By: Russ Kamp, Managing Director, Ryan ALM, Inc.
Many pension systems lack a formal liquidity policy. As a result, they often ask their custodians to sweep cash (residual cash among managers, dividends, interest, and distributions) from wherever they can find it. But is that the right approach to meeting monthly benefits and expenses? We’d say NO primarily for the reason that the total return of the S&P 500 benefits greatly from dividends and dividends reinvested over 10- and 20-year timeframes. In fact, one study suggests that nearly 50% of the total return of the S&P 500 is generated through the distribution of dividends and their reinvestment. Sweeping cash dividends may dramatically reduce future equity returns. But even worse than sweeping cash is having to sell equity and fixed income exposures – since you aren’t selling alternatives – when your liquidity needs exceed available cash.
Do you believe that liquidity is abundant at this time with significant corrections occurring in both domestic equity and US bonds, let alone foreign securities? How likely is it that you can sell what you need without increased transaction costs? I’m not referring to commission costs, which are just the tip of the iceberg. Below the surface exist execution costs and unexecuted orders that can dramatically increase costs for the plan. Sure, plan sponsors and their advisors may use periods of dislocation such as this one to rebalance back to policy normal levels and skim a little for benefit payments, but how realistic is that when both stocks and bonds are getting smacked? Again, your alternative exposure has likely grown on a relative basis (perhaps because there is no current market value) when compared to bond and equity allocations, but are you going to be able to reduce exposure to these alternative funds that often come with 10-year lock-ups? Likely not.
Is there an alternative to this questionable activity? Sure. In an environment of rising (rapidly) US interest rates, total return core bond strategies will get crushed, as witnessed so far in 2022 as the BB Aggregate Index is down more than 11% as of yesterday’s close. Regrettably, rates look as if they will continue to rise putting additional pressure on your fixed-income assets. We’d suggest converting a traditional bond mandate from one seeking a total return to one that SECURES the fund’s promised benefits by matching asset cash flows (principal and income) to the plan’s liability cash flows.
Not only does a cash flow matching (CDI) strategy protect the funded status for that portion of the pension plan, but liquidity is no longer an issue, as the assets and liabilities cash flows are matched to meet every payment chronologically as far out as the CDI allocation will fund. There is no more scurrying for cash or forced liquidations where the transactions may not be possible without greater cost. Furthermore, there is no longer an exposure to an asset class that won’t add value as long as rates are rising (bonds). The bond allocation will now meet all of your liquidity needs. In this environment, a 10-year cash-flow matching portfolio has a yield in the high 4% area and, given how rates are moving, it wouldn’t be surprising to see these portfolios with yields well into the mid 5% range soon.
So, if liquidity is an issue, we have a solution! If significantly underperforming bond portfolios are an issue, we have a solution! If you want to maximize the potential equity return from investments such as the S&P 500, we have a solution! It has been decades since we last suffered through a protracted rising rate environment. It can be quite destructive to a pension plan’s assets and funded status. Protect your funded status and stabilize contribution expenses by adopting a tried and true many decades old approach – cash flow matching. Don’t just ride the asset allocation rollercoaster up and down. Jump off now and try something that will truly provide numerous benefits. This strategy will help both you and the plan’s participants sleep well at night.