At the end of 1999, the average US public pension plan had a funded ratio >100%. Yes, just a couple of short decades ago the average public pension plan was overfunded thanks to great equity returns during most of the 1990s. Wow! During the 1990s asset allocation models reduced their allocations to bonds as interest rates kept going down so by 1999 they had the lowest allocation to bonds in modern history. Why? Well, when the yield on bonds went below the ROA target (8.0%+) starting in 1989, it was perceived that any exposure to fixed income would jeopardize a plan’s ability to achieve the ROA. If only a plan’s liabilities, and not its ROA, were top of mind in 1999 we wouldn’t have the pension issues that we do for many state and municipal plans.
According to several actuarial firms that track the funded status for public DB plans, the average funded ratio for a public fund is now in the low 70% range, when applying GASB accounting rules, which means that the discounting of liabilities uses the ROA rate instead of FASB that calls for a AA corporate bond rate to be used. The current yield on the 10-year US Treasury note is at 27% of the 5.65% (12/31/99 US Treasury note) yield that was deemed too low to be meaningful. Had plans focused on the liabilities by driving asset allocation through a liability lens, plans would have defeased their Retired Lives liabilities through cash flow matching when they were fully funded thereby securing benefits and low contribution costs. That exposure should have been used to defease the Retired Lives Liability. This action would have stabilized the plan’s funded status and contribution expenses, while also buying time for the alpha assets to work through some very challenging times, such as the Dot-Com bubble burst and the Great Financial Crisis.
As we discussed in a recent blog post, US public pension plans do have exposure to fixed income, primarily to provide the cash necessary to fund benefits and expenses. However, in a rising rate environment, traditional fixed income programs will see the value of their assets decline, producing a likely negative return for the plan. It is far better to cash flow match bonds with the plan’s liabilities ensuring that the cash necessary to meet the promised benefits will be kept. Furthermore, future values of promised benefits are not interest rate sensitive.
Instead of driving asset allocation decisions through a ROA lens, let’s adopt a return to traditional pension management that views the plan’s liabilities as the most important variable in the asset allocation decision tree. It makes no sense that a plan that is funded at 60% should have the same asset allocation as one funded at 90%, but this happens all the time, as these plans are focused on achieving the same 7.25% ROA. Given the improved funding that we’ve witnessed, it is time to focus on securing the promised benefits at low cost and with prudent risk.