Monthly Archives: May 2024

05.01.24
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CFM: Buy Time and Reduce Risk

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

A traditional DB plan’s asset allocation comes with a lot of annual volatility (see the graph below). That volatility gets reduced as one extends the investing horizon, but it is still quite uncertain until you extend sufficiently, such as 10 or more years. However, as plan sponsors and investment managers, we have been living in a quarter-to-quarter measurement cycle for decades. In that environment, a 1 standard deviation (1 SD) measurement for a 1-year time frame (Ryan ALM asset allocation model since 1999) is +/- 10.5%. In the example below, 68% of the observations (1 SD) will fall between 16.5% and -4.5%. A 2 SD measurement would have the range for 95% of the observations between 27% and -15%. That gap, or should I say canyon, is a 1-year observation. Extend the measurement period to 5-years and the range of results is still wide but less so at +/- 9.8% for 2 SDs. It isn’t until you get beyond 10 years that the volatility associated with a fairly traditional asset allocation gets to a reasonable level.

Is there a way to bring more certainty to the asset allocation process that would allow for longer observation periods and less volatility? Absolutely! A plan sponsor and their advisors can adopt a bifurcated asset allocation in which a liquidity bucket is created that will fund and match the plan’s liability cash flows of benefits and expenses chronologically from the next month as far out as the allocation will cover (10+ years) allowing for the remainder of the alpha assets (all non-bond assets) to now grow unencumbered. The task for those assets is to meet future liabilities.

As the graph below highlights, a carefully constructed cash flow matching (CFM) portfolio can help plan sponsors wade through the volatility associated with shorter timeframes. The CFM portfolio will consist of investment grade bonds whose cash flows of interest and principal will be matched to the liability cash flows. This process now ensures (absent defaults) that the necessary liquidity is available when needed as those future promises have been SECURED. The remaining assets can now be managed as aggressively as the plan’s funded status dictates.

With this process, short-term market dislocations will no longer impact the plan’s ability to meet its obligations. There will be no forced selling to meet benefit payments. The alpha assets can now grow without fear of being sold at an unreasonable level. The CFM program takes care of your needs while establishing a buffer (longer investing horizon) from market corrections that happen on a fairly regular basis. This structure should also lead to less volatility related to contributions and the plan’s funded status.

Given the elevated US interest rate environment, now is the time to engage in this process. CFM will provide a level of certainty that doesn’t exist in a traditional asset allocation. This is a “sleep well at night” strategy that should become the core holding for DB pensions. As I mentioned in an earlier blog post today, bonds should only be used for the cash flows they produce. They should not be used as total return-seeking instruments. Leave that task to the alpha assets that will benefit from a longer investing period.

05.01.24
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Another Challenging Month for US Fixed Income

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

S&P Dow Jones is out with its monthly “Dash Board” on a variety of benchmarks, both domestic and foreign. April proved challenging for both US equities and bonds. With regard to stocks, the S&P 500 was down -4.1% bringing the YTD performance to +6.04%. It was a tougher environment for both mid cap (-6.0%) and small cap (-5.6%). Small caps (S&P 600) continue to be pressured and the index is now down -3.3% YTD. As US interest rates continue on a course higher, US equities will continue to be challenged.

The higher US rates are also continuing to pressure US fixed income. The Aggregate Index produced a -1.8% April, and the index is now down -2.4% since the start of 2024 despite the rather robust YTM of 5.3%. As we’ve discussed on many occasions, bonds are the only asset class with a known cash flow of a terminal value and contractual coupon payments. As a result, bonds should be used for the certainty of those cash flows and specifically to defease pension liabilities. As a reminder, pension liabilities are bond-like in nature and they will move with changes in interest rates. Don’t use bonds as a total return strategy, as they will not perform in a rising rate environment. Sure, the nearly 40-year decline in rates made bonds and their historical performance look wonderful, but that secular trend is over.

Use the fixed income allocation to match asset cash flows of interest and principal to the liability cash flows of benefits and expenses. As a result, that portion of the total assets portfolio will have mitigated interest rate risk, while SECURING the promised benefits. Having ample liquidity is essential. Using bonds to defease pension liabilities ensures that the necessary liquidity will be available as needed. The current US interest rate environment may be pressuring total return-seeking fixed income managers, but it is proving cash flow matching programs with a very healthy YTM that dramatically reduces the cost of those future value payments. Don’t waste this golden opportunity.