The capital markets have been on a wild ride over the past decade or so, and have taken pension plan sponsors, managers, and participants on a roller coaster ride along with them.  During the 1990’s, equities were the name of the game.  With the end of the bull market, others have proposed that pension plan sponsors invest exclusively in fixed-income securities.  While such strategies may work well over a given time period in a specific market environment (such as Internet stocks from 1994-1999), these non-diversified strategies have more in common with speculation than responsible investment management.

But how do we ensure that there will be sufficient assets to pay for both current and future needs?  Ideally we would create a well-diversified portfolio with the best risk-return characteristics that also makes sense in the context of the liabilities.

Historically, pension sponsors have utilized a “target return” approach.  In this approach, the pension sponsor (or, more likely, a consultant retained by the plan) examines the actuarial data and determines what rate of return is necessary to maintain the health of the plan.  An investment portfolio is built that will hopefully meet or beat the return target.  A glaring shortcoming of this approach is that the timing of the liabilities is rarely given much consideration with the exception of holding sufficient cash to meet short-term needs.

With many pension sponsors reeling from the shock of the demise of the most recent bull market, others have proposed immunizing the portfolio with fixed income investments that match the actuarially predicted cash outflows for the life of the plan.  Immunization is really just a basic form of gap analysis called cash flow matching which involves aggregating the cash flows into maturity buckets and then checking to see if the cash flows in each maturity bucket nets to zero.  This strategy has its merits, most conspicuously the elimination of uncertainty.  Unfortunately, with today’s interest rate environment the main guarantee that portfolio immunization offers plan sponsors is that they will certainly have to increase contributions. What is needed is....