By: Ron Ryan, CFA, CEO, Ryan ALM, Inc.

Most pension investments are focused on earning Alpha… defined as a positive return difference between the investment and its objective (usually an index benchmark). Each asset class and its subsets seem to have an index benchmark today. Monthly risk/reward measurements of the asset return behavior are compared to the index benchmark return behavior as a strict discipline to monitor that Alpha is being earned with an appropriate risk behavior. All of this ends up in a rigorous and time-consuming review by the pension consultant with the plan sponsor.

If the true objective of a pension is to secure benefits in a cost-efficient manner with prudent risk… then where are the liabilities in this review? Liabilities behave like bonds since they are priced with a discount rate. As a result, liability growth (return) can be volatile with a high positive or even negative annual growth rate. Comparing the annual growth rate of assets to the annual growth rate of liabilities is a required annual accounting and actuarial practice. This will determine the funded ratio, funded status, contribution cost as well as pension expense. In the end it is the growth rate of assets versus the growth rate of liabilities that count… this is where liability Alpha is calculated.

All of the pension assets can outperform their index benchmark and create market Alpha but unless this asset allocation creates liability Alpha…the pension plan loses! This will result in a lower funded ratio and status as well as higher contribution costs. Pensions are all about assets versus liabilities cash flows and growth rates (returns). Most important is that the asset cash flows match and fund with certainty the liability cash flows. This is a future value calculation and can only be implemented with a cash flow matching strategy using bonds. The present value growth rate (return) of assets versus liabilities is also important as it affects the accounting and actuarial calculations mentioned earlier. The focus here should be earning liability Alpha.

Since the liability growth rate is not a common or frequent calculation, the Ryan team invented a Custom Liability Index (CLI) in 1991  as the proper benchmark for asset liability management (bonds) or even total asset allocation. Our CLI is a monthly report providing  all of the calculations and data needed to monitor the risk/reward behavior of liabilities. Our CLI will allow for the pension consultant and plan sponsor to easily calculate if the plan has earned liability Alpha.

The Ryan ALM cash flow matching model (Liability Beta Portfolio™ or LBP) will fund benefits chronologically with certainty. Our LBP will outyield liabilities (if discount rate = ASC 715) thereby also providing liability Alpha. As a result, our LBP can achieve both the future value and present value goals of fully funding benefits in a cost effective manner while earning liability Alpha.

“Given the wrong index(s)… you will get the wrong risk/reward” – Confucius