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

We, at Ryan ALM, believe that Risk is best defined as the uncertainty of achieving the objective. Any argument? What is the primary objective of managing a pension plan? Again, we believe that it is the funding and SECURING of the promised benefits in a cost-efficient manner and with prudent risk. The only reason that defined benefit pension plans exist is to pre-fund promised retirement benefits. Regrettably, our industry, at least for public and multiemployer plans, has adopted a very different primary objective… one that is focused on achieving a return on asset objective (ROA).

With a return focus, great uncertainty is introduced into the process. So if risk is defined as the uncertainty of achieving the objective, why would one want to adopt a strategy that only serves to create greater uncertainty? When pension systems were first introduced many decades ago, they were often managed in a similar fashion to insurance companies and lottery systems that took a present value (PV) calculation of the future promised benefits (FV) and funded the plan accordingly, and usually thru a cash flow matching strategy or defeasement. There was no need to subject precious fund assets to the whims of the market. There was no forecasting of asset class performance based on a historical perspective that might be achieved at some point in the future. No games!

Has the changing of the primary objective/focus led to better outcomes? Absolutely, not. As a result of all the volatility associated with a return focus, pension plan sponsors are saddled with greater contribution expenses, a more volatile funded status, the introduction of much more complicated products/structures, less liquidity, and far greater uncertainty as to the sustainability of these critically important plans.

Despite all this, there is some good news. After nearly four decades of falling US interest rates that created a bunch of unintended consequences, the current US interest rate environment is once again very positive for pension systems. Not only are allocations to fixed income producing wonderful cash flow, but the PV of pension liabilities is falling, too. With only a modest change in the asset allocation approach, one could significantly reduce the uncertainty of achieving the primary objective of securing the promised benefits at both a reasonable cost and with prudent risk.

Migrate your current core fixed income from a return-seeking focus to one that uses the fixed income cash flows to secure the promised benefits through a cash flow matching defeasement strategy. Your plan’s assets and liabilities will move in lock-step with one another for that portion of the plan that is defeased. Now that is certainty! Don’t continue to just ride the asset allocation rollercoaster hoping to achieve a ROA objective.