For years I’ve written about the importance of conducting asset allocation studies based on the plan’s specific liabilities and cash flow needs, as liabilities are like snowflakes in their uniqueness. I recently read an article in P&I that reported the details of an upcoming asset allocation study. The review was to include the “Systems” three plans. It was reported that each of these plans has the same asset allocation targets and the same return on asset (ROA) objective. I wasn’t surprised to read this, but I was disappointed.
As of the end of 2018, this System’s three plans had very different funded ratios: 70.7%, 55.2%, and 82.2%. Given the very different funded status, how is it that they have the same asset allocation? Does that make sense at all? Wouldn’t you think that a plan with an 82.2% funded ratio would have a very different asset allocation from a plan that is only 55.2% funded? Why would you want to subject that plan to a more aggressive asset allocation then is required? Furthermore, if the asset allocation is geared more to the plan that is 82% funded, the one that is 55.2% funded may never see improvement.
As I wrote just the other day, it is neither the asset allocation nor the ROA that dictates how a pension system should be managed. It is the funded status and the cash flows needed to meet the benefit promises that should drive the asset allocation bus. Once those cash flow needs are understood, then the asset allocation and the ROA target can be determined. Regrettably, defined benefit plans are quickly evaporating in the private sector. We must do what we can to preserve public and multiemployer plans. Setting the right ROA and asset allocation targets that are based on the required cash flows will help reduce cost, volatility, and will ultimately stabilize the plan’s funded status. It is pretty elementary my dear Watson.