As a young man growing up in Palisades Park, NJ, I loved the folk duo Simon and Garfunkel, and one of my absolute favorite songs was “Bridge Over Troubled Water” (released in January 1970). Much to the chagrin of my family, I will still belt out that song when I hear it. However, until yesterday I would not have thought that I’d use this song as a metaphor for potential issues in the pension/investment industry, but Ryan ALM’s Head Trader, Steve DeVito, provided us with the following chart and title that is just perfect for what we try to do for DB pension plans.

As the graph highlights, the decade of the ’00s was tragic for pension America. As we recently reported, the decade of the ’90s ended with most pension plans fully-funded if not in surplus funded status. But those funded ratios soon plummeted as the result of two incredible drawdowns in the S&P 500 (8/20 – 9/02 and 10/07 – 2/09). Had pension America engaged in a de-risking strategy when pension plans were fully funded in the 1990s, such as cash flow matching that would have protected what had been earned, the impact of those two major market declines would have been somewhat muted. First, DB plans would have maintained a greater allocation to fixed income, which performed superbly during that decade when equities truly suffered, while importantly matching the growth rate of the plan’s liabilities. Second, a cash flow matching bond strategy buys time for the alpha assets (non-fixed income) to grow unencumbered. Why is that important? The graph below highlights the fact that it took thirteen years for the S&P 500 to recover it’s $ value as of 1999.

By permitting the assets to grow without being a source of liquidity, equities benefit from the reinvestment of dividends. Studies have shown that more than 50% of the S&P 500’s return over 20+ rolling year periods is from dividend reinvestment. Furthermore, by establishing a cash flow matching program that provides for the payment of benefits and expenses, a plan is not forced to raise liquidity from equities when valuations have already been driven lower. Lastly, it also protects plans from making improper asset allocation decisions during periods of distress.

Pension America has benefited from an amazing period of performance since the Great Financial Crisis ended in early 2009. Funded ratios have improved for all DB plan types. It would be sinful to see this improved funding wasted as a result of inaction. It is time to secure the plan’s cash flow needs, funded ratio, and contribution expenses. A pension plan should covert the current fixed income allocation from a return seeking instrument to one that focuses on a bond’s cash flows. In a rising interest-rate environment such as the one that we might be experiencing, traditional fixed income strategies will likely generate negative total returns with as little as a 30 basis point move upward in rates. That could happen very easily. However, in a cash flow matching strategy, where we carefully match maturing principal and income cash flows with benefits and expenses, we are ensuring that the plan’s liquidity needs are being met and that interest rate risk is being eliminated, as future values are NOT interest rate sensitive.

Defined benefit plans need to be protected and preserved for the millions of plan participants who are counting on that promised benefit. Let’s not give those supporting these plans ammunition to seek their destruction. Risk reduction and the securing of benefits should be at the top of every plan’s working agenda. I’m not smart enough to know when the equity markets (perhaps bonds, too) will crater. I just know that history DOES repeat itself in the pension industry.