Tag Archives: certainty

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?