How to De-Risk A Pension * FPPTA Trustees School Program Ryan ALM, Inc. The Solutions Company 561-656-2014 www.RyanALM.com.

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Presentation transcript:

How to De-Risk A Pension * FPPTA Trustees School Program Ryan ALM, Inc. The Solutions Company

What is Risk? Sharpe (1966) Volatility of Returns Risk-free asset = 3 month T-Bill Ryan (1994) Uncertainty of meeting Objective Risk-free asset = matches objective

Pension Objective To fund liabilities such that contribution costs are low and stable over the future of active lives. To reduce risk over time.

Problem Liabilities are MIA in: Asset Allocation Asset Management Performance Measurement

Why? Actuarial Reports: Annual 6+ months delinquent No benefit payment schedule Actuarial valuation not market S&P 500?

Custom Liability Index Proper Benchmark Given projected benefit payments CLI calculates Monthly reports: PV (GASB 67 and AA Corporates) Interest Rate Sensitivity Growth Rate

Funded Ratio / Status Acid Test: FR = Assets / Liabilities FS = Assets – Liabilities Critical: FR/FS have correct valuations FR/FS are updated frequently

Problem: Accounting GASB 25 GASB 67 AssetsSmoothed Fair Value (5 years) (Market Value) Liabilities ROA ROA until assets exhausted (yield of 20-year muni) Error: 36% to 48% Moody’s: AA corporates as discount rate

ROA Discount Rate for Liabilities Hurdle Rate for Assets ROA became Asset Allocation focus Instead of Funded Ratio/Status Pension Consultant

ROA Actuary Calculates Projected Contributions Actuary needs growth rate for A + L Assets + Liabilities = same growth rate Deficits erased only thru Contributions

Contributions Future Assets Predictable + Sizable Fund Liabilities Initially ExcludedFunded Ratio / Status IncludedAsset Exhaustion Test Fiduciary Net Position (Assets – Liabilities)

Problem : Asset Allocation Asset Allocation models used to validate ROA (Auditors) AA uses historical returns of asset classes (except Bonds = Yields) Lower rates trend reduced Bond allocation 1990s = Lowest Bond Allocation in history!

Solution: Responsive AA AA Based on Funded Ratio Surplus =/= Deficit Separate Beta + Alpha assets 130% = Beta 100%, Alpha 30% 60% = Beta 20%, Alpha 80%

Beta / Alpha Beta = Portfolio that matches Objective Alpha = Excess growth vs. Objective growth Requires CLI = to calculate Objective growth to create Beta Portfolio to measure Alpha

Objective: De-Risk Plan Liability Beta Portfolio Investment grade bond portfolio Cash flow matches benefit payments Chronologically or % of total At Lowest Cost Reduces Cost Reduces Risk (FR volatility) Buys time for Alpha assets to perform

De-Risk Plan Liability Beta Portfolio Cash Flow Matches Liabilities at Low Cost $1 million Liability Payment 5 year costs = $920,870 (YTM = 1.67%) 10 year “ = $787,690 (YTM = 2.41%) 20 year “ = $556,930 (YTM = 2.96%) 30 year “ = $398,090 (YTM = 3.13%)

Performance Measurement Total Asset vs. Total Liability Growth Measured frequently + accurately (quarterly + market values) Requires CLI to measure: Liability Growth Alpha Risk

Rates Go Up (5 Years) Liabilities = 3.00% >> 6.00% Growth Rate = ( 2.56%) Annual Note: Liabilities duration = 12 years Assets 5.0% 6.0% 7.0% Liabilities - 2.6% - 2.6% - 2.6% Alpha (Annual) 7.6% 8.6% 9.6% FR = 60% … 88% 92% 97%

Recommended Guidelines 1. Install Custom Liability Index (CLI) 2. Install Liability Beta Portfolio (De-Risk) 3. AA respond to Funded Ratio/Status 4. Total Asset vs. Total Liability Growth