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

There recently appeared in my inbox an article from an investment advisory firm discussing Cash Flow Driven Investing (CDI). Given that CDI, or as we call it Cash Flow Matching (CFM), is our only investment strategy, I absorb as much info from “competitors” as I can.

The initial point in the article’s summary read “There is no one-size-fits-all approach for cashflow driven investment strategies.” We concur, as each client’s liabilities are unique to them. Like snowflakes, there are no two pension plan liability streams that are the same. As such, each CDI/CFM portfolio needs to reflect those unique cash flows.

The second point in their summary of key points is where we would depart in our approach. They stated: “While most will have a core allocation to investment grade credit, the broader design can vary greatly to reflect individual requirements.” This is where I believe that the purpose in using CFM is confused and unnecessarily complicated. CFM should be used to defease a plan’s net outflows with certainty. At Ryan ALM, Inc. we use 100% of the bond assets to accurately match the liability cash flows most often through the use of investment-grade corporate bonds. Furthermore, It is a strategy that will reduce risk, while stabilizing the plan’s funded status and contribution expenses associated with the portion of the liability cash flows that is defeased. It is not an alpha generator, although the use of corporate bonds will provide an excess yield relative to Treasuries and STRIPS, providing some alpha.

As we’ve discussed many times in this blog, traditional asset allocation approaches having all of the plan’s assets focused on a return objective is inappropriate for the pension objective to secure and fully fund benefits in a cost-efficient manner despite overwhelming use. We continue to espouse the bifurcation of the assets into liquidity and growth buckets. The liquidity bucket should be an investment-grade corporate bond portfolio that cash flow matches the liability cash flows chronologically from the next month as far out as the allocation will cover. The remaining assets are the growth or alpha assets that now have time to grow unencumbered.

Why take risk in the CFM portfolio by adding emerging markets debt, high yield, and especially illiquid assets, when the purpose of the portfolio is to create certainty and liquidity to meet ongoing benefits and expenses? If the use of those other assets is deemed appropriate, include them in the alpha bucket. As a reminder, CFM has been used successfully for many decades. Plan sponsors live with great uncertainty every day, as markets are constantly moving. Why not embrace a strategy that gives you a level of certainty not available in other strategies? Use riskier strategies when they have time to wade through potentially choppy markets. CFM provides such a bridge. If you give most investment strategies a 10-year time horizon without the need to provide liquidity, you dramatically enhance the probability of achieving the desired or expected outcome.

Unfortunately, we have a tendency in our industry to over-complicate the management of pensions. Using a CFM strategy focused on the plan’s liabilities, and not the ROA, brings the management of pensions back to its roots. Take risks when you have the necessary time. Focusing the assets on the ROA creates a situation in which one or more assets may have to be traded (sold) in order to meet the required outflows. Those trades might have to be done in environments in which natural liquidity does not exist.