A Step in The Right Direction, but Not Quite There.

I read with interest about a public pension system approving the issuance of a pension obligation bond (POB) to sure up their plan’s poor funding (this is not unusual in today’s environment). I applaud them for doing so, as the historically low-interest rates are providing a unique opportunity. However, the proposed implementation leaves a lot to be desired in my humble opinion.

As we’ve written before, POBs that have failed have done so because they have not captured the potential arbitrage that existed between the plan’s return on assets assumption (ROA) and the interest rate on the POB. That failure has led to increased costs when both the bond’s interest and the loss on the bond’s proceeds have to be paid. We believe that this failure has been caused by injecting the POB’s proceeds into the plan’s existing asset allocation subjecting those assets to the whims of the markets. Given the current fundamentals for both stocks and bonds, the risk of the markets working against this asset allocation is greater than it is being supportive.

The plan that I’m referencing recognized this issue and they plan to invest 1/6th of the assets each quarter hoping that dollar-cost averaging will smooth the returns and reduce the risk that they are injecting a significant sum of money at the peak of the market’s cycle. I’m glad to see that someone is thinking outside the box, but this strategy comes with the potential for significant opportunity cost, as the POB’s non-invested proceeds will be kept in very short-term instruments. This will clearly have an impact on the plan’s ability to achieve the ROA during the next couple of years.

We, at Ryan ALM, would suggest that the POB’s proceeds be used to cash flow match or defease the plan’s benefits and expenses for the next 10-years or more through cash flow matching with investment-grade bonds. This is where the bond allocation belongs, as a liquidity strategy. This strategy would provide for an enhanced yield relative to cash (cash flow match through a corporate bond portfolio) while securing the benefits and reducing the cost of future benefits through the defeasement. Furthermore, it is likely that only a modest portion of the POB’s proceeds would be needed to accomplish this objective. The remainder of the assets (we call alpha or growth assets) would then be used in concert with the existing corpus and future contributions to meet the plan’s future liabilities. Importantly, the cash flow matching creates an extended investing horizon for the growth assets to grow unencumbered, as they are no longer a source of liquidity. These Alpha assets can be managed more aggressively in strategies without bonds that provide a liquidity premium.

The longer the investment horizon the greater the probability of success. The S&P 500 doesn’t outperform bonds in every 10-year period, but they do so more than 80% of the time. Creating that extended horizon and removing the bond allocation improves the odds that the ROA will be achieved longer-term, if not enhanced. Furthermore, being able to secure the plan’s benefits and expenses for the next 10-years reduces the volatility of both the funded status and contribution expense. To repeat, our strategy secures benefits and expenses, reduces the future cost of these benefits through the defeasement, extends the investing horizon improving the odds that the ROA will be achieved while reducing the volatility of the funded status and contributions. Seems almost too good to be true: but it isn’t!

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