I’m thrilled that pension plans both large and small, private and public, are focusing more attention on their plan’s liabilities. It is about time, especially given that the only reason that DB plans exist is to meet the promised benefits (liabilities) that has been made to their employees/participants. As regular readers of this blog know, we, at Ryan ALM, have two ALM strategies – cash flow matching and $ duration matching – that help plan sponsors de-risk their pension systems.
When should a plan consider de-risking? Our answer: all the time! The plan’s funded status should determine the return on asset objective (ROA) and asset allocation. For instance, a plan with an 80% funded ratio should have a very different ROA from one that is only 50% funded. Seems obvious, right? But you would be surprised by how often we’ll see two plans that have the same ROA objective and asset allocation yet have very different funded status. As a reminder, DB plans were once managed like lottery systems and insurance companies. They knew what the promised benefits looked like in the future and they defeased that liability from day one. There was no hoping that a combination of investment strategies would achieve the ROA. There was only one objective – fund the promised benefits with both reasonable risk and cost.
We were asked recently if there is a difference in our approach if a plan is open versus one that is closed. Our answer is that it doesn’t matter. When implementing a cash flow matching strategy (aka Cash Flow Driven investing or CDI) we are focused on defeasing the Retired Lives Liability, which is the more certain liability. It is also the most important as it is the liability that must be paid first. Our approach provides the necessary cash flow (liquidity) to meet each benefit payment from the first month as far out as the allocation to our strategy permits. In most cases, we are managing a Liability Beta Portfolio™ (LBP) for roughly the first 10-years. This implementation allows for the alpha assets (performance or non-defeased assets) to grow unencumbered as they are not a source of liquidity to meet benefit payments.
DB pension systems – both public and private – have seen terrific improvement in the funded status of their plans since 2009. The equity markets have provided returns well above historic norms, while fixed income markets have continued to enjoy a nearly 40-year bull market as US interest rates continued to plummet. If you believe in regression to the mean, absolute returns in the next decade or so will likely be below the long-term average for both major asset classes putting pressure on plans to achieve the ROA target. Now would be the perfect time to take some or more risk off the table, secure the funded status and stabilize contribution expenses. Again, it doesn’t matter if your plan is open or closed. Don’t subject your plan’s assets to the whims of the markets, especially at these lofty valuations.