The Public Plan Sponsor’s Dilemma

The last one and one-half days at the Opal Public Funds Summit East conference has been filled with outstanding panel discussions on a variety of asset classes and investing strategies.  Each discussion geared toward the plan sponsor’s dilemma of achieving the return on asset assumption (ROA). For most public plans the ROA objective falls between 7% and 8%.

In this environment, the likelihood of meeting the ROA has been diminished, as the bull market for public equities and bonds extends.  The hand-wringing has been quite noticeable. Why? Because most plan sponsors have been told that achieving the ROA is the only way to pension “success”, meaning that a plan has accumulated the assets necessary to meet the plan’s promise to their participants (liability).  They are mistaken.

Trying to shoot for a combination of assets at this time that will achieve the Holy Grail ROA will likely mean that the plan has had to inject more risk (investment and liquidity) into the process. However, there is another path, but one that is seldom discussed among public fund trustees because their asset consultants and actuaries believe that plan assets and liabilities grow at the same discount rate, which couldn’t be further from the truth.

The possibility that a plan might generate a return well below the ROA can create anxiety for the sponsor, but their minds could be put at ease if they understood that liability growth can be negative.  How? Pension liabilities are highly interest rate sensitive similar to bonds. In a rising interest rate environment, both liabilities and bonds will fall in value. Pension liabilities also have a fairly long duration so “losses” can be significant, and funded ratios can improve quickly. More “money” isn’t the only formula for improving pension funding in an environment of rising rates.

Unfortunately, most sponsors don’t get a mark-to-market view on their plan’s liabilities as their actuary is likely presenting a once per year view under GASB preferring to discount liabilities at the ROA discount rate. By creating a set of economic books (preferred by the Society of Actuaries) a plan trustee can quickly see how interest rate sensitivity impacts liability growth. As the liabilities fall in value in a rising rate environment, the funded status can improve.  Plan sponsors should take risk off the table by cash flow matching as many of the plan’s retired lives as possible. The remainder of the assets now has an extended investment horizon that will prove useful in trying to capture the liquidity premium.

We’d love the opportunity to speak with you about our approach. Don’t fret about the possibility of missing the ROA objective, and certainly don’t stretch for return in this environment, as greater volatility will be realized but the hoped-for return might not.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s