Tag Archives: certainty

10.08.25
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An Alternative Pension Funding Formula

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.

05.07.25
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Source Ryan – Question of the Day.

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

We often get comments and questions following the posting of a blog. We welcome the opportunity to exchange ideas with interested readers. Here is a recent comment/question from a LinkedIn.com exchange.

Question: In reviewing the countless reports, reading past agendas, and meeting minutes for these 20 plans, I did not notice any CFM or dedicated fixed income strategies employed by any of them. Perhaps there are a couple that I missed that do, or perhaps some have since embarked on such a strategy. Why wouldn’t public fund plan sponsors use Cash Flow Matching (CFM)?

There really isn’t a reason why they shouldn’t as pointed out by Dan Hougard, Verus, in his recent excellent piece, but unfortunately, they likely haven’t begun to use a strategy that has been used effectively for decades within the insurance industry, by lottery systems, and early on in pension management. Regrettably, plan sponsors must enjoy being on the rollercoaster of returns that only guarantees volatility and not necessarily success. Furthermore, they must get excited about trying to find liquidity each month to meet the promised benefits by scrambling to capture dividend income, bond interest, or capital distributions. If this doesn’t prove to be enough to meet the promises, they then get to liquidate a holding whether it is the right time or not.

In addition, there must be a particular thrill about losing sleep at night during periods of major market disruptions. Otherwise, they’d use CFM in lieu of a core fixed income strategy that rides its own rollercoaster of returns mostly driven by changes in interest rates. Do you know where rates are going? I certainly don’t, but I do know that next month, the month after that, followed by the one after that, and all the way to the end of the coverage period, that my clients will have the liquidity to meet the benefit promises without having to force a sale in an environment that isn’t necessarily providing appropriate liquidity.

The fact that a CFM strategy also eliminates interest rate risk because benefit payments are future values, while also extending the investing horizon for the fund’s growth assets are two additional benefits. See, there really is NO reason not to retain a cash flow matching expert like Ryan ALM, Inc. to bring certainty to the management of pensions that have lived with great uncertainty. In doing so, many plans have had to dramatically increase contributions, alter asset allocation frameworks to take on significantly more risk, while unfortunately asking participants to increase employee contributions, work more years, and receive less at retirement under the guise of pension reform. Let’s stop doing the same old same old and explore the tremendous benefits of Cash Flow Matching. Your plan participants will be incredibly grateful.

04.22.25
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WHY?

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

Why do we have two different accounting standards in the U.S. for valuing pension liabilities?

Why does it make sense to value liabilities at a rate (ROA) that can’t be used to defease pension liabilities in this interest rate environment?

Why do we continue to create an asset allocation framework that only guarantees volatility and not success?

Why do we think that the pension objective is a return objective (ROA) when it is the liabilities that need to be funded and secured?

Why haven’t we realized that plowing tons of plan assets into an asset class/strategy will negatively impact future returns?

Why are we willing to pay ridiculous sums of money in asset management fees with no guaranteed outcome?

Why is liquidity to meet benefits an afterthought until it becomes a major issue?

Why does it make sense that two plans with wildly different funded ratios have the same ROA?

Why are plan sponsors willing to live with interest rate risk in the core bond allocations?

Why do we think that placing <5% in any asset class is going to make a difference on the long-term success of that plan?

Why do we think that moving small percentages of assets among a variety of strategies is meaningful?

Why do we think that having a funded ratio of 80% is a successful outcome?

Why are we incapable of rethinking the management of pensions with the goal to bring an element of certainty to the process, especially given how humans hate uncertainty?

WHY, WHY, WHY?

If you are as confused as I am with our current approach to DB pension management, try cash flow matching (CFM) a portion of your plan. With CFM you’ll get a product that SECURES the promised benefits at low cost and with prudent risk. You will have a carefully constructed liquidity bucket to meet benefits and expenses when needed – no forced selling in challenging market environments. Importantly, your investing horizon will be extended for the growth (alpha) assets that haven’t been used to defease liabilities. We know that by buying time one dramatically improves the probability of a successful outcome. Furthermore, your pension plan’s funded status will be stabilized for that portion of the assets that uses CFM. This is a dynamic asset allocation process that should respond to improvement in the plan’s funded status. Lastly, you will be happy to sit back and watch the mayhem in markets unfold knowing that you don’t have to do anything except sleep very well at night.

07.23.24
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Oh, The Games That Are Played!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Managing a defined benefit pension plan should be fairly straightforward. The plan sponsor has made a promise to each participant which is based on time of service, salary, and a multiplier as the primary inputs. The plan sponsor hires an actuary to do the nearly impossible of predicting the future benefits, administrative expenses, salaries, mortality, etc., which for the most part, they do a terrific job. Certainly in the short-term. Since we have a reasonable understanding of what that promise looks like, the objective should be to SECURE that promise at a reasonable cost and with prudent risk. Furthermore, sufficient contributions should be made to lessen the dependence on investment returns, which can be quite unstable.

Yet, our industry has adopted an approach to the allocation of assets that has morphed from focusing on this benefit promise to one designed to generate a target return on assets (ROA). In the process, we have placed these critically important pension funds on a rollercoaster of uncertainty. How many times do we have to ride markets up and down before we finally realize that this approach isn’t generating the desired outcomes? Not only that, it is causing pension systems to contribute more and more to close the funding gap.

Through this focus on only the asset-side of the equation, we’ve introduced “benchmarks” that make little sense. The focus of every consultant’s quarterly performance report should be a comparison of the total assets to total liabilities. When was the last time you saw that? Never? It just doesn’t happen. Instead, we get total fund performance being compared to something like this:

Really?

Question: If each asset class and investment manager beat their respective benchmark, but lost to liability growth, as we witnessed during most of the 2000s: did you win? Of course not! The only metric that matters is how the plan’s assets performed relative to that same plan’s liabilities. It really doesn’t matter how the S&P 500 performed or the US Govt/Credit index, or worse, a peer group. Why should it matter how pension fund XYZ performed when ABC fund has an entirely different work force, funded status, ability (desire) to contribute, and set of liabilities?

It is not wrong to compare one’s equity managers to an S&P or Russell index, but at some point, assets need to know what they are funding (cash flows) and when, which is why it is imperative that a Custom Liability Index (CLI) be constructed for your pension plan. Given the uniqueness of each pension liability stream, no generic index can ever replicate your liabilities.

Another thing that drives me crazy is the practice of using the same asset allocation whether the plan is 60% funded or 90% funded. It seems that if 7% is the return target, then the 7% will determine the allocation of assets and not the funded status. That is just wrong. A plan that is 90% funded has nearly won the game. It is time to take substantial risk out of the asset allocation. For a plan that is 60% funded, secure your liquidity needs in the short-term allowing for a longer investment horizon for the alpha assets that can now grow unencumbered. As the funded status improves continue to remove more risk from the asset allocation.

DB plans are too critically important to continue to inject unnecessary risk and uncertainty into the process of managing that fund. As I’ve written on a number of occasions, bringing certainty to the process allows for everyone involved to sleep better at night. Isn’t it time for you to feel great when you wake up?

07.18.24
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Different Levels of Certainty

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

A friend of mine in the industry emailed me a copy of Howard Marks’ latest memo titled, “The Folly of Certainty”. As they normally are, this piece is excellent. As regular readers of this blog know, I’ve encouraged plan sponsors and their advisors to bring more certainty to defined benefit plans through a defeasement strategy known as cash flow matching. I paused when I read the title, thinking, “oh, boy”, I’m at odds with Mr. Marks and his thoughts. But I’m glad to say after reading the piece that I’m not.

What Howard is referring to are the forecasts, predictions, and/or estimates made with little to no doubt concerning the outcome. He cited a few examples of predictions that were given with 100% certainty. How silly. Forecasts always come with some degree of uncertainty (standard deviation around the observation), and it is the humble individual who should doubt, to some degree, those predictions. I’ve often said that hope isn’t an effective investment strategy, but that thought doesn’t seem to have resonated with a majority of the investment community.

Ryan ALM’s pursuit of greater certainty is brought about through our ability to create investment grade bond portfolios whose cash flows match with certainty (barring a default) the liability cash flows of benefits and expenses. We accomplish this objective through our highly sophisticated and trade-marked optimization model. We are not building our portfolios with interest rate forecasts, based on economic variables that come with a very high degree of uncertainty. No, we build our portfolios based on the client’s specific liability cash flows and implement them in chronological order. Importantly, once those portfolios are created, we’ve locked in a significant cost reduction that is a function of the rate environment and the length of the mandate.

As stated previously, I have a great appreciation for Howard Marks and what he’s accomplished. He is absolutely correct when he questions any forecast that has little expectation for being wrong. In most cases, the forecaster is not in control of the outcome, which should lend itself to being more cautious. In the case of the Ryan ALM cash flow matching strategy, we are in control. Having the ability to bring some certainty in our pursuit of securing the promised benefits should be greatly appreciated by the plan sponsor community. Because of the uncertain economic environment that we are currently living in, bringing some certainty should be an immediate goal. Care to learn more?