I believe that every pension plan should engage in the practice of focusing on plan liabilities to help inform asset allocation and investment structure decisions. This has become common practice for a majority of corporate plans, but they often engage in LDI or duration-matching efforts. If securing the promised benefits is the number one objective in managing a pension system, then utilizing an LDI approach is wrong, as reducing interest rate risk does nothing to ensure that cash is available to meet the next benefit payment.
The only strategy that meets this requirement is cash flow-driven investing (CDI), which utilizes a carefully constructed bond portfolio (we refer to our portfolio as a Liability Beta Portfolio) to meet each and every benefit payment, net of contributions, chronologically from the next monthly payment as far out as the allocation will fund. As the title of this post suggests, cash flow is superior to capital appreciation.
For a plan that is in a net-negative cash flow situation (and what plans aren’t?), having the cash to meet payments when they are due is critically important. Furthermore, it important to control costs, and meeting cash flows through redemptions results in transaction costs and is only possible when the assets are sufficiently liquid. In times of market stress, like now, the cost of trading “liquid” assets can increase dramatically. As plans have moved more of their assets into the alternative bucket, the risk of being a forced seller to meet benefits has increased. Utilizing a CDI approach “buys time” for the non-bond asset to grow unencumbered.
P&I has on the cover of their May 4th edition an article highlighting the fact that the funded status declined for the top 100 corporate plans in 2019 from 90.1% to 87.8% despite generating a 15.7% aggregate return, as the discount rate fell 95 basis points to 3.3%. As a result, liability growth for these large corporate plans grew more than 11%. Wait, liabilities were up 11.3%, while assets were up 15.7% then how is it that funded status declined? This demonstrates that plans with deficits have to work harder and outgrow liability growth in dollars, not percents, to enhance their funded status. Asset growth is not an absolute return target (ROA) but a relative growth rate versus liability growth in dollars.
In the same article, a strategist for Goldman Sachs Asset Management points out that this “paradox reinforces the importance for a liability matched fixed income glide path”. We agree on the need to focus on liabilities but disagree on the strategy of using long bonds in this environment to accomplish the objective. LDI strategies have benefited from a roughly 38-year bond bull market, as interest rates have plummeted.
Given where rates are today, there is a fairly significant probability that rates will rise during the intermediate period creating losses for your portfolio, while not securing the benefits as discussed above. In addition, a CDI approach accomplishes the objective of eliminating interest rate risk, as future values (benefit payments) are not interest-rate sensitive. It is a win-win! We think that CDI approaches work for all pension plans, but if you have any doubts we are here to answer any of your questions.
Russ, “promises” i.e. pensions would have been much less under CDI ( which is a good thing). Securing promised pensions could also be accomplished using higher risk investments but with a 2.5% to 3% smaller discount rate. ( assumed rate of return).
Good morning, Tom. The use of a CDI approach doesn’t necessarily mean that a plan will generate a lower rate of return. For instance, we recommend cash flow matching the next 10 years of benefit payments, if the current allocation to bonds can fund that amount. If it can – great. If not, reduce the CDI exposure. Our CDI portfolio will outyield a traditional fixd income account managed against the Barclays Agg. In that case, we are enhancing the ability of the fund to achieve its ROA target. Furthermore, it is extending the investing horizon for the balance of the portfolio’s asset buying time for them to capture the liquidity premium that exists in those assets. With that portion of the portfolio a plan sponsor can get more aggressive.
WIth regard to your second point, if you lower the discount rate you increase contributions. With more contributions coming in you can actually get less aggressive with your investments.
Have a good day, Tom.