By: Russ Kamp, Managing Director, Ryan ALM, Inc.
Ryan ALM is a (THE) leading voice within the US Pension community regarding the need to protect and preserve defined benefit (DB) pension plans through de-risking strategies. We’ve been imploring plan sponsors to adjust their focus away from the return on asset (ROA) assumption as the primary goal to one where SECURING the promised benefits at a reasonable cost and with prudent risk. Our fear continues to be associated with the asset allocation roller-coaster that pension systems ride. We are currently on the downward slope of another trip and for how long and how far is anyone’s guess. At what level of funding will the plan be at when the cart begins its journey back up?
Institutional Investor is out with a recent article highlighting the fact that Q1’22 produced the largest $ amount of pension risk transfer (PRT) activity ever at $5.5 billion and those involved in the conversation expected that robust trend to continue and perhaps accelerate given what is transpiring in our capital markets. They were focused on the asset side of the equation coming under pressure from a number of influences such as inflation, rising US interest rates, the war in Ukraine, etc. There was very little discussion focused on the fact that funded ratios improved during the quarter as a result of higher US rates impacting the discounting of pension liabilities to a greater extent than markets impacted asset levels.
What grabbed my attention the most, however, had to do with the points that were made by Serge Agres, Managing Director, Cambridge Associates. Serge to his credit said that “plan terminations are expensive.” He believes that plan sponsors may be “overpaying for a minuscule amount of risk protection”. Importantly, Agres believes that the best option for plan sponsors is to manage risk through asset allocation. We at Ryan ALM have been saying for years that a carefully constructed cash flow matching strategy can dramatically reduce the cost of securing future benefits and expenses. In fact, we believe that we can save the plan sponsor roughly 20-25% of the cost that would be associated with a PRT or lift-out. Of note is the recent Milliman study showing that corporate pensions are now so well funded that they have turned pension expenses into pension income for the first time since the 1990s. If the main reason for a pension risk transfer (PRT) was the cost hit to an income statement, then this “problem” may have now become a positive effect on income statements.
Agres further stated that “a good liability hedging strategy…can reduce a lot of your risk from things like equity markets or interest rates.” Hear, hear! We couldn’t agree more! As we’ve stated, bi-furcate the plan’s assets into liquidity (beta) and growth (alpha) buckets. The liquidity bucket will consist of bonds, whose cash flows of principal, interest, and re-invested interest will match and fund the plan’s liability cash flows chronologically from the next payment as far out as the allocation will go. The alpha bucket is everything else that is found in your fund. The alpha assets now have time to grow unencumbered. The splitting of assets into these two buckets will mitigate interest rate risk as future benefit payments are not interest-rate sensitive. Liquidity is certainly improved, as all the payments are met by the beta bucket.
We applaud Agres for thinking outside the box when it comes to pension management. Again, these plans need to be protected and preserved. Shifting the pension liabilities to an insurance company doesn’t accomplish that objective and it is expensive. We recommend that you maintain your plan. The rising US interest rates may just provide the corporate plan sponsor with pension earnings, as opposed to pension expenses. Lastly, keeping a DB pension plan alive may just be a way to minimize the impact of the “Great Resignation”.