Place Your Bets!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There are few things that provide fairly certain outcomes within financial markets, especially during this period of high inflation and rising rates. In fact, there is only one asset class (bonds) that has a certain cash flow of income + principal (terminal value) that is known. Given these positive attributes, we believe that bonds are the perfect instrument to use for asset/liability management in defined benefit pensions. By cash flow matching asset cash flows (interest and principal payments) with liability cash flows (benefits and expenses), one creates as certain an outcome as we have in pension management bearing a very low probability of default (especially when investing in investment grade bonds).

Cash flow matching aka cash flow driven investing (CDI) has been a tool used by pension professionals since basically the dawn of the DB pension plan. It is also the foundational investment for both lottery systems and insurance companies that understand the benefits of matching asset cash flows to liability cash flows. The ultimate benefit of utilizing a CDI program is the “funding cost savings” are locked in as soon as the portfolio is constructed. We at Ryan ALM believe that the difference between the present value (PV) of asset cash flows and the future value (FV) of benefit payments is funding cost savings. Others in our industry argue that the savings are created by the time value of money and that other assets can potentially achieve a greater return and thus greater savings. That potential exists, but at what level of volatility? …and what certainty?

When constructing a cash flow matched portfolio, the difference between the assets PV and the liabilities FV (savings or reduced cost) is locked in on day one given the certainty of a bond’s cash flows. Other asset classes that lack a known income stream + a terminal value can’t claim to have the same known FV outcome. Sure, we can roll the dice with other assets, but at what potential cost should those assets produce a result within a “normal” expected range? It should be quite comforting to the plan sponsor and their advisors to know how a portion of the plan’s portfolio will behave, especially since it is providing the liquidity necessary to meet those liabilities.

Most defined benefit plans, if not all, have exposure to fixed income (bonds), but they are likely using the fixed income assets to outperform a generic index such as the Bloomberg Barclays Aggregate Index. These mandates have benefited tremendously from a 39-year decline in US interest rates. That wonderful tailwind has shifted and the stiff breeze blowing in the faces of fixed income investors is producing steep losses as US interest rates rise steadily. The US Federal Reserve has indicated that interest rates will continue to be elevated for the foreseeable future as they combat excessive inflation. Sure, you can roll the dice once more and “hope” that rates will stabilize and then fall, or you can utilize a time-tested investment strategy (CDI) that will produce a known FV outcome while providing additional benefits such as improving the fund’s liquidity and buying time for the remainder of the assets to grow unencumbered.

In markets that produce unknown outcomes every day, bringing a little certainty to the process is a breath of fresh air. You can claim that the difference in the PV and FV of our portfolios is nothing more than the time value of money, but I prefer the certainty of a CDI outcome over the potential of investing in other asset classes with uncertain outcomes. As a proof statement, if you bought US STRIPS to fund college expenditures decades ago and as a result, the $50,000 investment helped fund $200,000 in college costs, didn’t you “save” $150,000?

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