By: Russ Kamp, CEO, Ryan ALM, Inc.

I’ve spent the last few days attending and speaking at the FPPTA conference in Sawgrass, Florida. As I’ve reported on multiple occasions, I believe that the FPPTA does as good a job as any public fund organization of providing critical education to public fund trustees. A recent change to the educational content for the FPPTA centers on the introduction of the “pension formula” as one of their four educational pillars. In the pension formula of C+I = B+E, C is contributions, I is investment income (plus principal appreciation or depreciation), B is benefits, and E represents expenses.

To fund B+E, the pension fund needs to contribute an annual sum of money (C) not covered by investment returns (I) to fully fund liability cash flows (B+E). That seems fairly straightforward. If C+I = B+E, we have a pension system in harmony. But is a pension fund truly ever in harmony? With market prices changing every second of every trading day, it is not surprising that the forecasted C may not be enough to cover any shortfall in I, since the C is determined at the start of the year. As a result, pension plans are often dealing with both the annual normal cost (accruing benefits each year) and any shortfall that must be made up through an additional contribution amortized over a period of years.

As a reminder, the I carries a lot of volatility (uncertainty) and unfortunately, that volatility can lead to positive and negative outcomes. As a reminder, if a pension fund is seeking a 7% annual return, many pension funds are managing the plan assets with 12%-15% volatility annually. If we use 12% as the volatility, 1 standard deviation or roughly 68% of the annual observations will fall between 7% plus or minus 12% or 19% to -5%. If one wants to frame the potential range of results at 2 standard deviations or 19 out of every 20-years (95% of the observations), the expected range of results becomes 31% to -17%. Wow, one could drive a couple of Freightliner trucks through that gap.

Are you still comfortable with your current asset allocation? Remember, when the I fails to achieve the 7% ARC the C must make up the shortfall. This is what transpired in spades during the ’00s decade when we suffered through two major market corrections. Yes, markets have recovered, but the significant increase in contributions needed to make up for the investment shortfalls haven’t been rebated!

I mentioned the word uncertainty above. As I’ve discussed on several occasions within this blog, human beings loathe uncertainty, as it has both a physiological and mental impact on us. Yet, the U.S. public fund pension community continues to embrace uncertainty through the asset allocation decisions. As you think about your plan’s asset allocation, is there any element of certainty? I had the chance to touch on this subject at the recent FPPTA by asking those in the room if they could identify any certainty within their plans. Not a single attendee raised their hand. Not surprising!

As I result, I’d like to posit a slight change to the pension formula. I’d like to amend the formula to read C+I+IC = B+E. Doesn’t seem that dramatic – right? So what is IC? IC=(A=L), where A are the plan’s assets, while L= plan liabilities. As you all know, the only reason that a pension plan exists is to fund a promise (benefits) made to the plan participant. Yet, the management of pension funds has morphed from securing the benefits to driving investment performance aka return, return, and return. As a result, we’ve introduced significant funding volatility. My subtle adjustment to the pension formula is an attempt to bring in some certainty.

By carefully matching assets to liabilities (A=L) we’ve created an element of certainty (IC) not currently found in pension asset allocation. By adding some IC to the C+I = B+E, we now have brought in some certainty and reduced the uncertainty and impact of I. The allocation to IC should be driven by the pension plan’s funded status. The better the funding, the greater the exposure to IC. Wouldn’t it be wonderful to create a sleep-well-at-night structure in which I plays an insignificant role and C is more easily controlled?

To begin the quest to reduce uncertainty, bifurcate your plan’s assets into two buckets, as opposed to having the assets focused on the ROA objective. The two buckets will now be liquidity and growth. The liquidity bucket is the IC where assets and liabilities are carefully matched (creating certainty) and providing all of the necessary liquidity to meet the ongoing B+E. The growth portfolio (I) are the remaining plan assets not needed to fund your monthly outflows.

The benefits of this change are numerous. The adoption of IC as part of the pension formula creates certainty, enhances liquidity, buys-time for the growth assets to achieve their expected outcomes, and reduces the uncertainty around having 100% of the assets impacted by events outside of one’s control. It is time to get off the asset allocation and performance rollercoaster. Yes, recent performance has been terrific, but as we’ve seen many times before, there is no guarantee that continues. Adopt this framework before markets take no prisoners and your funded status is once again challenged.