I applaud J.C. Penney for its Pensionomics and Pensions & Investments for its lead story in the June 29 issue. As Robert B. Cavanaugh, Penney CFO, explained, “The accounting liability has it all wrong. The tax liability has it all wrong. The economic liability ... is the liability we always managed to.” Until companies create a set of economic books that mark to market assets vs. liabilities in an accurate and frequent way, all asset functions are in jeopardy of operating to the wrong objective. Indeed, that is the core problem. It is hard to find the liability objective in asset allocation, asset management and performance measurement.
That is why I created the Custom Liability Index concept in 1991 as the proper asset benchmark that best represents the client objective. Until the CLI is installed, all asset functions are not in sync with the liability objective. With a CLI benchmark, any liability-driven investment assets can now be managed to the liability objective. Most asset allocation models use the return on assets as their target return instead of focusing on the funded ratio (assets/liabilities). This ROA creates a static asset allocation that is reviewed usually infrequently and is not responsive to the economics of the plan (funded ratio). With a CLI, asset allocation can now focus on the economic funded ratio. In the late 1990s when pensions had surpluses, they didn't correct their asset allocation to more bonds matched to liabilities because they were focused on meeting the ROA hurdle rate and bond rates were low.
Asset management and performance measurement use generic market indexes as the objective, which focuses the management of assets to a risk/reward behavior that has a low or negative correlation to liability growth behavior. The CLI creates a bridge that allows assets to be managed and measured vs. the liability objective (especially bonds). The function of negative correlation assets should be to outgrow liabilities as measured by the CLI (i.e. liability alpha) not market indexes and thereby enhance the funded ratio. As such, you cannot measure economic alpha without a CLI. Bonds should be managed vs. the CLI instead of traditional generic bond indexes whose cash flows look nothing like any pension benefit payment schedule. Bonds should be the core or beta portfolio, whose function is to match and fund the liabilities. Performance measurement should compare asset growth to liability growth in a timely and accurate economic valuation. As Confucius might say, “Given the wrong index, you will get the wrong risk/reward.”
Ronald J. Ryan
CEO, Ryan ALM Inc.