There has been a tug of war for decades within pension systems (public, private, and multiemployer) as to what is the correct objective: maximizing return or securing the promised benefits. Unfortunately, the idea that pension systems should maximize return has come out on top in this battle. Regrettably, this “goal” has done little to improve the funded status of these plans despite the last decade of strong equity and fixed income returns. We’ve gotten a lot of risk with little to show in terms of more stable plans.

So what is the goal? I grabbed the following quote from a Voya white paper “The Lost Decade” that suggests that securing the promised benefits should be the primary objective. “Pension plans are not hedge funds. Their objective function… should be geared toward solvency and liquidity — not maximizing returns.” Furthermore, “there is an asymmetric payoff when it comes to taking equity risk. Plans receive limited upside when equities rise and incur all of the downside when equities underperform.”

Given that objective, how do we accomplish the goal of improving solvency and liquidity? We, at Ryan ALM, would recommend adopting a cash flow driven investing (CDI) approach to secure the near-term Retired Lives Liability, while then using the balance of the corpus as alpha assets to maximize return in order to meet future liabilities. In this example, we accomplish both competing objectives – securing benefits and maximizing return – while also reducing funding costs and risk.

A CDI strategy is nothing new. Immunization and dedication strategies have been utilized since the creation of DB plans. However, somewhere in the early 1980’s the pension objective switched to a more aggressive implementation that favored maximizing returns in lieu of protecting the promise that was made to the participants. We think that the current environment is perfect for adopting this strategy. Equity valuations are near all-time highs, and despite recent strength in the markets, there seems to be a disconnect between stock performance and the global economy that continues to struggle under the weight of Covid-19.

The benefits of a CDI approach are numerous, including; 1) improved liquidity, 2) reduced funding costs, 3) buys time for the alpha assets to do their job, and 4) secures the promised benefits. Importantly, this is a “sleep well at night” implementation that would be quite comforting to your plan participants. I have no idea where markets are going to be in the next 2-3 years let alone tomorrow, so if I were a plan sponsor, I’d much prefer securing the promised benefits which buys my alpha assets time as opposed to letting the focus be on achieving the ROA by injecting more risk into the process today with no guarantee of success.