Ron Ryan (Ryan ALM) and KCS have been crisscrossing the country for the last 6-7 years trying to encourage plans sponsors (and in some cases their asset consultants) to embrace the use of their plan’s liabilities to drive investment structure and asset allocation decisions. We are now 9 1/2 years into a historic U.S. equity bull market and funded-ratios haven’t improved a whole bunch and contribution expense continues to escalate. Do sponsors truly believe that their plans will earn their way to better funding in the next several years? Unfortunately, corrections occur and we are likely to see one in the not too distant future.
Here are our thoughts on the return on asset assumption (ROA) and why we believe that having a cost objective is superior to one focused on return.
- The true objective of a pension is to fully fund (secure) benefits in a cost-efficient manner with prudent risk. It is NOT a return objective.
- Projected benefit payments are future value (FV) dollars while the ROA is in present value (PV) dollars.
- The ROA is a forecast (and not a particularly good one). Actual annual asset returns (and liability growth rates) deviate greatly from the ROA. This deviation is called actuarial gains and losses and could be significant each year and for multiple years.
- The ROA is NOT a calculated number! It ignores the funded status. As a result, pension systems with 60% and 90% funded ratios could have the same ROA and the same asset allocation. The Ryan ALM and KCS teams can calculate the true ROA needed to fully fund the plan (with future contributions factored in). We recently completed a project for a client who had a 7.75% ROA. When we ran the Asset Exhaustion Test it was obvious that even at 6.00% ROA, the assets were not exhausted suggesting that 6.00% would be a better fit as the target hurdle rate for asset allocation. Why run at a more aggressive rate than is necessary?
- The Funded Ratio is in PV dollars. Would a pension plan have the same funded status with an asset allocation of $100 million PV of:
- 100% Treasury portfolio with a YTM of 3.00%
- 100% A corporate bonds with a yield of 4.00%
Answer: The same Funded Ratio in PV, but certainly better funded in FV dollars when using the corporate bond portfolio.
- If you focus on returns then it should be asset growth vs. liability growth in market value dollars, not actuarial valuations (AV). This is where the creation of the Custom Liability Index (CLI) can play a role.
- If you focus on market values and if interest rates go up by 60 basis points per year on average over the next 5 years, liability growth (based on a 30-year Treasury as the proxy discount rate) would have a -2.56% per year average growth. As a result, low asset growth of just 5% would create liability Alpha of 7.56% per year and enhance a 60% funded ratio to 87.8% in just 5 years.
If one were only focused on asset growth and a plan generated that 5% annual return there would be the feeling that the yearly return was inadequate. However, when comparing assets versus liabilities that 5% looks almost heroic versus a negative liability growth rate.
The U.S. Federal Reserve is certainly on a path to raise U.S. interest rates. In this environment, liability growth will likely be negative. We could see funded ratios improve rather dramatically in an environment such as this, but who would know if a sponsor and their consultant are only focused on the ROA as an asset objective and liability discount rate? It really is a poor practice.