Large cash flows change the dynamics of a pension plan

One feature of the maturation of the pension sector is that benefit payments have become a bigger consideration for many plans. Not only is there the administrative effort of ensuring cash is on hand each month to make the payments, but there’s also a change in the dynamics of the plan itself.

Benefit payments accentuate the impact of volatility...

One change is that the plan responds differently to volatility when benefit payments are significant. A temporary setback can turn into something more serious. My colleague Michael Thomas explains: “In the presence of cash flows, the path dependency of returns matters. Imagine that you experience a large negative return followed by significant benefit payments. Now there are less assets left in the plan to earn back the return. The remaining assets have to work that much harder.”

...push down funded status...

Most plans are currently underfunded, so taking money from both sides of the pension balance sheet reduces funded status. For example, if a plan has $80 of assets and $100 dollars of liabilities, it’s 80% funded. A $10 benefit payment would leave the plan with $70 of assets and $90 of liability, reducing funded status by more than two full percentage points. So an underfunded plan that is cash flow negative will tend to see funded status drift down over time.

...increase the required hurdle rate of return...

It follows that for asset returns to reduce a funding deficit, matching the actuary’s assumption is not enough. The math of actuarial valuations is such that if every assumption made by the actuary is borne out in practice, then the dollar value of a pension deficit increases over time in line with the assumed discount rate; simply earning a return in line with the discount rate (or, for public plans, the assumed return on assets) will lead to an underfunded plan slipping further away from full funding.

...make money-weighted returns more important than time-weighted...

Related to the impact of volatility is that the returns in the years when the plan is largest have more impact than later years. So even though every CFA charter holder has been trained to think of time-weighted returns as the best measure of an investment manager’s success, it’s money-weighted returns that actually drive the outcome.

...and push everything toward mark-to-market.

Smoothing of asset or liability values is commonly used in pension funding calculations and corporate pension cost accounting. This reduces the year-to-year fluctuations in results. But benefit payments are made with market value dollars not smoothed dollars, and the case for smoothing only holds if there’s time for the fluctuations to even out. Which means that the larger the benefit payments, the more the plan needs to think in terms of a pure mark-to-market approach.

This all adds up to a material change in the dynamics of pension plan management. Pension risk transfer activity – such as lump sum payments or annuity buyouts – accelerates the effect. For corporate DB plans as a whole, benefit payments probably now exceed new benefit accruals plus interest cost, so the underlying trend on total liabilities is down (albeit with lots of short-term variation due to interest rate movements.) It’s not unusual for a mature plan to be making benefit payments each year of 6%, 8% or more of the total liability value. This changes the nature of the game.