We are working with a public fund prospect on a cash flow matching project to secure benefit payments as far out as the current fixed income allocation will permit. In our normal implementation we would cash flow match each monthly benefit payment (and expenses, if desired) chronologically. This particular project is unique in that this plan is cash flow positive through 2028. The current allocation to fixed income would allow for the matching of benefits from 2029 to 2033. Given the positive cash flow situation we were asked why the plan sponsor should implement the strategy now as opposed to waiting until they become cash flow negative. Good question. Here, I hope, is a better answer.
Ron Ryan, CEO, Ryan ALM, preaches to me and others that the longer the bond, the lower the cost. In addition, the higher the yield, the lower the cost. By implementing our CDI approach in 2021 instead of waiting until 2028, we are able to save substantially more for that four year period then we would if we waited. In fact, by investing in bonds with maturities of 8-12 years, as opposed to 0-4 years, we are getting substantially more yield resulting in cost savings equal to 24.5% on the future benefit payments. A current 4-year implementation beginning one-month out would result in “savings” of only 3-5% given the historically low-interest rates in the 0-4 year range. It is important to note that the savings is realized upfront allowing for the savings to be invested in alpha assets.
Speaking of alpha assets, the plan sponsor can now extend the investing horizon 12-years for the non-bond assets to grow unencumbered. This lengthening of the investment horizon allows for the greater use of less liquid assets since they are no longer a source of cash flow. It should also result in a higher probability of success in achieving the required return on asset assumption (ROA) since bonds will be used exclusively for their cash flows and not as a source of performance.
Cash flow driven investing approaches have been around for many decades. They are the backbone of many insurance products and lottery systems, and once were the dominant strategy to ensure that the promised pension benefit was funded with little to no risk. Unfortunately, we as an industry moved away from this effective strategy and began to focus more on return than low cost and low risk. We believe that CDI strategies work in every market environment, but we believe that they are especially important in today’s low-interest-rate environment in which bonds are not performance drivers.
LOGIC: Uncertainty is risk. It is always more prudent to be able to budget expenses now than to wait for a better opportunity to come along, which just might not.