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

We at Ryan ALM, Inc. have been preaching the benefits of Cash Flow Matching (CFM) for nearly two decades. So, when we see one of the big boys (large fixed income shop) writing about the benefits of CFM we get excited. However, just because they are big, doesn’t necessarily mean that their approach is correct, as all CFM strategies are not equal.

Specifically, CFM when done appropriately is NOT a laddered bond portfolio which is sub-optimal in any market environment. Bond math is very straightforward. The longer the maturity and higher the yield, the lower the cost, which is the ultimate goal. A positively shaped yield curve is wonderful for us because it reduces costs. Done correctly, funding costs can be reduced by 2% or more per year in this environment. Secure the pension promises for Retired Lives 1-30-years and the present value (PV) cost to fund those future value (FV) benefits and expenses can be reduced by 50% or more. Furthermore, the current environment of higher short-term rates (inverted yield curve) does not make the opportunity to use CFM a short-term phenomenon. That might be the case if one were to ladder bonds, but since Ryan ALM uses a cost optimization process that truly matches cash flows, we very much appreciate the benefits of a “normal” positively sloped yield curve.

Pension plans need liquidity on a constant basis. Creating a bifurcated approach to asset allocation in which two buckets are used – liquidity and growth – as opposed to having all of the pension assets focused on the ROA, provides the pension plan with enhanced liquidity and lower transaction costs associated with constantly rebalancing the assets. This will eliminate the common approach of a “Cash Sweep” which takes away income from growth assets. Studies prove that close to 50% of the S&P 500 total return on a rolling 10-year horizon since 1940 (Guinness Asset Management) comes from dividends reinvested. So why would you want to take away these dividends… let CFM fund liabilities chronologically. Pension systems do not need to be fully funded or close to fully funded to receive significant benefits from using CFM. Given the liquidity needs, every pension plan should use CFM to secure the promised benefits for some prescribed period of time. We normally suggest funding Retired Lives or 1 to 10-years of liabilities which creates a long investing horizon for the growth assets that can now grow unencumbered. 

We are so thankful to see others in our industry write about the benefits of CFM, but as I stated earlier, not all CFM is created equal. It requires a deeper understanding of the implementation which is measured by the efficiency of the model’s output. The more efficient, the lower the ultimate cost to SECURE those promises.