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

Twice in the last two days, I’ve been asked by very knowledgeable industry professionals to define for them our benchmark. Knowing that we are a fixed income manager focused on defeasing (securing) pension liabilities through our cash flow matching (CFM) capability, they correctly assumed that it wasn’t the Lehman (now Bloomberg Barclay’s) Aggregate Index (homage to Ron Ryan who designed the AGG as Director of Fixed Income Research at Lehman), as no generic index can adequately replicate the unique liabilities of a plan sponsor’s liability cash flows. The answer is… in order to successfully manage a CFM mandate, one has to build a Custom Liability Index (CLI) so that the assets know what they have to fund and when the assets need to be available, especially given that benefit payments are needed on a monthly basis and actuarial reports provide annual forecasts.

The use of a CLI seems fairly obvious although it is not yet a standard practice. However, there is a second “benchmark”, too. Not all CFM managers are created equal. There are tremendous skills necessary to create an optimization framework that minimizes excess cash reserves while maximizing the cost reduction created through the construction of the CFM portfolio. It isn’t always easy to evaluate one investment firm or investment product versus another. Often, the size (defined as AUM) of the manager is a differentiator. Other factors might include fees, number of professionals assigned to a product, years implementing the strategy, etc. But rarely do consultants and their clients get to see under the hood. I’m speaking specifically of the efficiency of the model.

We at Ryan ALM, Inc. take great pride in our Models. The Models are the system! We treat our Models (discount rates, CLI, and CFM) as assets of the firm and not just products. We are particularly proud of the fact that all of the development has occurred in-house over decades. When we produce a cash flow matching portfolio, we also highlight the Model’s efficiency as it relates to that specific portfolio/mandate. We often produce a free analysis of what a potential mandate will look like for the consultant, plan sponsor, or both, which provides them with that look “under the hood”. If they are looking at multiple managers for a potential assignment, they should be getting this free look from the other firms, as well. They should be demanding to see how efficient the other offerings are. Why? Greater Model efficiency results in lower cost for the program, which should be the determining factor in whether one manager gets chosen over another, and not the other factors that often play a role.

Managing a cash flow matching assignment is not the same as building a laddered bond portfolio. Bond math is very straightforward. The higher the yield and the longer the maturity, the lower the cost. You want your CFM portfolio producing abundant cash flows that will cascade throughout the years of the mandate, but you don’t want excess cashflows given the potential negative impact of reinvestment risk. Having the most efficient model will reduce the negative impact of excess reserves building throughout the program. It will maximize the yield advantage from longer maturities and the cash flow that is produced from those longer maturities that will be used to meet near-term benefits and expenses. Let us know if you are interested in CFM. As stated above, we are always willing to produce a free analysis that will help guide you in your decision making. You’ll learn quickly just how efficient our system and models are.