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

I’ve been extremely fortunate to participate in the Opal Public Fund Summits – both East and West – for the better part of the last 10 years. I used to attend these events and almost never hear the word liability uttered, especially as it related to a pension liability. They might have spoken about so and sos golf swing being a liability or some teams QB, but pension liabilities were missing in action.

I’m thrilled to say that several of the panels/panelists mentioned pension liabilities, with terms such as ALM, defeasement, immunization, de-risking, duration, and even cash flow matching (CFM), and not just by me, also being uttered. It was so refreshing. They are right to be discussing this strategy at this time given the sea change that has occurred in US interest rates. The cost to implement asset/liability management strategies, especially CFM, have been reduced significantly in the last two years.

That said, there are still so many misconceptions regarding CFM. It is NOT a laddered bond portfolio, which would be quite inefficient and costly. It IS a highly sophisticated cost optimization process that maximizes cost savings by emphasizing longer maturity bonds (within the program’s parameters = # of years defeased) and higher yielding corporate bonds, such as A and BBB+.

Furthermore, it is not just a viable strategy for private pension plans, as it has been deployed successfully in public and multiemployer plans for decades. It is also NOT an all or nothing strategy. The exposure to CFM is a function of several factors, including the plan’s funded status, current allocation to core fixed income, Retired Lives Liability, etc. Many of our clients have chosen to defease their pension liabilities from 5-30 years or beyond. When asked, we recommend a minimum of 10 years, but again that will be a function of each plan’s unique funding situation.

CFM strategies are NOT “buy and hold” programs. CFM implementations must be dynamic and responsive to changes in the actuary’s forecasts of benefits, expenses, and contributions. There are also continuous changes in the fixed income environment (I.e. yields, spreads, credits) that might provide additional cost savings that need to be monitored and managed. Plan sponsors may seek to extend the initial length (years) of the program as it matures which will often necessitate a restructuring or rebalancing of the original portfolio to maximize potential funding coverage and cost reductions.

CFM programs CANNOT be managed against a generic index, as no pension plan’s liabilities will look like the BB Aggregate or any other generic index. Importantly, no pension plan’s liabilities will look like another pension plan given the unique characteristics of that plan’s workforce and plan provisions. The appropriate management of CFM requires the construction of a Custom Liability Index (CLI) that maps the plan’s liabilities in multiple dimensions and creates the path forward for the successful implementation of the asset/liability match.

Importantly, CFM programs are NOT going to negatively impact the plan’s ability to achieve its desired ROA. In fact, a successful CFM program, such as the one we produce, will actually enhance the probability of achieving the return target. How? Your plan likely has an allocation to core fixed income. Our implementation will likely outyield that portfolio over time creating alpha as well as SECURING the promised benefits. Given the higher corporate bond interest rates, an allocation to this asset class can generate a significant percentage of the ROA target with risks substantially below those of other asset classes.

What a successful CFM implementation does is the following:

Secures benefits for time horizon LBP is funding (1-10 years +)

Buys time for the alpha assets to grow unencumbered

Outyields active bond management… enhances ROA

Reduces Volatility of Funded Ratio/Status

Reduces Volatility of Contribution costs

Reduces Funding costs (roughly 2% per year)

Mitigates Interest Rate Risk as benefits are future values that are not interest rate sensitive.

It was a great conference spurred on by the fact that folks are beginning to think outside the “performance/return” box. Taking advantage of higher US interest rates is the prudent action today. CFM strategies accomplish a lot for the plan and plan sponsor, but most importantly it provides everyone with a great night’s sleep.