Maximize The Efficiency of The Asset Allocation

We believe that the primary objective of managing a pension plan is to secure the promised benefits through a cash flow driven investing (CDI) approach. However, there is a very important secondary benefit when using CDI and that is the fact that a plan’s asset allocation becomes much more efficient.

In this era of very low US interest rates, exposure to both cash reserves and traditional fixed income can weigh on a plan’s ability to achieve the ROA. How excited would you be as a plan sponsor if you could take your current 20% exposure to fixed income and reduce it to 3.5%, while still having the cash flow to fund all of the net benefits and expenses each year for the next 10 years? It would be quite beneficial to the long-term success of the plan to use the 16.5% that had been sitting in fixed income in a more aggressive implementation.

Let me present a hypothetical case for you. ABC public pension has $2.5 billion in assets, a 7.5% ROA objective, 20% in fixed income, and net benefits and expenses of $10 million / year (after contributions). The traditional fixed income portfolio is generating a 2% YTM in this market, which exceeds the Bloomberg Barclays Aggregate index by about 40 bps. If the fixed income account is the primary source of cash flow to meet the $10 million in annual net benefits and expenses, then the $500 million that is currently allocated will just about do the trick ($500 million X a 2% YTM gets you $10 million/year).

In this example the remaining 80% of the corpus is invested however the plan sponsor and their consultant(s) decide with the goal to achieve a rate of return greater than 7.5%, since the 20% of fixed income exposure generating 2% earns the plan only 0.4% of the 7.5% goal. Given this example, the remaining 80% would need to generate a return of 8.875% to accomplish the objective.

Now, consider the following example using a CDI approach to secure and fund the net benefits and expenses of $10 million/year. In a CDI approach income, principal, and re-invested income are used to fund the net benefits. If the goal is to secure the next 10-years of net payouts, an allocation to fixed income would only have to be $84 million in present value $s to meet the future $100 million in payouts. The remaining $416 million (original allocation was $500 million) would now be available to use in the alpha bucket to help generate additional excess returns.

In this example, the 3.5% allocated to the CDI program will generate a roughly 3.3% yield, as it is invested in investment grade corporate bonds contributing roughly 11.6 bps to the overall return. If the residual 96.5% in the alpha bucket can achieve the 8.875% that was needed in the previous example, the “expected” ROA moves from 7.5% to 8.68%, far improving the probability of success. In addition to this improved performance, the plan has secured the benefits and expenses for the next 10 years, reduced funding volatility, eliminated interest rate risk, improved liquidity, and extended the investing horizon for the alpha assets to grow unencumbered for the next 10-years. Seems like a much more efficient implementation to me. Questions? We are ready to help you think through this strategy enhancement.

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