By: Ronald J. Ryan, CFA, CEO, Ryan ALM, Inc.

We are pleased to provide you with this ALM-related “pop quiz”.

Q: Can a Generic Bond Index Replicate Pension or OPEB Liabilities?

A:  Never… Mission Impossible!

Pension and OPEB liabilities are unique to each plan sponsor. Each has a different labor force, salary structure, mortality profile, plan amendments, actuarial assumptions, etc. It is impossible for a generic bond index to replicate the unique liability cash flows and risk/reward behavior of any pension and OPEB liability for several additional reasons:

Problems:

1. Generic bond indexes use coupon bonds while liabilities are to be priced and viewed as zero-coupon bonds. Coupon bonds are less interest rate sensitive than zero-coupon bonds with the same maturity as they have a shorter duration, especially on longer bonds. 
2. Generic bond indexes have a maximum duration of about 15 years today vs. much longer liability cash flows.
3. Pension and OPEB liabilities are a term structure or yield curve of monthly liability cash flows which tend to be rather linear through time.

A generic bond index is weighted based on corporate new issues which rarely, if ever, are issued as a term structure. This creates gaps between the index term structure.

4. Long generic bond indexes usually have no maturities shorter than 10 years. This leaves out a major portion of liability cash flows.
5. The Durations of generic bond indexes are interest rate sensitive and can change significantly through time. In the early 1980s, the longest duration bonds were around 8 years. After 1982, durations began to extend as interest rates were in a secular decline.

A 30-year maturity 20 years later (2002) had a duration of around 16 years or twice as long as in 1982. Liability durations do not change radically and tend to be rather stable for active plans and open groups. Even closed groups will have durations that change slowly.

Ryan ALM Solutions:

1. Only a Custom Liability Index (CLI) could replicate liability cash flows and monitor their risk/reward behavior. The CLI is based on the unique actuarial projections of each plan sponsor. 

Since contributions are the initial source to fund benefits and expenses (B+E), current assets fund net liabilities after contributions. Moreover, B+E are monthly liability payments. The actuary does not calculate net and monthly B+E payments. The CLI will calculate net monthly liability payments. The CLI produces monthly reports that include summary statistics (yield, duration), liability growth rate, interest rate sensitivity, present value, and future value.

2. Accounting rules require the pricing of liabilities at a AA corporate zero-coupon yield curve. Since these bonds do not exist in the marketplace, they have to be manufactured. Ryan ALM is one of few ASC 715 discount rate vendors providing four distinct yield curves (top 10% yielding, top 33% yielding, top 50% yielding, full curve). Such pricing determines all of the present value summary statistics and liability growth rate.
3. The true objective of any pension and OPEB plan is to fund liabilities in a timely and cost-efficient manner with prudent risk. It is all about asset cash flows versus liability cash flows. The most prudent and efficient way to achieve this objective is through cash flow matching. The Ryan ALM model (Liability Beta Portfolio™ or LBP) is a cost optimization model that will fund and match liability cash flows monthly at a cost savings of about 2% per year. If Ryan ALM was your asset manager for the 1-7 year liabilities, we could reduce the cost to fund benefits and expenses by about 14%. This is a significant cost saving and allows plan sponsors time for their other assets to grow unencumbered without a cash sweep.

“Where is the knowledge we have lost in information” T.S. Eliot