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

Given this opportunity, what would you do? You can continue to strive to achieve a 7% annual return through a traditional asset allocation strategy that is accompanied by significant annual volatility of >10% or you could match a portion of the plan’s liabilities through a Cash Flow Matching (CFM) strategy that carefully matches asset cash flows to liability cash flows effectively ensuring that assets and liabilities move in lock-step with one another. Need more input?

The recent rise in US interest rates is providing Plan Sponsors of defined benefit pension plans with a unique opportunity that hasn’t occurred in decades. Working with their advisors, Plan Sponsors can now SECURE near-term benefits and expenses (meeting all of the liquidity needs) as far into the future as the allocation to a Cash Flow Matching (CFM) strategy will take them. In doing so, a pension fund may generate through an investment-grade corporate bond portfolio a YTM of roughly 5.5% to 6%.

We haven’t seen yields like this from IG corporate bonds since the early ’00s. Why is this an attractive option when the plan may be striving for 7%? First, the “return” as measured by the YTM is locked in on the day that the portfolio is built, since this is a mostly buy-and-hold endeavor. By defeasing pension liabilities through the cash flows of principal and interest from the bonds, the YTM becomes the portfolio’s expected return (barring a default). Furthermore, a carefully matched portfolio will insulate the bonds from interest rate risk as benefits owed are future values, which are not interest rate sensitive. That is a critical attribute given the great uncertainty surrounding Fed policy and the future direction of rates.

In addition, creating a liquidity bucket allows the alpha or growth assets not invested in the CFM portfolio an opportunity to grow unencumbered since they are no longer a source of liquidity. We know from previous studies (Guinness Asset Management) that sweeping cash dividends from equity accounts can dramatically reduce long-term returns, as dividends and dividends reinvested represent nearly 50% of the return of the S&P 500 over rolling 10-year periods dating back to 1940. It is even more beneficial for 20-year periods (57%). Do you still need more info? You are a tough one to convince!

The strategy that I’m highlighting is how most insurance companies and lottery systems are managed. Those entities know what that future promise looks like (as do pension plans). They take a present value (PV) calculation of what it would take to fund that future value (FV) commitment and they invest that sum of money in investment-grade corporate bonds through an optimization strategy – not a laddered bond portfolio. We refer to this implementation as a SWAN strategy (Sleep Well At Night). Wouldn’t it be great to announce to your plan participants that no matter what transpires in the markets the promised benefits have been secured?

So, I ask again, wouldn’t it be the prudent exercise to invest a portion of your plan’s assets into a liquidity bucket that secures the promised benefits at a reasonable cost and with prudent risk as opposed to hoping that the aggregate exposure to a variety of asset classes and products can produce a return close to the 7% return target on an annual basis? I’m not a gambler, so maybe it is just me, but I know what I would do if I was put in the position to manage a pension plan that is responsible for a group of participants planning on a dignified retirement.