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

Kudos for the new format for some of the educational sessions at FPPTA, which just concluded on Wednesday. The new format, which consisted of four subject experts and 36 attendees in a large square, led to much more conversation with greater interaction from the mostly pension plan trustees. The 3 modules during this conference included conversations with asset consultants, actuaries, and one focused on pension funding. Each one was terrific, as the experts guided the conversation in response to many fantastic questions.

During the asset consulting conversation, a trustee brought up the subject of de-risking and wondered why he hadn’t been introduced to the subject by his consultant. He asked if it was the responsibility of the consultant to introduce the subject despite the current total return (ROA) focus of his plan. As you may recall, I had just returned from an IFEBP conference in Las Vegas in which I brought up the subject of de-risking DB plans in order to protect and preserve the funded status and reduce the volatility associated with contribution expenses. I mentioned that the audience during my session was quite eager to learn more about de-risking and the mechanics to accomplish the objective. I implored the asset consulting community to take the lead in providing education on the subject.

What I found most interesting about the subsequent discussion on de-risking was the focus on the part of consultants on the issue of closed versus open plans. As I recall, each consultant said that they would absolutely explore de-risking if their client’s plan was “closed”. But does that limitation make sense? Defined benefit pension plans have on-going benefit obligations that must be met on a month-to-month basis. Yes, the liabilities of a closed plan are more concrete, but they aren’t precise despite the actuary’s best efforts. Open plans have a Retired Lives Liability (RLL) that is more certain and less susceptible to actuarial noise. Why wouldn’t you want to secure that ongoing monthly obligation as opposed to a pay-as-you-go approach used today.

We, at Ryan ALM, Inc., often talk about a new approach to asset allocation that bifurcates the assets into two buckets – liquidity and growth – as opposed to having all of the plan’s assets focused on the ROA. In our approach, the liquidity bucket should be a defeased bond portfolio of high-quality investment grade corporate bonds in which the asset cash flows (principal and interest) are matched against the liability cash flows (benefits and expenses) to ensure that the necessary liquidity is available each and every month. Does that only work in a closed plan? Of course not!

Open plans have experienced great volatility in their funded status and annual contributions because they ride the asset allocation rollercoaster up and down while chasing the return target. In the process, contributions grow and grow in order to make up the shortfall. This is no way to operate a DB plan. Secure a portion of your promises. The allocation to the liquidity bucket should be determined by the current funded status. A plan with a 90% funded ratio should have a greater exposure to bonds (liquidity) than a 60% funded plan, but that is not what we’ve observed throughout the years. If a plan has a 7% ROA objective, they are going to have a similar asset allocation no matter what the funded status.

Lastly, public pension systems continue to kid themselves by claiming to be a perpetual entity. Yes, most cities and states are not going anywhere, but just because something in perpetual doesn’t mean that it is sustainable. Secure your promises so that the sponsors of these critically important plans don’t decide that they can no longer afford to provide the benefits.