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

I had the opportunity to listen in on a conference panel yesterday in which the individuals of several public pensions were asked if the asset allocation frameworks for their pension systems were based on the return on asset assumption (ROA) or the plan’s funded status. Somewhat surprisingly each of the participants responded that the plan’s funded status didn’t influence the asset allocation. Perhaps it is an appropriate answer if the horizon is a one-year timeframe in which funded status isn’t likely to vary too significantly unless, of course, we experience another GFC. But for longer measurement periods the funded status should absolutely drive asset allocation.

For instance, does it make sense for a pension plan that is 60% funded to have the same asset allocation (AA) as one that is 90% funded even if they are striving for the same ROA? No, it doesn’t! Yet, we see this quite often. Why would the plan that is 90% funded want to assume the same level of risk as one that is more poorly funded? The plan that is better funded should be striving to reduce risk in order to stabilize both the funded status and contribution expenses. Again, reducing risk doesn’t mean shuttering the plan or eliminating the possibility of providing benefit enhancements or COLAs. What it does mean is that a portion of your assets should be removed from the rollercoaster of returns bringing some stability to the funded status and contribution expenses.

Furthermore, we don’t believe that an asset allocation strategy should have all of the assets focused on the ROA. That AA strategy guarantees a lot of volatility, but no guarantee of success. We highly recommend bifurcating the assets into two buckets – liquidity and growth. The liquidity bucket should be a bond portfolio that matches asset cash flows of interest and principal with the liability cash flows of benefits and expenses. By adopting this framework the plan assures that appropriate liquidity is always available even during periods of great market stress. By building a liquidity bucket the plan sponsor is buying time for the growth assets to grow unencumbered. One of the most important investment tenets is time! Then longer the investing period the higher the probability of achieving the desired outcome.

Importantly, this cash flow matching strategy can fit within the existing asset allocation framework. Bond allocations still exist in a significant majority of plans. They may be smaller given the interest rate environment from which we’ve just come, but they will still provide ample assets to begin to de-risk. A 5-year cash flow matching (CFM) program is better than not having secured the benefits at all. Once adopted, the CFM can always be extended, especially if the funded status continues to improve.

The primary objective in managing a DB plan is to SECURE the promised benefits at a reasonable cost and with prudent risk. I would posit that the current focus on the ROA doesn’t support that objective. Get off the rollercoaster of returns and begin to bring effective risk control into your asset allocation process.