Why All Defined-Benefit Plans are Short-Term Investors

Section 1: Introduction

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

Section 2: Path Matters! Timing Matters!

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

Section 3: DB Plans Face Risk of Ruin With Virtually Any Level of Random Risk

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

Section 4: Why Properly-Constructed Fixed-Income Allocations Substantially Reduce Risk of Ruin

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

Section 5: Why Don’t Plan Bankruptcies Occur More Often?

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.

Section 6: Conclusions

At a pension plan conference not long ago, a plan manager asked, “Why can’t I just forget about de-risking and behave like a long-run investor: maximizing expected total return?” The simple and short answer is that because a defined-benefit (DB) plan makes regular benefit payments, it simply can’t afford to focus only on long-run returns. There is always substantial risk that a run of only modestly bad luck—combined with regular benefit payments—could so deplete assets that the plan could not recover even when and as asset returns rebounded to long-run averages.

The allure of the long-term investor arises from investment assumptions that are crucially different from those facing a DB plan. Decades ago, when Harry Markowitz and Paul Samuelson debated whether a “long-term investor” should care about risk or only return, they both considered an investor who could put funds away and let them accrue untouched until some terminal date. Because 100% losses in any specific period were assumed away, the investment pile never went to zero. So it would ultimately fully rebound once average asset returns had returned to their expected levels.

Once intervening—and regular—cash payouts are allowed for, everything changes. Cash payouts can exhaust assets in finite time when asset returns are only slightly negative or even positive but below-average, in which case assets remain depleted even when asset returns have averaged out to long-run norms. So, even long-run-minded investors can find themselves dead in the short-run (apologies to Keynes).

Furthermore, the risks of exhausting assets under a risky asset allocation are substantial. In the following sections, we’ll show that when asset returns randomly fluctuate alongside regular payouts, the chances of premature asset exhaustion look to be better than 50%, even with adequate initial funding. When initial funding is less than adequate, such insolvency is almost inevitable.

Every real-world DB plan faces the certainty of having to draw on invested assets well in advance of its “terminal date.” It simply can’t afford to act as a long-run investor. It must manage short-term risks. There are two steps a DB plan can follow to reduce the risk of asset exhaustion: it can tailor the risk aspects of its plan assets to match those of its liabilities and/or it can fund the plan in excess of what would be considered adequate.

With respect to risk matching, the plan will have some terminal date when final payouts are made. As time passes, that terminal date draws nearer, and its liabilities mature. Asset types such as equities, alternatives, and real estate do not mature, but proceed indefinitely, whereas fixed-income assets do mature. Thus, fixed-income portfolios can be structured to match the maturity structure of a plan’s liabilities in a way that other asset types cannot, thereby reducing the risks of asset exhaustion for the plan. Furthermore, fixed-income returns can be viewed as non-random—mean-reverting—and this also makes the chances of asset exhaustion less relevant for them.

As for more-than-adequate funding, this is an option regardless of the level of risk in the asset allocation, but it contravenes the cost-minimization motive that drives risky DB asset allocations in the first place. Also, the overfunding should be achieved early. If the plan waits until assets are nearly exhausted, even substantial subsequent contributions may not be sufficient. (Remember that asset exhaustion occurs not necessarily because of negative asset returns, but because of below-average returns alongside continuing cash payouts.) But here again, substantial overfunding runs counter to the desire to reduce pension costs.

Notice that these findings are just as relevant for a public plan as for a corporate plan. We deal here with avoiding asset exhaustion, not necessarily with minimizing funded status volatility. The real benefit of fixed-income assets to a DB plan is that they maximize the chances of plan solvency, an issue that is irrespective of accounting regimes. (Zero assets are zero assets regardless of what the liability valuation is accounted to be.)The fact that fixed-income assets do minimize funded-status volatility under a particular accounting regime is an indication of how well that accounting regime reflects the economics underlying the plan’s solvency. The particular accounting regime a plan faces is incidental to it. Maintaining solvency is a palpable reality.