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October 17, 2014 01:00 AM

Solutions to the pension crisis

New accounting rules needed

Ronald J. Ryan, CEO of Ryan ALM Inc.
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    Ryan ALM Inc.
    Ronald J. Ryan, CEO of Ryan ALM Inc.

    If U.S. pensions funds were to mark-to-market assets and liabilities, they would have a deficit of about $4 trillion. If TARP I was a national emergency at $800 billion, what do you call this? In my new book, “The Pension Crisis,” I blame inappropriate accounting rules that led to this demise with “Woody,” the pension pencil, depicted as the weapon of mass destruction. I also detail a prudent strategy to cure this pension dilemma.

    The true objective of a pension is to fund liabilities with low and stable contribution costs withreduce risk over time. Unfortunately, inappropriate accounting rules led to using the return-on-asset assumption as the goal as they allow for the ROA to be used as the offset to pension expense (according to FASB) or the discount rate for liabilities (according to GASB). The new IASB accounting rules (IAS 19) eliminate the ROA and other accounting rules that distort economic reality (smoothing of assets, actuarial gain/loss amortization and the corridor). The Society of Actuaries urge pension funds to create a set of economic books so asset liability management can function in harmony with the true objective.

    If inappropriate accounting rules created the pension crisis, then appropriate accounting is where we start to find solutions. The first step in solving the pension dilemma is to install a custom liability index as the proper benchmark. The CLI should provide a set of economic books that calculate the true market value, yield, duration, growth rate and interest rate sensitivity of liabilities monthly. It must be a CLI since, just like snowflakes, you will never find two pension liability cash flows alike. With the calculations from the CLI, the asset side can now function effectively to achieve the true objective.

    Given the economic (market) value of liabilities, we can now monitor the funded ratio on a monthly basis. This is in sharp contrast to the current trend of calculating the funded ratio annually, months delinquent, using actuarial valuations. Asset allocation can now focus on the funded ratio as its barometer of success. Asset allocation should separate assets into liability alpha and beta classes.

    The objective of the liability alpha assets is to outgrow liabilities and erase the deficit over a time horizon equal to the duration of the liabilities. Based on the CLI and the funded ratio, the asset allocation model should calculate the annual liability alpha needed for the plan to be fully funded over a time horizon equal to the duration of the liabilities. You cannot measure liability alpha without a CLI.

    The objective of the liability beta portfolio is to match liabilities and de-risk the pension plan. The liability beta portfolio should be the core portfolio and quest of a pension. You cannot create a liability beta portfolio without a CLI. Asset allocation should be responsive to the funded ratio such that as the funded ratio gets closer to fully funded asset allocation shifts to a more liability beta allocation and vice versa. Had pension funds de-risked their plans by shifting assets to a liability beta dominance in the late 1990s when they had growing surpluses, there would be no pension crisis! This responsive asset allocation is in sharp contrast to strategic asset allocation that changes infrequently due to the ROA objective changing infrequently.

    Asset liability matching is a team effort. The assets combined goal is to reach a fully funded status and then fund liabilities at low and stable contribution costs with reduced risk over time. As the liability alpha assets outperform liability growth, as measured by the CLI, the liability alpha earned should be ported (transferred over) to the liability beta portfolio to secure the victory and reduce the volatility of contribution costs. The CLI is the set of economic books that provide all of the critical calculations needed for ALM to function efficiently. ALM is about relative returns of asset growth vs. liability growth … it is not about absolute returns (ROA).

    Performance measurement should then monitor the success of asset allocation and ALM by comparing total asset growth (returns) to total liabilities growth (as measured by the CLI). This constant monitoring is a key to understanding the economic funded ratio and responding quickly and correctly on asset allocation.

    Pension funds need to focus on their true liability objective with cost restrictions and risk reduction strategies. Pensions are not an absolute return objective (i.e. ROA). The moral of the pension crisis is: given the wrong objective (ROA) … you will get the wrong risk/reward!

    Ronald J. Ryan is CEO and founder of Ryan ALM Inc. Previously, he was founder and president of Ryan Labs and Ryan Financial Strategy Group, and director of fixed-income research at Lehman Brothers.

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