In our recent post, “Right Idea, Wrong Implementation” we discussed the fact that using STRIPS in lieu of coupon bonds would neither reduce the cost of de-risking nor work more effectively than a cash flow matching portfolio. We believe that the true pension objective is all about cash flows…asset cash flows versus liability cash flows. The use of US Treasury STRIPS in lieu of coupon bonds is a very expensive implementation. Just how expensive?
We produced two Custom Liability Indexes (CLI) as of June 30, 2021 – one using STRIPS and the other coupon bonds. We have a representative defined benefit liability stream that is $1 billion in future value liabilities and has payments going out to 2102. When using U.S. Treasury STRIPS to implement a de-risking strategy the present value cost to defease that liability is $695.2 million. The yield on that portfolio is 1.77% and the modified duration is 16.3 years. When implementing a defeasance strategy using our Liability Beta Portfolio (LBP) invested in U.S. investment grade corporate bonds, we see a cost savings versus the STRIPS implementation of $142.2 million! The yield on our portfolio is 3.6% and the modified duration is 13.3 years. The cost to defease $1 billion in pension liabilities using our cash flow matching approach saves the “client” $446 million (44.6%).
As a reminder, the funding cost savings are realized immediately upon implementation allowing the client (and their consultant) to use those savings within the alpha or performance portfolio to hopefully improve the probability of achieving the return on asset (ROA) objective. Oh, and by the way, a cash flow matching portfolio, which uses interest, principal, and reinvested income to meet the future benefits is the most efficient implementation. For example, a $10 million per year projected benefit schedule would require a $500 million bond portfolio at a 2% yield to fund benefits through income. Our LBP cash flow matching could fund these same projected benefits for only $84 million.