By; Russ Kamp, CEO, Ryan ALM, Inc.
I first posted about this phenomenon 5-years ago. It is still so relevant today. I can’t tell you how many times I’ve read articles about underfunded pension systems that are “on track” to be fully funded in x # of years. The most recent one claims that the fund will be stable by 2048 (should I hold my breath?). However, what these articles fail to highlight are the actions required to achieve a fully funded status. First, the plan sponsor must make all annual actuarially determined contributions, which usually increase every year. Second, the assets must earn the actuarially determined ROA consistently for the next 22 years. But those are HUGE ifs, especially when one looks at the tremendous uncertainty that investors must wade through today – oil, inflation, interest rates, geopolitical crisis, the AI trade, etc.
What is the probability that the ROA will be achieved on a consistent basis? Furthermore, the sequencing of returns can play a meaningful role in whether the return objective is met, especially since the DB plan in question is a closed plan that will have greater outflows tomorrow than 20 years from now. What this plan needs to do is to secure the promised benefits for the next 10 years or so through a cash flow matching (CFM) mandate. Doing so will BUY TIME that will insulate the plan from potentially adverse market conditions that would harm the plan’s alpha assets. Buying time (extending the investing horizon) for these alpha assets permits them to grow unencumbered, as they are no longer a source of liquidity.
Furthermore, buying time enhances the probability that these growth assets will achieve their forecasted ROA since they are not diluted to make benefit payments. A Guinness Global research study on history of the S&P 500 tells us that dividends and dividends reinvested account for 47% of the total return on a rolling 10-year horizon since 1940 and the contribution to the total return is even greater for 20-year periods.
Actuaries do a terrific job despite the uncertainty in forecasting contributions, benefit payments, and expenses far into the future. But they aren’t magicians. There should be an expectation built into their forecasts that those inputs will not be achieved as predicted, especially market-based forecasts. We’ve seen this scenario play out time and time again. Given the volatility associated with predictions of this kind, perhaps a greater emphasis should be placed on the contributions, which reduces the reliance on markets, thus improving the likelihood of success. Just a thought!
