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

I’ve been asked to speak to this topic on many occasions. In one such case, the IFEBP conference in October 2017, I returned to New Jersey and penned a post on the subject. In reviewing what I wrote that day and where we are today, I have to ask: What has changed? We are nearly 6 1/2 years removed from that event, but one needs to ask have pension asset allocations truly evolved.

For most plan sponsors and their consultants, the concept of “Advanced Asset Allocation” has to do with altering exposures to one asset class or style category (growth vs value) versus another. The adjustments often result in token shifts of 2-3% from one asset class to another. Is that really an advanced asset allocation discussion? Does the inclusion of private debt or equity really support the concept of a dramatic improvement in asset allocation, especially when one contemplates that these strategies come with higher fees, a lack of transparency, and poor (non-existent) liquidity? NO!

The problem with most asset allocation frameworks is that they focus attention on returns and not nearly enough on the benefit promise that has been given to the plan participant. With a focus on the return on asset assumption (ROA), volatility of the funded status and contribution expenses is assured, but the full funding of the plan is not, as we continue to ride the asset allocation rollercoaster up and down. Currently, the cars on that rollercoaster are making their way up, but who knows when the peak will be breeched and the cars will once again plummet, leading to further funding shortfalls and the need to get more aggressive with the return target and composition of the portfolio.

I don’t believe that approaches to pension asset allocations have changed much, especially among public pension systems. Sure, there have been moves among the asset classes, especially from public markets to private, but does that highlight an advancement? I suggest that it doesn’t. However, we have witnessed the markets change quite dramatically. We currently have a US interest rate environment that we haven’t experienced in two or more decades. In addition, we have a US equity market that is experiencing an “unprecedented” concentration in leadership (Tech) that is leading to persistent underperformance by active managers trying to eclipse the S&P 500’s return. Furthermore, we’ve had significant assets moving into private debt (>$3 T) at a time when higher rates may create problems for the companies trying to cover their interest expenses. Do you want to discuss real estate or private equity that have their own issues at this time? Does shifting marginally among these asset classes protect the funded status of the pension plans?

An advanced asset allocation framework would be one that gets the pension system off the performance rollercoaster. It is one that SECURES the promised benefits at both a reasonable cost and with prudent risk. It is one that stabilizes the funded status and contribution expenses. It is one that creates a liquidity profile that ensures that monthly benefit payments and expenses are met without having to liquidate assets, perhaps during periods of market disruption. Importantly, having an enhanced liquidity profile buys time for the remainder of the assets – presumably the fund’s alpha assets – to now grow unencumbered, as they are no longer funding monthly payments for several years or more.

Furthermore, an advanced asset allocation strategy understands that a pension plan’s liabilities need to be the focus of any asset allocation framework. Those liabilities need to be measured, monitored, and managed. A once per year, at best, review of the plan’s liabilities doesn’t accomplish the objective. Could you play a football game without knowing how many points your opponent has scored? Of course not! Then how can you manage a pension plan without knowing how the plan’s promises (liabilities) are behaving?

Having an advanced asset allocation that factors into the equation both liabilities and risk doesn’t mean that 100% of your assets have a new mandate. The funded status and the sponsoring entity’s ability to contribute will provide guidance on just what percentage of your assets will be impacted. There is no excuse for a plan with a 60% funded status to have the same asset allocation and ROA as one that is 90% funded. Yet, we see this all the time when both plans are striving for the same or similar ROA.

We, at Ryan ALM, Inc. understand and preach advanced asset allocation strategies. Our cash flow matching (CFM) capabilities become the backbone of the new asset allocation framework. CFM provides the necessary liquidity, while buying time for the alpha assets (non-bonds) to meet future liabilities. Our approach actually secures the promised benefits. This is a “sleep well at night” process that brings certainty to a very uncertain environment. We’d be happy to do a free analysis for you to highlight what can be done to truly create an advanced asset allocation framework.