Russ Kamp, Managing Director, Ryan ALM, Inc.

The following post was drafted on March 22, 2022. I’m not sure why I didn’t publish it then, but the content remains quite relevant. It isn’t too late to do something to help SECURE your pension system.

Following a terrific performance year for Pension America in 2021, which was highlighted by outsized performance results and improved funded status, plan sponsors and their advisors (actuaries, consultants, and investment advisors) are once again dealing with turbulent markets that threaten to significantly unwind the funding progress. This situation is certainly not unique, as the focus on the return on asset assumption (ROA) as a plan’s primary objective creates these boom and bust cycles. We’ve described this phenomenon as the rollercoaster to uncertainty driven by an aggressive asset allocation of plan assets as they strive for an optimistic return in the 7% to 7.5% range for most plans.

Given the uncertainty created by elevated inflation concerns, a fear that the 39-year bull market in bonds is over likely leading to higher interest rates, supply chain disruptions, lingering covid-19 implications, equity valuations that are stretched, and now a war in Ukraine that may further destabilize global markets and access to important commodities – oil and nickel to name just two, it isn’t surprising that heads are spinning. What should a plan sponsor do in this environment? What can they do?

We’d suggest that the pension plan’s Investment Policy Statement (IPS) needs to be revisited to reflect new thinking. First, plans need to realize that the primary objective in managing a DB pension plan is to SECURE the promised benefits at both reasonable costs and with prudent risk. The pursuit of the ROA has insured greater volatility, but not guaranteed funding success. In addition, we’d recommend that a plan’s asset allocation should reflect the goal of securing the pension promises (benefits). In order to accomplish this goal, plan assets should be bifurcated into two buckets – Beta and Alpha. The Beta (liquidity) bucket will be invested in bonds whose cash flows are carefully matched with the liability cash flows (benefits and expenses). We suggest cash flow matching assets to liabilities that will defease the next 10-years of the Retired Lives Liability.

The Alpha (growth) assets will consist of all non-bonds. This bucket will now have as its goal the meeting of future liabilities. Since this collection of assets will not be used for liquidity purposes, the assets can now grow unencumbered. One of the most important investment tenets is time. Our asset allocation approach has now created a runway that spans 10-years. Studies have shown that 47% of S&P 500’s total return since 1940 on a 10-year moving average basis has come from dividends and dividends reinvested. Regrettably, pension systems have a tendency to sweep cash from all assets each month to meet cash flow needs. Doing so creates a significant drag on equity performance and mitigates the benefits from reinvesting dividends.

A cash flow matching strategy ensures that plan liabilities and assets move in lockstep. Importantly, benefits are future values (FV). A $1,000 payment due in April 2027 is $1,000 no matter what happens to interest rates. Given this reality, cash flow matching eliminates interest rate risk for those assets that are defeased. On the other hand, a total return-focused bond program would likely be severely damaged during a rising rate environment. For instance, given the current level of interest rates, a 7-year duration bond would only need to see rates rise roughly 30 bps to create a negative total return for the year (we saw that and a whole lot more!). That interest rate movement can occur in a week.

Defined benefit pension plans are incredibly important for our workforce and we must do whatever we can to secure their future. Asking untrained individuals to fund, manage, and then disburse a benefit through a 401(k) plan is just poor policy. Why do we think that everyone can be a portfolio manager? However, in order to secure their future, we must get off the asset allocation rollercoaster to uncertainty. We must adopt a new approach that secures the promised benefits, improves a plan’s liquidity, protects the plan from rising interest rates while creating an environment for equity and equity-like product to grow unencumbered in order to meet future liabilities. Today’s thinking doesn’t accomplish those objectives. Are you ready to adopt new thinking? If not now, when?