Funded-Status Risk versus a Private Credit Reallocation
The $1.8 billion Meridian Manufacturing defined benefit plan is 91% funded on a liability-driven basis: liabilities of $1.98 billion with a duration of 12.4 years. The committee proposes moving from 60% global equity / 40% core bonds to 45% equity / 35% long-dated corporate credit / 20% private credit and infrastructure. Under a funding relief schedule contributions are zero for three years; benefit payments are $95 million this year and are expected to grow about 4% annually. The plan's liquidity policy requires 24 months of net benefit payments in cash and Treasuries. The CIO cites private credit's 9% expected return and 0.6 correlation with equities. The actuary notes that the liability discount rate is based on high-quality corporate bond yields and that the plan has been in negative net cash flow since 2022.
1. Quantify the plan's liquidity requirement and assess whether the proposed allocation complies with the liquidity policy.
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Requirement: 24 months of net benefit payments = 2 × $95m = $190m, or about 10.6% of $1.8 billion. Including a buffer for the 4% benefit growth and timing, a practical minimum is $200–220m.
Proposed allocation: 45% equity + 35% long corporate credit + 20% private credit/infrastructure = 0% cash and Treasuries. The policy is breached outright, before any stress scenario.
Three further liquidity drains the proposal ignores:
- Capital calls. The 20% private allocation ($360m) is typically drawn over 3–5 years; unfunded commitments are a contractual cash obligation that must be met regardless of market conditions.
- Negative net cash flow. The plan pays out more than it receives every year, so it is a forced seller. Selling equities or long credit into a drawdown is the exact procyclical behavior the liquidity policy exists to prevent.
- Long credit is not a liquidity reserve. It is tradable, but spreads gap and dealer depth disappears in stress - precisely when equities are also down.
Remedy: carve out $200–250m in Treasuries or short-duration government securities, funded from the long credit sleeve, and size the private allocation so that unfunded commitments plus two years of benefit payments remain covered by liquid assets.
2. Evaluate the CIO's claim that a 0.6 equity correlation makes private credit a diversifier for this plan.
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The claim misidentifies the relevant risk. For a 91%-funded plan with a 12.4-year liability duration, the dominant risk is the funded status, not equity volatility. The right question is how each asset covaries with the liability, not with equities.
- Correlation is unreliable here. The 0.6 figure is estimated from appraisal-based, quarterly, mark-to-model valuations. Smoothed marks mechanically dampen measured correlation and volatility; the true economic correlation in a liquidity event is materially higher. Both private credit and equities are exposed to the same default and risk-appetite cycle.
- Private credit partially hedges the liability, but expensively. Because the discount rate is a high-quality corporate yield, credit spread duration does hedge the liability. But long Treasuries hedge the same rate risk without spread, illiquidity, or valuation opacity - and they satisfy the liquidity policy.
- The 9% expected return is an illiquidity and leverage premium, earned with a wide dispersion of outcomes and no daily price to test the assumption against.
Recommendation: split the 35% long credit sleeve into long Treasuries/strips (pure duration hedge) and long credit (spread), set an explicit hedge-ratio target - for example, 70–80% of liability duration - and cap private credit at a size the plan's liquidity can genuinely support (approximately 8–10% of assets here).
3. How should the committee judge whether the change improved the plan's risk position, rather than just its expected return?
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Judge the decision on surplus (funded-status) metrics, not on total return or return volatility:
- Surplus volatility and surplus VaR over 1- and 5-year horizons, under a stress scenario combining a 100bp fall in rates, a 150bp widening of credit spreads, a 25% equity decline, and a freeze on private-market distributions. If the proposal leaves the plan unable to pay benefits without selling growth assets at depressed prices, it fails regardless of expected return.
- Hedge ratio - the share of liability interest-rate sensitivity matched by assets - before and after.
- Liquidity coverage ratio - liquid assets divided by two years of net benefit payments plus unfunded commitments.
- Contribution risk. With contributions at zero for three years, any funded-status shortfall must be closed later, possibly at the worst point in the cycle. Model the probability of falling below 80% funded and the resulting contribution.
The proposal's real effect is to swap a known, hedgeable risk (interest rates) for an illiquid, opaquely priced, and partly unfunded one. Expected return should be the last item on the agenda, not the first.