I continue to be perplexed, befuddled, mystified, and perhaps stumped by the reticence shown by plan sponsors and their consultants in wanting to know the value of the liabilities in their defined benefit plan on an on-going basis!
As a reminder, the defined benefit plan solely exists to provide a predefined benefit to past, present and future employees of the system in a cost effective manner such that contribution costs remain low and stable. Again, the plan exists to meet a liability. It doesn’t exist to meet a return on asset assumption. Yet, plan sponsors spend 95% of their time worried about the assets in their plan and very little time on how liabilities are being impacted by market forces.
If two pension plans have widely differing fund ratios, say 100% and 60%, should they have the same asset allocation? No, they shouldn’t. They certainly shouldn’t have the same ROA objectives. Why would a plan sponsor of a well funded plan want to live with the volatility associated with an asset allocation designed to support a 60% funded plan? Plan sponsors should adjust their asset allocation based on the plan’s funded ratio.
A more fully funded plan should have a much more conservative asset allocation than a poorly funded program. However, in order to know what the funded ratio is, one needs a more accurate and current understanding of the value of the plan’s liabilities. Currently, the only visibility on a plan’s liabilities is through the annual actuarial report, which tends to be provided 4-6 months delinquent. For many plans, they may still only have a view on year-end 2013 liabilities. We can assure you that liability growth has swung wildly in the last 17-18 months, as interest rates fell significantly in 2014, before backing up so far this year.
In a previous blog posting we discussed 2014’s performance for the average pension plan. We highlighted the fact that the average plan slightly underperformed the average ROA, and that based on that performance most sponsors likely felt that it was an okay year. Unfortunately, that perception would be incorrect as liability growth easily outpaced asset growth in 2014.
In addition, had sponsors taken risk off the table in 1999 when most DB plans were over-funded, they would have adjusted their asset allocations toward fixed income and away from equities. Regrettably, more risk was put into the plans when fixed income allocations were dramatically reduced for fear that the lower yielding environment would reduce a plan’s ability to meet the ROA objective. As you know, DB plans have missed the last 15 years of a bond bull market, while subjecting those plans to greater equity risk and two major market declines.
Clearly, liabilities and assets have different growth rates. Yet, the industry continues to believe that by achieving the Holy Grail ROA annually that everything will be fine. Unfortunately, that perception is false.
Would you be comfortable playing a football game in which you only knew your score (assets), but had no clue as to what your opponent was doing (liabilities)? How would you adjust your play calling or defense? I suspect that you wouldn’t play any game in which this scenario existed. Then why as an industry are we playing the pension game by only focusing on the assets with no understanding as to how your liabilities are doing?
We can win the pension game, WE NEED TO WIN THE PENSION GAME, but in order to do so we must utilize tools that provide us with all the information that we need to manage these plans more effectively. Having greater clarity on the liabilities doesn’t have to be a bad thing! What are you afraid of?