For decades, Pension America has focused almost exclusively on cobbling together a portfolio designed to exceed the return on asset assumption (ROA), and for decades many plans have failed. As a result, the ROA objective continues to fall. As we discussed yesterday, in 2010 the median ROA target for public pensions was 8% and today it has fallen to 7.25%. During that period assets have continued to underperform liability growth insuring that plan funded status would decline despite the tremendous equity bull market, while contribution expenses have grown exponentially. Is there another approach that should be explored? Absolutely!
The objective of a pension system is to SECURE the promised benefits in a cost-efficient manner. Unfortunately, there are only two ways to secure benefits: 1) Insurance annuity buyouts, and 2) Cash flow matching liabilities through a bond portfolio. Many believe that duration matching strategies accomplish this objective but they don’t as they don’t have certain cash flows to meet the future benefit payments.
Importantly, getting ones arms around the promised benefits (plan liabilities) is the only way that a DB plan can de-risk. Through becoming more liability aware a plan sponsor can acquire the following:
- Greater transparency of the plan’s unique liabilities in multiple dimensions – discount rates based on GASB (ROA), FASB and a risk-free rate (STRIPS)
- Enhanced knowledge of both cash flow and liquidity requirements
- Greater accuracy in calculating the TRUE return on assets (ROA) that is required in a test of solvency
- The ability to establish a cash flow matching bond portfolio created to meet benefit payments
- Stabilization of both the funded status and contribution expense
- A much longer investing horizon for the portfolio’s growth assets in order to fund future liabilities
- Reduced costs
- Peace of mind that benefits are secure for the next 10 years or so (depends on funded status)
- Enhanced viability of the pension system
These benefits seem to be pretty significant, yet many plans fail to gain these advantages. Regrettably, most plans only get a once-per-year view of their specific liabilities, which is too infrequent to engage in these important activities. There are many reasons why we’ve witnessed a dramatic reduction in the use of defined benefit plans. Becoming liablity aware will help secure those that remain. Our participants are counting on our industry to take a different path to help them achieve a prosperous retirement.