By: Ronald J. Ryan, CFA, Chairman, Ryan ALM, Inc.

Problem:  Pension Liabilities… MIA

Solution:  Cash Flow Matching (CFM)

The true objective of a pension is to secure and fully fund benefits (and expenses) in a cost-efficient manner with prudent risk. Although funding liabilities (benefits and expenses (B+E)) is the pension objective, it is hard to find liabilities in anything that pertains to pension assets. Asset allocation is more focused on achieving a ROA (return on assets target return), and performance measurement compares assets versus assets, as the asset index benchmarks are void of any liability growth calculations. If you outperform your index benchmark does that mean asset growth exceeded liability growth? Perhaps NOT.

Pension liabilities behave like bonds since their discount rate is most similar to a zero-coupon bond yield curve (especially ASC 715 discount rates which are a AA corporate yield curve). Yes, public and multiemployer pension plans use the ROA as the discount rate to price their liabilities but even then it is not shown in any performance measurement reports. In fact, what shows up in the CAFR annual report is the GASB requirement of an interest rate sensitivity test by moving the discount rate up and down 100 basis points to determine the volatility of the present value of liabilities and the funded ratio. But a total return or growth rate comparison of assets versus liabilities seems to be MIA.

Ryan ALM solves this problem through our asset liability management (ALM) suite of synergistic products:

1. Custom Liability Index (CLI) – The management of assets should actually start with liabilities. In reality, assets need to fund NET liabilities defined as (benefits + expenses) – contributions. Contributions are the first source to fund B+E. Assets must fund the net or residual. This is never calculated so assets start with little or no knowledge of what there job really is. Moreover, B+E are monthly payments, which are also not calculated, as the actuary provides an annual update. The CLI performs all of these calculations including total return and interest rate sensitivity as monthly reports.

2. ASC 715 Discount Rates – Ryan ALM is one of very few vendors who provide ASC 715 discount rates, and we’ve done so since FAS 158 was enacted (2006). We provide a zero-coupon yield curve of AA corporate bonds as a monthly excel file for our subscribers including a Big Four accounting firm and several actuarial firms.

3. Liability Beta Portfolio™ (LBP) – The LBP is the proprietary cash flow matching model of Ryan ALM. The LBP is a portfolio of investment grade bonds whose cash flows match and fully fund the monthly liability cash flows of B+E. Our LBP has many benefits including reducing funding costs by about 2% per year (20% for 1-10 year liabilities). The intrinsic value of bonds is the certainty of their cash flows. That is why bonds have always been chosen as the assets for cash flow matching or dedication since the 1970s. We believe that bonds are not performance or growth assets but liquidity assets. By installing a LBP, pensions can remove a cash sweep from the growth assets, which negatively impact their growth rates. We urge pension plan sponsors to use bonds for their cash flow value and transfer the bond allocation from a total return focus to a liquidity allocation. Moreover, the Ryan ALM LBP product is skewed to A/BBB+ corporate bonds which should outyield the traditional bond manager who is usually managing versus an index which is heavily skewed to Treasuries and higher rated securities that are much lower in yield. The LBP should enhance the probability of achieving the ROA by the extra yield advantage (usually 75 to 100 basis points). The LBP should also reduce the volatility of the funded ratio and contributions. In fact, it should help reduce contribution cost by the extra yield enhancement. 

For more info on the Ryan ALM product line, please contact Russ Kamp at  rkamp@ryanalm.com.