ASSET-LIABILITY MANAGEMENT AND CUSTOMIZED LIABILITY INDEXES

March 12, 2010

The Investment Governance, Inc. editorial team recently caught up with Mr. Ronald J. Ryan, CFA and CEO of Ryan ALM, Inc. to learn more about his risk insights in the aftermath of recent market turbulence. Mr. Ryan is founded Ryan Labs, Inc. in the 1980’s. In 2006, he was named the recipient of the William F. Sharpe Index Lifetime Achievement Award. For a full bio, click here.  

Investment Governance: Ron, welcome and thank you for taking time to speak with us today about asset allocation and hedging.

Ron: It’s great to be here. Things have certainly been far from peaceful over the last few years.

Investment Governance: Some use the term “pension risk management.” How do you define that term?

Ron: Risk should be defined as the uncertainty of not meeting the client’s objective. If the objective is liability driven, then risk should be measured as not being able to meet that liability. That would require a customized liability index or you can’t measure and manage risk or reward.

Investment Governance: What is a customized liability index?

Ron: It should be the liability payments modeled as a zero coupon bond portfolio. The defeasance rules require the use of a zero bond portfolio.

Investment Governance: What information does an actuary need to provide before a proper liability-driven analysis can be created?

Ron: No work can be done without having reasonable projected monthly or annual payments going out to beneficiaries. In our case, we would take that information and create an index of zero coupon bonds that match the monthly payments. Numbers from the actuary would have to include cost of living adjustments and the basis of numbers being provided, i.e. PBO, ABO, retired, active, etc. We then provide a unique liability index for each liability schedule. (Editor’s Note: PBO stands for Pension Benefit Obligation. ABO stands for Accumulated Benefit Obligation.)

Investment Governance: What if the actuary’s numbers are not updated regularly?

Ron: Usually the actuarial projections are updated annually although while the present valued numbers should be updated daily. Pension funds are urged to update inflation, mortality, merger, plan amendment and other critical factors on a routine basis.

Investment Governance: Do you think people are starting to understand the importance of assessing both liabilities and assets before embarking on a comprehensive pension risk management program?

Ron: First of all, the actuarial numbers are very hard to understand and the accounting rules never forced pensions to look at actuarial projections in a meaningful way. Until the accounting rules changed, pension had no incentive to look hard at these numbers. FAS 158 allows pensions to estimate rate of return (ROA) numbers which tend to create phantom earnings. The Governmental Accounting Standards Board (“GASB”) is working to reform its pension accounting rules for public entities. Until the accounting rules use real interest rates and market values, pension reporting will never reflect the true economics of the plan(s). Fortunately, the International Accounting Standards Board (“IASB”) in Europe is an advocate of fair value or market value accounting. As fair market value takes hold, pension disclosures will start to reflect the true economics of the plan(s).

Investment Governance: What took people so long?

Ron: It usually takes a crisis to change things for the better. The decade of the 2000s has been the catalyst for proper accounting changes.

Investment Governance: Are there good examples of pension risk management best practices?

Ron: Good examples are hard to find in America. Interested readers might want to examine what J.C. Penney has done in the area of pension asset-liability management.

Investment Governance: How often should a plan’s liability get updated?

Ron: Since the Funded Ratio is the market value (MV) of assets/liabilities, the MV should be updated often. We update custom liability indexes for clients every day.

Investment Governance: You have an opinion about aggregate bond indexes not being a good benchmark for a liability-driven investing program.

Ron: That is correct. In my opinion, there is NO generic index that can represent and measure the unique cash flows of any pension. Unfortunately, Wall Street has sold interest rate swaps (“IRS”) as the vehicle to hedge and match liabilities. However, swaps create several new risk exposures. For one thing, they are not assets but contracts. As a result, a sponsor still bears the risks associated with the underlying assets losing value. When the interest rate swap is used as a strategy to reduce bond allocations, the assets purchased are risky since they do not correlate to liabilities. IRS hedges price return and not income. Since income makes up most of a bond’s return, the interest rate swap is a bet on interest rate directions. As Lehman taught us, swaps entail counterparty risk. The accounting rules should really say that the discount rate used should be something that can be purchased, i.e. that will settle (defease) the liabilities. Tactical asset allocation is the best approach. Your asset allocation should be different with a deficit versus plan surplus. A customized liability index permits a plan sponsor to better know if a true economic surplus or deficit exists. The surplus should be held as a separate portfolio, with its own asset allocation. Pensions would be smart to build reserves for contingencies with a Funded Ratio goal of maybe 110%, not just 100%. Had that been done in the 1990’s, pensions would not have incurred the pain of 2000 to 2002, let alone current problems.

Investment Governance: What do you think should be the role of the consultants?

Ron: They are in charge of asset allocation and performance measurement. They need to understand proper asset-liability management (“ALM”) and liability-driven investing (“LDI”) concepts to be able to recommend the right approach, in the context of goals for every pension plan. Since the true objective of a pension is to fund liabilities, all asset decisions should be in harmony with this objective. This requires a customized liability index as the proper benchmark for assets.

Investment Governance: What is the biggest concern you have about the pension industry?

Ron: The public pension side is in the worst shape. They need proper and stringent accounting rules. GASB allows them to price liabilities using the ROA as the discount rate and to smooth assets over five years. This creates an error in calculating the funding ratio is in the neighborhood of 30-50%. The accounting rules should require that you cannot increase benefits if there is a deficit, just like the Pension Protection Act of 2006 (“PPA”). Due to huge pension and budget deficits, many cities and states will raise taxes significantly. This is a “snowball from you know where” and it is not at all clear how municipalities will solve their problem. We have to move away from an asset only world. We have to have accounting rules that direct pensions to behave in conformity with the liability objective, not the estimated return on assets managed. Public pension plans are gravitating toward assets they never considered before to meet their ROA target instead of focusing on the true economic Funded Ratio. It is troublesome at best when you see actuarial reports that have gains amortized over 10 years versus amortizing losses over 30 years.

Investment Governance: Please comment further on the use of interest rate swaps. In terms of sheer numbers, they seem to be a popular way to manage risk.

Ron: Swaps are not a replacement for bonds. You must consider their price behavior. If the asset you bought does not match or behave like liabilities, the volatility of the plan’s Funding Ratio has been increased. Pensions tend to buy interest rate swaps whose average duration supposedly matches liabilities. This does not work mathematically. You need a yield curve of bonds to match the liabilities cash flow. Use some type of portable alpha strategy to cure pension deficits but make sure that the “beta” portfolio is a liability index portfolio that matches some portion of the customized liability benchmark. The alpha assets are typically not bonds. The goal is to outgrow liabilities. The size of the Funding Ratio will determine how much a plan allocates to an alpha generating strategy. A bigger deficit leads to a larger alpha component. Most asset studies show that non-bond assets will outperform bonds, over time, especially at low interest rates. If they do, then the Funding Ratio should improve. As the Funding Ratio improves, a plan sponsor can export the “victory” (excess return) to a beta portfolio chronologically. Every time the sponsor ports the victory, it can reduce cost and risk. The plan is likewise reducing risk because more assets are behaving like liabilities. Alpha is the temporary strategy to help reduce the deficit. The discipline and transition of changing the asset allocation based on the Funding Ratio is lacking in many current situations. Until a plan specific liability index is built (and used as a cornerstone of decision-making), it is difficult for any asset mix initiative to function in harmony with the liability objective.

Investment Governance: Ron, this has been enlightening. Thank you for your time.

Ron: My pleasure. I’m glad to contribute.