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

For years we’ve attempted to reorient the plan sponsor community away from focusing their plan’s asset allocation on total return to one that secures the promised benefits through a focus on the plan’s liabilities. You know, the promise that has been made to the plan participant. At Ryan ALM, we believe that the primary objective in managing a defined benefit system is to SECURE the promised benefits at a reasonable cost and with prudent risk.

Given our expertise, we’ve been heartened by the increased focus on asset/liability management (ALM) strategies, and not just within the private pension universe. Consultants, actuaries, and plan sponsors are more willing to discuss the opportunity to reduce risk, while securing the promised benefits given the current U.S. interest rate environment. The goal of any ALM strategy is to align the fund’s asset cash flows with the liability cash flows or future obligations of the pension plan. The careful cash flow matching of the plan’s assets with the fund’s liabilities also acts to mitigate interest rate risk, since benefit payments are future values that are not interest rate sensitive. Importantly, through a cash flow matching (CFM) strategy, the plan’s liquidity is enhanced, and benefit payments are secured chronologically from the first month as far into the future as the allocation goes.

ALM is NOT a return objective, since the careful matching of assets and liabilities ensures that they move in lockstep with each other whether rates are rising or falling. Those liabilities should be removed from the funding equation. The balance of the assets should be used to meet future liability growth. These assets can now be managed as aggressively as needed since the CFM mandate has bought time by creating a longer investing horizon.

We were grateful to recently be included in a search conducted by a leading asset consulting firm that was seeking to employ a strategy to secure the overfunded status for their pension client. We produced a series of reports highlighting the fact that we could defease all of the plan’s liabilities as far into the future as the actuary could forecast. Effectively, they had won the pension game. Congratulations! Yet we were recently told that they were leaning toward a duration matching (DM) strategy because DM products will outperform CFM. What? Our CFM is heavily skewed to A/BBB+ corporate bonds which should outyield any duration matching strategy since they tend to use higher rated bonds especially Treasury STRIPS for longer durations. Again, the use of ALM strategies is to reduce risk and secure the promised benefits. It isn’t a return seeking effort. Save that for the residual assets that now have time to wade through whatever markets will present in the future.

Furthermore, CFM strategies will always out perform DM mandates at the same duration/maturity because of the higher yield, especially the Ryan ALM CFM product that emphasizes A/BBB+ exposure. Furthermore, since the longest duration today of any bond is around 17 years, DM products are forced to use low yielding Treasury STRIPS past 17 years. Whereas CFM can buy 17- to 30-year A/BBB+ bonds to cash flow match long liabilities. The difference in yield could be significant at +100 bps or more.

Plan participants are counting on the benefits to be paid as promised. We have an obligation to manage them with that goal in mind. Let’s get off the asset allocation rollercoaster driven by the industry’s focus on return that only creates incredible uncertainty regarding the volatility of returns, contributions, and funded status. If you are going to engage in ALM/CFM, please focus on how best to neutralize assets and liabilities and forget return. It isn’t part of the game plan.