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

Q:  Should a pension plan with a 90% funded status have the same asset allocation as a 60% funded plan?

A:  NO! Asset allocation should be based on the economic funded status.

Many asset allocation models are based on achieving a target return (ROA) and ignore the funded status. This has been a critical mistake as best demonstrated by what has happened since 1999. In the 1990s, most pensions had a growing surplus. Instead of reacting to this funded status, most pensions focused on achieving a then target ROA of around 8.00%. During the 1990s, asset allocation models increased their weight for equities and reduced their weight toward fixed income to the lowest level ever as interest rates continued a secular decline. By the end of 1999, it was common to see an allocation of 75%+ to equities.

When the equity correction came in 2000, it hit the funded status hard. Ryan ALM estimates that the S&P 500 underperformed economic liability growth by over 60% during the 2000 – 2002 equity correction. As a result, the funded status went from a nice surplus to a sizeable deficit. This reality caused a spike in contribution costs. For many pensions, contribution costs went up over 300% in those three years and they have continued to spike through today. Contributions for many pensions are now over 10x higher today than in fiscal 1999. This is the pension crisis I outlined in my 2013 book “The U.S. Pension Crisis”. This increased contribution cost led numerous corporations to freeze and terminate their defined benefit plan through a pension risk transfer (PRT). This may be the worst outcome for new employees who were given a less secure defined contribution plan instead.

There are several lessons to be learned from the 2000-02 equity correction:

1. True Economic Objective – is to secure benefits in a cost-efficient manner with prudent risk… it is not a return objective.
2. It’s All about Cash Flows – the goal is to have asset cash flows match or exceed liability cash flows with certainty. This should be the quest of any pension. This is best accomplished with a cash flow matching strategy using bonds. It used to be called Dedication and Defeasance.
3. Actuarial Projections – the actuarial projections of benefits and expenses or liability cash flows should be the focus of asset cash flows. Too often such actuarial projections are not provided in the annual actuarial report. It is critical that pension assets know what they are funding. As a result, actuarial projections should be mandated by the plan sponsor, so consultants and asset liability managers know the liability cash flows they need to fund.
4. Economic Funded Status – actuaries have a tough and tedious job given all the calculations they need to create. As a result, they tend to publish their actuarial report annually several months after the end of the fiscal year. It is hard, if not impossible, for assets to function efficiently if their objective is only known annually several months delinquent. As a solution, the Ryan team developed the Custom Liability Index (CLI) as the proper benchmark for any pension providing all of the calculations and data needed for plan sponsors, consultants and asset liability managers to perform their duties effectively. The CLI will calculate the market value of liabilities so the economic funded status can be determined when compared to the market value of assets. This economic funded status should be the focus of asset allocation.

5. Asset Allocation – should be responsive to the funded status. As the funded ratio improves, a greater allocation to cash flow matching with bonds should be enacted. Any pension fully funded should consider a high cash flow matching allocation. Utopia is to have risky assets in the surplus portfolio and not the asset liability portfolio. Had pensions done this in the late 1990s there would not have been the contribution cost spikes pensions suffered ever since.  

“Common sense is not common. It requires preferred sense”.