”.

   5-year Scenario

                 What would happen to a plan’s liabilities if long U.S. Interest Rates were to rise 60 basis points per year for the next 5 years?

                 30-year Treasury at 3.00% going to 6.00%

                 Liability growth rate would be -2.56% annually or –12.81% cumulative

                 Note: duration of liabilities = 12 years

                                                 —– Annual Growth Rate —–

                  Assets                         5.0%      6.0%       7.0%      8.0%

                  Liabilities                – 2.6%     -2.6%   – 2.6%     – 2.6%

                  Alpha (annual)       7.6%      8.6%      9.6%      10.6%     

Funded Ratio starts at 60%:  87.8%   92.1%    96.5%   101.1%

Every DB plan, public or private, should use an economic set of books to value plan liabilities. Furthermore, every pension system should have a derisking plan in place. Just because a plan’s funded status is currently poor doesn’t mean that it can’t see dramatic improvement in a relatively short time frame. Improving transparency on a plan’s liabilities is an enhancement to the process. Without this honest evaluation how does a sponsor know if they are winning the game?