Would you utilize a strategy that enhanced return relative to the strategy that is currently used in your portfolio, especially if it eliminated interest rate risk, secured a plan’s Retired Lives, improved the fund’s liquidity profile, and cost LESS? This question seems silly given all the benefits highlighted above, but alas it is not. You see, despite all of the proven benefits, and we didn’t mention that the funded status and contribution expense for the fund are stabilized for that portion of the portfolio, too, plans and their consultants seem to be reluctant to embrace a cash flow driven investing approach.
Why? I’m not positive that I know the answer, but maybe they feel that the claims are too rosy or perhaps it is just different! But, how different is this strategy? It is what lottery systems use on a daily basis. Furthermore, the insurance industry has built its businesses through matching assets against liabilities. In fact, Pension America used to manage very effectively plan assets versus plan liabilities (the promised benefits) using defeasement strategies. What happened? Why has this concept become so foreign.
As I’ve shared many times before, the true objective of a pension plan is the securing of the promised benefits at low cost and reasonable risk. It is NOT the generation of the highest return, which only serves to create a much more volatile pattern of performance and funding. We have a pension crisis unfolding in the U.S. and for many Americans the idea of a dignified retirement is beyond imagination. There are many contributors to this problem, but one rather large one is plan asset allocations that continue to strive for return and be damn everything else – such as liquidity, cost, volatility, etc.
Are bond portfolios really return generators in this low-interest-rate environment? No! Yet, most plans have a decent if not rather healthy exposure to this asset class. Wouldn’t that segment of your portfolio be better served as a source of cash flow that is matched to your monthly benefit payments chronologically as far out as your current allocation permits? In fact, bonds are the only asset that has a known cash flow and terminal value. They should only be used to defease your plan’s liabilities (Retired Lives) that will then create an environment for the balance of your assets to maximize the liquidity premium that exists.
This cash flow driven investing (CDI) approach maximizes the efficiency of a plan’s asset allocation despite the fact that there is no change in the allocation to fixed income or the return on asset objective (ROA). Now plan liabilities are secured, liquidity to meet those obligations is improved, return on the bond portoflio is improved, and costs reduced. Find out for yourself why this isn’t a fairy tale!