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How Bonds Can Enhance the Pension ROA
By: Ronald Ryan, Ryan ALM
The true objective of a pension is to secure and fully fund the benefit payments in a cost-efficient manner with prudent risk. Cash flow matching is the best fit to accomplish the pension objective.
This is an excerpt from NCPERS Summer 2025 issue of PERSist.The true objective of a pension is to secure and fully fund the benefit payments in a cost-efficient manner with prudent risk. Cash flow matching is the best fit to accomplish the pension objective.
Given the volatility and uncertainty of the financial markets, bonds can provide a solution through the certainty of their cash flows. Most pensions focus on earning the return on asset (ROA) assumption as the goal of asset allocation. Because bonds yield less today than the ROA (7.00% average) the asset allocation to bonds tends to be somewhat low. But the bond allocation could enhance the ROA. Here's how:
1. Cash Flow Matching – if bonds were used to cash flow match and fund net liabilities (after contributions) chronologically they would produce the liquidity needed to fully fund such net liabilities with certainty. Cash flow matching works best with longer coupon bonds where you use semi-annual interest income to partially fund liabilities (benefits + expenses). A 10-year bond has 20 interest cash flows and one principal cash flow all priced at a 10-year yield. This would eliminate the need to do a cash sweep of other asset classes which is a common liquidity procedure. According to a study by Guinness Global, the S&P 500 has 48% of its historical returns from dividends and reinvestment since 1940 on a 10-year rolling period basis. Wouldn't you want to reinvest dividends back into growth assets rather than spend it on funding benefits and expenses? By using bonds as the liquidity assets, the growth assets are left unencumbered to grow. The longer the cash flow matching period, the more time the growth assets can compound their growth. This could significantly enhance the total ROA.
2. Yield on Bonds – asset allocation models forecast the return of each asset class in the model, then weight each asset class to get the derived ROA for total assets. The ROA for most asset classes is based on the historical returns of each asset class index benchmark except for bonds. The current yield on the bond index benchmark is usually used as the forecast for bond returns. The Bloomberg Barclay Aggregate is most favored as the bond index benchmark. This index was designed at Lehman Bros. by Ron Ryan when he was the head of Fixed Income Research & Strategy from 1977 to 1983. The Aggregate is a very large and diversified portfolio of bonds with the following summary statistics as of March 31, 2025:
| # of issues | 13,770 | Treasury | 44.79% | AAA | 3.06% |
| YTM | 4.51% | Agency | 1.29% | AA | 47.86% |
| Duration | 6.08 yrs. | Mtg. Backed | 24.85% | A | 11.38% |
| Avg. Maturity | 8.38 yrs. | Corporates | 24.06% | BBB | 11.43% |
| NR | 25.60% |
As a result, most asset allocation models would have a ROA for bonds of about 4.50%. If you can build a bond portfolio that outyields the Aggregate index with the same or similar term structure, by definition, it should enhance the ROA for total assets. Cash flow matching is optimal using a portfolio of A/BBB corporate bonds providing a 50 to 100 basis points yield advantage over the Aggregate index. Moreover, given America's deficit financing there should be a greater supply of Treasuries issued in the future skewing the index to lower yielding bonds.
3. Cash – many pension plans have a cash allocation of around 2% to 3%. Cash is usually the lowest yielding asset. Using cash flow matching (CFM) as the liquidity assets to fully fund benefits and expenses (B+E) chronologically, there is little need for cash to fund B+E. Cash might only be needed for capital calls on Private Equity and Alternative Investments. CFM should significantly increase the yield margin versus cash since it is heavily weighted to A/BBB issues. With the CFM fully funding B+E, the cash allocation can be reduced to around 1%. Replacing most of the cash allocation to fund B+E with the CFM allocation is another ROA enhancement… it all adds up.
4. Performance - The intrinsic value in bonds is the certainty of their cash flows. They are not performance or growth assets but liquidity assets. The past performance of the Bloomberg Aggregate for rolling periods as of 3/31/25 is a testament to this:
| 1 year = 5.2% | 5 years = - 0.3% | 10 years = 1.5% |
| 3 years = 0.6% | 7 years = 1.6% | 20 years = 3.2% |
Logic: Oension plans who use their fixed income allocation for cash flow matching instead of a total return focus versus a generic bond index should enhance their ROA and liquidity. The benefits are significant and clear.
“Where is the knowledge we have lost in information”
T.S. Eliot
T.S. Eliot
Bio: Ronald J. Ryan, CFA is the Chairman and Founder of Ryan ALM, Inc.. Ryan ALM is an asset liability manager specializing in cash flow matching. He also created Ryan Labs in 1988 which became a leading bond asset manager. He was the former Director of fixed income research at Lehman Bros. from 1977 – 1983 where he designed most of the popular Lehman bond indexes including the Aggregate.
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