The return on asset (ROA) calculation
The ROA calculation is certainly a mysterious activity. Why would a pension plan with a 60% funded ratio and another with a 90% funded ratio have the same ROA, which we witness frequently? Why is the ROA so static when market returns are so volatile? The truth is the ROA is not a calculated number but a target return. Moreover, pension plans are brain washed into thinking that if they don’t earn the ROA they cannot become fully funded – this is incorrect thinking. There are two examples to disprove this ROA mentality:
First, if we use market values for liabilities we can easily see that liabilities are highly interest rate sensitive (bond-like in nature). Using the 30-year Treasury as a proxy for liabilities reveals that a small increase in interest rates (+60 bps per year) would create negative growth in liabilities! How great would it be if you were playing a sport and your opponent could score negative points? Accordingly, any positive growth in assets would enhance the funded ratio. In just five years a 60% funded ratio could be 89% funded with just 5% asset growth and a 70% funded ratio would become 104% and in no case did your fund match or exceed the ROA!
Liabilities (30-yr Treasury) = if the discount rate goes from 2.50% to 5.50%
Liabilities Growth Rate = (3.06%)
Assuming a Liability duration = 12 years
—– Annual Growth Rate —–
Assets growth 5.00% 6.00% 7.00%
Liabilities – 3.06% -3.06% – 3.06%
Alpha (Annual) 8.06% 9.06% 10.06%
Funded Ratio = 60% … 89.37% 93.79% 96.46%
= 70% … 104.36% 109.41% 111.47%
Secondly, under GASB 67/68 public pensions need to run an asset exhaustion test (AET). The AET determines at what point in time the assets are exhausted (including contributions) and can no longer fund benefit payments. At that point the discount rate bifurcates into a 20-year AA muni yield if the plan has not consistently paid the ARC (did someone say NJ?). This exercise brings up two key considerations. GASB is now requiring using market rates to price liabilities and contributions are now included as assets. What has been missing from the funded ratio forever has been contributions. Contributions are a very large future asset and initially fund benefit payments plus administrative expenses. In truth, current assets fund the net liabilities after contributions and not the gross projected liabilities!
Because of the singular focus on the ROA, many pension systems have injected significant risk into their asset allocation in an attempt to achieve the out-sized returns dictated by the ROA. In addition, striving for a greater ROA has caused pension systems to habitually underfund their plans. By adopting a greater liability focus, plans will be able to understand that achieving the ROA is not the objective, but having assets outperform liability growth is all that matters. Remember, the pension mission is to secure the benefits in a cost effective manner. It is NOT to generate the highest return, which guarantees greater risk but not more return!