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

I just returned from speaking at the FPPTA conference at the Sawgrass Marriott, FL. This organization continues to provide world class education to a significant percentage of Florida’s public fund trustees. I am always grateful for the opportunity to share my insights. I spoke on two subjects during my time in Florida, but I want to focus my attention on the subject of de-risking a pension plan, as DB plans need to be protected and preserved through a risk mitigation technique. My presentation was centered on adopting a new asset allocation framework that moved away from having all of a plan’s assets focused on achieving a return on asset assumption (ROA) to a new structure that bifurcates the assets into two buckets: liquidity and growth.

My liquidity bucket is designed to use Cash Flow Matching (CFM), which is a strategy using bond cash flows of principal and interest that has been employed by financial institutions and corporations for many decades as a “risk management” technique. These strategies primarily aim to match the timing and amount of cash inflows and outflows to meet specific liabilities or financial obligations. With regard to pension plans, this process is used to SECURE the promised benefits and the expenses incurred to meet those obligations.

Cash Flow Matching involves constructing a portfolio of bonds, which for Ryan ALM is usually investment-grade corporate bonds rated BBB+ or better, that match and fund the liability cash flows (benefits and expenses). The cash flows from the bonds are optimized in such a way that the principal and interest align with the timing and amounts required to fulfill the obligations. This strategy is commonly used by insurance companies, and was initially the primary investment strategy for pension plans, to ensure they have sufficient funds to meet future payment obligations, such as insurance claims.

The process of cash flow matching typically involves analyzing the future cash flow requirements, such as the timing and amounts of liabilities. This is done by first building a Custom Liability Index (CLI) that was first created by Ron Ryan in 1991. Once the liabilities have been mapped, a bond portfolio is constructed to minimize the cost to defease those future obligations. Importantly, and especially in today’s environment, the use of CFM minimizes interest rate risk, which remains the greatest risk for bonds and bond managers, as benefit payments are future values which are not interest rate sensitive.

The remainder of the plan’s non-bond assets will be part of the growth (alpha) bucket, that can now grow unencumbered in their quest to meet future liability growth. These assets are not a source of liquidity, which is handled exclusively by the CFM portfolio. As success is achieved in the growth portfolio, the excess assets can be ported (transferred) to the liquidity bucket to further extend the benefit coverage period thus reducing the volatility of the plan’s funded status and contributions.

Pension America should be taking full advantage of the current US interest rate environment to secure as many of the promised benefit payments as possible. Done right, CFM will bring a measure of certainty to the management of pension plans that presently operate in a world of great uncertainty due to the focus on return. Traditional, return-seeking fixed income products will be hurt by rising interest rates, as we’ve seen during the last couple of years. Only through a CFM program can you ensure that the assets and liabilities of your plan will move in lockstep with each other.