Liability Index:  The True Objective

by Ronald J. Ryan

The sole purpose of most institutional assets is to fund some type of liability schedule unique to that organization (e.g. pensions, medical, insurance, debt service.). Indeed, funding liabilities is the true objective of most institutions. Even individuals have liabilities as a common objective (e.g. pensions, weddings, education). However, this liability objective is often overlooked and even violated.

The absolute size of liabilities in financial America is enormous. Have you heard of Social Security? There’s an asset / liability dilemma in progress. Just the pension fund industry alone has over four trillion dollars in pension assets (defined benefit). If the purchasing power of pensions were viewed as the GNP of a country, it would be the third largest GNP in the world. At its current growth rate, it would be a close second by 2001. For most pension plan sponsors, the pension asset is one of their largest assets, and the pension liability is one of their largest liabilities. Legally, the pension liability is supposed to rank senior to all debt.

However, most institutional asset managers are given a generic index as their index benchmark, which may have no similarity to the behavior pattern of liabilities. Furthermore, actuaries and plan sponsors tend to price liabilities differently than either the market or the Financial Accounting Standards Board (FASB) would confirm as proper. It has become common practice to price all liabilities at the same interest rate regardless of their maturity or payment date. Have you ever seen a flat yield curve? Too often, this discount rate is much higher than the market rate, causing an underpricing of liabilities. The higher the yield, the lower the present value of liabilities. Just like in golf, the pencil (that keeps the score) may be the most important wood in the bag.

Moreover, liabilities are usually analyzed annually, with the data available up to three months late. Given this infrequent and delinquent data, it is difficult, if not impossible, for the asset side to understand the liability side. As a result, most asset managers manage assets versus generic market indices. But what do these generic indices have in common with liabilities? In fact, these indices may even violate the liability objective or risk/reward behavior pattern. What is happening is assets are managed vs assets (e.g. generic asset indices) and not versus liabilities. By losing sight of the true liability objective, several problems, if not crises, may develop.

Liabilities: FASB DEFINITION

The FASB does the best job of explaining how any liability works and should be priced. FASB regulates corporate financial statement reporting and is quite clear on how to report and measure pension and medical liabilities. FASB 87, Paragraph 44 deals with pension liability pricing:

Therefore, according to the FASB, pension plans should use high quality, noncallable-for-life bonds that match the maturity date of the bond to the payment date of the pension benefit. Since the only high quality for life, non-callable for life bonds are Treasuries, it follows... pension liabilities should be priced off the Treasury yield curve.

Furthermore, FAS 87, Paragraph 199 says:

Therefore, each liability should be priced individually off the Treasury yield curve with the same maturity as the liability benefit payment date

In 1993, the SEC got involved when it questioned a registrant about the selection of discount rates under FASB 87. The SEC wrote a letter to corporations and the FASB, stating that the guidance provided in Paragraph 186 of FASB 106 (created for medical liabilities), should be used if there is confusion on FAS 87. Apparently, according to the SEC, the present value of any type of liability should all be calculated the same way.

FASB 106, Paragraph 186 reads:

The FASB needs little or no translation here. Liabilities are to be priced as if they were zero-coupon bonds whose maturities match the liabilities benefit date and whose par values match the liability payment amounts. Since there are only government zero-coupon bonds, it follows:

Liabilities = Treasury Zero-Coupon Bond Portfolio

This should be no surprise since to defease liabilities, we buy only zero-coupon bonds to match liabilities (e.g. Lotteries). Many companies appear to take great liberties with the FASB guidelines. Instead of pricing each liability at the market for Treasury zeroes (STRIPS) they use a higher and singular rate for all liabilities. Since horizontal or flat yield curves are not common, the mispricing of liabilities here seems careless or intentional.

Some companies interpret high-quality, zero-coupon bonds to be anything with a rating of AA or higher. Since zero-coupon corporate bonds do not exist, we are dealing with theoretical discount rates. Companies know that AA corporate bonds have higher yields thereby creating a lower present value on liabilities. Be-ware of the pencil!

First Dilemna: Asset Allocation

The goal of traditional asset allocation is to create the optimal absolute return. As a result, stocks have been favored consistently. However, the true objective of asset allocation should be to create the optimal relative return versus liabilities. Each client has a unique liability term structure. Similar to snowflakes, no two client liability schedules are identical.

Logically, therefore, the liability term structure should dictate the shape of the asset allocation. Un-fortunately, most asset allocation models have no input for clients’ liability characteristics. They only analyze historical generic market indices. Without a client’s liability structure, such generic models could give most clients similar asset allocations. In fact, this is a national trend. It is hard to imagine that a generic asset allocation model fits most liability schedules, that the asset/liability ratio (surplus/deficit) is so static that it doesn’t require dynamic asset allocation shifts.

Let’s take, for example client A and client B. Client A has 82% in long liabilities, suggesting an allocation of 82% in long assets, (unless there is a unusual deficit/surplus situation). Client B has only 28% in long liabilities, suggesting an allocation of 28% to long assets, (unless there is an unusual deficit/surplus situation). The term structure of each clients’ liability payout schedule should become the base for asset allocation. Asset allocation should be tailored to each client’s unique liability term structure and not based on generic models.

Now let’s look at the graph, attached at the end, showing the last 10 calendar years of assets versus liability risk/reward behavior. The line is the Ryan Labs Liability Index where the present value of the one through 30 year liability payments are equal (equal weighted index). The dots are asset classes represented by the most popular generic market indices. Notice that the Lehman Aggregate behaves like the four year STRIP (four year Liability); the S&P 500 behaves like a 17 year STRIP and EAFE behaves like a 24 year STRIP. The first step of asset allocation should be to define the risk/reward behavior of asset classes to determine what liabilities they should fund (e.g. short, intermediate, long, very long). You wouldn’t buy equities to fund the one-year liability because that would be a serious risk/reward mismatch. As the graph clearly indicates, there is a definite distinction among asset classes risk/reward behavior that determine what liabilities they should fund:

Notice that the Ryan Labs Liability Index (Treasury STRIP Curve) covers the complete spectrum of volatility for any asset class. Since the duration of a STRIP is equal to its maturity, the STRIP curve has durations out 30 years. The popular bond indices have durations of five years suggesting that very long liabilities can be six times more volatile given the same interest rate movement. You can find a Treasury zero-coupon bond that has the volatility of any asset class! You would think the value added of any asset class is versus the STRIP with the same or similar volatility. If you lose to the Treasury STRIP (with no credit, event or liquidity risk) over long time horizons your value is negative. As a result, EAFE should be severely questioned as an appropriate asset class or an appropriate index.

Once a Custom Liability Index is built, the term structure of such an index can be established frequently and clearly. This becomes the asset allocation process (e.g. 32% in very long liabilities = 32% allocated to very long assets). Those asset classes within each liability term structure now compete for the allocation to that term structure cell. The client may decide to give 100% of the very long liability cell allocation (32%) to EAFE asset managers or a diversified blend of small cap plus EAFE managers. Moreover, a Liability Index Fund for that term structure could be the core asset management (50%+ of cell).

Second Dilemma: Performance Measurement

Historically, assets managers are given generic indices (e.g., S&P 500) as their objective. Their performance is measured by comparing their total return to the generic market index return for that asset class (e.g., stocks, bonds). Money managers are hired and fired based on their performance versus an asset index.

An important reason why this situation persists is that liabilities are traditionally calculated annually and re-ported months after the fact! More importantly, the present value pricing of liabilities is not calculated using market yields. It is extremely difficult, if not impossible, for an asset manger to manage against such an ill-defined opponent.

What is needed is a Custom Liability Index system that correctly prices client's liabilities (in conformity with the FASB) as a tangible, frequent (i.e., daily) system for investment management. The asset side must know frequently the liability growth rate for each term structure cell (e.g. short, intermediate, long). Performance measurement can then be properly assessed as the growth rate of assets versus the growth rate of liabilities for each term structure cell as well as total assets vs total liabilities.

A review of past performance is very revealing. As the table attached indicates, here is the 11 year history of asset growth (returns) versus liability growth. Let’s again use the Ryan Labs Generic Liability Index where the one through 30 year liabilities are equal weighted. Using a common and static asset allocation ratio of 5% Cash, 30% Fixed Income, 60% Equity, 5% International shows that assets lost to liabilities five out of the last 11 years. Moreover, 1995 was the worst year. Most practitioners rejoiced in 1995 when the S&P returned 37.57% and your favorite bond index 18%. Ryan Labs was a lone voice crying that 1995 was the worst year in pension history ! If a five-year generic bond index grows at 18%, what do you think a 15-year pension liability grew at in that same year? Most plan sponsors witnessed 40% plus growth in liabilities in 1995.

Most plan sponsors didn’t know this until after the fact. The truth is that the greatest bull market in American history (1982 – 1998) was also a bull market for liabilities.

Third Dilemma: Pricing Liabilities

As explained earlier, liabilities are to be priced as if they were a zero-coupon bond portfolio whose par values match the liability payment amount and whose maturities match the liability payment date. This is not com-mon practice. Traditionally, liabilities are priced @ 100 basis points higher than the Treasury STRIP curve. If you multiply the interest rate difference times the average duration of liabilities you get an estimate of the error in present value calculations:

Accordingly, there is evidence to believe that liabilities are undervalued by about 10% to 30% per year. This is strictly a pricing problem of using inflated discount rates. In time, this could show up as added costs, lower credit ratings and/or deficits. 

Solution: CUSTOM LIABILITY INDICES

It is critical that each client’s liability objective be properly measured and supported. In 1991, Ryan Labs created the 1st Liability Index after two years of development. This index is customized and tailored to accurately calculate liability present values and present value growth for any client liability schedule. Asset allocation and performance measurement can now be properly fitted to the clients’ liability term structure. Performance measurements can now properly assess asset growth versus the liability growth these assets are funding (e.g. long assets vs long liabilities).The table attached shows a history of assets vs liabilities using the Ryan Labs generic Liability Index (for educational purposes only) having an average duration of 15.5 years:

If asset managers can better understand the risk/reward behavior pattern of the liability opponent, they can better strategize how to outperform such an opponent. If assets managers can understand the term struc-ture of liabilities, they can build proper asset allocations for each term structure area (long assets versus long liabilities). Without accurate liability term structure measurements, clients face the greatest risk there is...mismatching assets versus liabilities by term structure. The S&L crisis is too vivid a memory of what can happen with mismatched term structure exposure. The S&L crisis of yesterday may very well be the Liability crisis of tomorrow (e.g. Pensions, Social Security). 

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