Operation Homerun

In keeping with the baseball season, we want to introduce Operation Homerun for defined benefit pension plans. We have a four base strategy for helping plan sponsors circle the bases while securing a pension victory.

First base: Separate Retired Lives (RL) from Active Lives (AL) – RL and AL are two distinctly different liabilities. RL are the most important, most imminent and most certain liabilities while AL are the more volatile causing actuarial noise. Your actuary can easily provide projected benefits for Retired Lives separate from Active Lives.

Second Base: Liability Beta Portfolio (LBP) – Contributions are the first source to fund RL benefits so current assets fund NET RL. Since the pension objective is to secure benefits in a cost efficient manner, only cash flow matching liabilities with bonds can accomplish this objective. We recommend cash flow matching the first 10 years of NET RL.  This will de-risk the plan gradually and buy time for residual assets to fund residual liabilities. Our LBP is a cash flow matching product that will also reduce funding costs by about 4%. The LBP will be an investment-grade corporate bond portfolio that will out-yield a traditional fixed income portfolio. As a result, the plan’s ability to achieve the return on asset assumption (ROA) will not be impaired.

Third base: Asset Exhaustion Test (AET) –  The AET will calculate the economic ROA that is necessary to fully fund all residual liabilities (RL past 10 years + AL). This is in contrast to the AET that is required by GASB 67/68 every two years, but it is recommended that the plan’s conduct the study more frequently. The GASB AET subtracts contributions from projected benefits. This net liability is then funded by current assets at the current ROA to determine solvency. If at some point the assets are exhausted and can no longer fund net liabilities, the discount rate from that point forward will be a 20-year AA municipal bond rate.

Home Plate: Alpha assets – Once the calculated economic ROA is known, the plan sponsor and consultant allocate the remaining Alpha assets (growth assets) with the goal of fully funding residual liabilities by earning the economic ROA. Bonds are removed from this asset allocation since they were used as the Beta assets. exceeding the ROA objective and future liability growth. Importantly, the assets should be allocated to products that have a low correlation with traditional fixed income, as liabilities are bond-like in nature and highly correlated to changes in interest rates. This is the final step of the process. Home plate has been reached and the plan has created a successful asset allocation strategy designed to stabilize the funded status and contribution expense. There is now a glide path in place to further de-risk the plan. As the return generated by the Alpha growth assets exceeds liability growth the excess profits should be ported over to the Beta cash flow matched portfolio which can now be extended to meet more of the Retired Lives liabilities.

Scoreboard: Custom Liability Index (CLI)– To keep score requires a Custom Liability Index (CLI), which calculates the economic liability growth rate while also measuring and monitoring  a plan’s specific liabilities (YTM, duration, interest rate sensitivity, etc.). With this information, the plan sponsor and their consultant can now understand the true funded status and the relative score of assets versus liabilities growth.

We hope that you are enjoying our national pastime’s post-season, and while you are watching we would encourage you to reach out to us for more details regarding our Operation Homerun. It is a winning strategy.

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