The pension industry has its own version of the “which came first: the chicken or the egg” riddle. For years, members of our community have debated whether the return on asset (ROA) assumption is set and then asset allocation is determined or the plan’s asset allocation is derived and then the ROA is calculated from that combination of asset class exposures. If you ask actuaries, asset consultants, and plan sponsors this question, you’d likely get 1/3 saying that asset allocation is first determined, another 1/3 saying that the ROA is set first, and another 1/3 that just don’t know. Well, we, at Ryan ALM, believe that none of those are right.

We believe that a DB plan (and E&Fs) must first determine their liability cash flow needs (benefits and expenses or spending requirements) over some prescribed period, which will then inform the plan’s asset allocation from which the ROA will then be determined. How can an asset allocation be determined without a true understanding of the plan’s liability cash flow needs? We’ve witnessed significant market dislocations within the last couple of decades that have challenged plan sponsors from a liquidity standpoint. The Great Financial Crisis (’07-’09) contributed significantly to the use of secondary markets for transactions involving the sale of private equity, private debt, and real estate partnerships when plans needed to raise cash to meet outflows.

Once an understanding of the liability cash flows has been determined, plans can match those needs with a bond portfolio to ensure that the asset cash flows will be on hand when it is required. Bonds are not performance generating instruments, especially in this low interest-rate environment, but they are great for creating cash flow through interest payments, reinvestment of income, and principal at maturity. These “cash flows” can be modeled. The use of a cash flow driven investment approach (CDI) to fund liability cash flows creates a much more efficient asset allocation normally requiring fewer assets allocated to bonds (beta assets), while enabling the remaining alpha assets to grow unencumbered.

The Science community believes that the egg came first when two birds that were almost-but-not-quite chickens mated and laid an egg that hatched into the first chicken likely answering that longstanding argument. We believe that focusing on liability cash flows first puts to bed the pension riddle. We’d be happy to discuss (debate) this subject with you. We are looking forward to hearing from you.