If You Don’t Like The Outcome, Switch The Objective.

I don’t like that public pension systems use the return on assets objective (ROA) to value their liabilities, but it is the accounting rules under GASB that dictate that requirement. I also don’t like that public pension systems continue to have such lofty ROA targets (7.22% based on a NASRA 2/20 brief). The higher the ROA target the lower the annual contributions required to fund the plan. For those plans that have failed to achieve the ROA, the combination of weaker performance and smaller than necessary contributions is an unaffordable double whammy that destroys the funded status of these plans longer-term.

If that isn’t bad enough, I was reading an investment annual report for 2019 for a large state plan (yes, I have a thrilling life) that showed performance for the fiscal year 2019 (June 30th fiscal year-end), and for 3-, 5-, 10-, and 20-year time frames ending June 30, 2019. The performance comparison was for the total fund versus the total fund benchmark (benchmark is a weighted composite of index returns in each asset class). The 2019 and 3- and 5-year comparisons were below that benchmark, while the 10- and 20-year performance revealed above benchmark returns. So what!

In the case of the 20-year period, the pension plan in question had generated only a 5.7% return while the total fund benchmark was up 5.3%. Does it really matter that this plan topped it’s total fund objective by 40 basis points when it failed to achieve the ROA by 1.8% per year for 20 years? Remember that annual contributions are determined based on the assumption that the ROA will be achieved. The fact that this system underperformed so badly should be the story. Let’s stop coming up with new ways to measure “success” when really the only thing that matters is if the plan can secure the promised benefits or at the very least, achieve the ROA. Oh, the games people play.

No Need For The Volatility

The following graph highlights the fiscal year returns for the Mississippi Public Employees Retirement System. I would hazard a guess that this pattern differs only marginally from the “average” public pension system, since most plans continue to focus on the ROA as the primary objective and they all tend to be 7% and greater. This volatility is neither necessary nor helpful, as it leads to big swings in both the funded status and contribution expenses.

The chart begins with the year that equity investing was first permitted. I have no issue with plans investing in a variety of asset classes and products provided that the primary objective is to secure the pension plan’s promised benefits. To that end, we recommend that you don’t have all of your assets as alpha generating assets. It is imperative that the near-term pension liabilities be defeased allowing for a longer investing horizon for the true alpha assets to generate excess returns versus future liability growth.

As we demonstrated in a recent post, the volatility associated with short time frames is difficult to manage (see above chart), but by extending the investing horizon to 10-year time frames the probability of success is greatly enhanced.

Also, in the article where I came across the fiscal year returns for Mississippi PERS they mentioned that the plan’s funded ratio was only 60%. I realize that there are many factors that go into why a plan’s funded status may be a certain level – contributions, benefits changes, returns, expenses, etc. – but I always find it interesting when an annualized return over some long period reveals outperformance versus the ROA objective only to have the plan’s funded status be so poor. It just highlights that achieving the ROA is not the answer to solving the DB pension problem.

No Time To Celebrate

The WSJ has published an article today that highlights Wilshire’s TUCS universe performance for public pension systems. The gist of the article is that public pension systems established a 22-year record for positive performance during the second quarter – great – but there is no time to celebrate. Yes, the median public pension generated a whopping 11.2% return for the 3-months ending June 30, 2020, but the 12-months through the second quarter produced only a 3.2% return for the same universe of plans, which dramatically undershoots their target return of roughly 7.2%.

Once again we find these plans riding the asset allocation roller coaster to ruin. Despite the terrific second quarter result, plan sponsors are still facing massive funding shortfalls that will continue to grow, as many states and municipalities deal with the consequences of falling revenues and escalating costs associated with the Covid-19 crisis making the full payment of this year’s ARC nearly impossible. Sure, no one saw this coming, but then again, do we ever see Black Swan events before they’re thrust upon us?

Adopting a different approach to asset allocation is imperative at this time. We would highly recommend splitting the assets between beta (cash flow matching retired lives liabilities) and alpha (growth assets to meet future liabilities) enabling the plan to maximize the efficiency of the asset allocation. We’ve discussed this subject in previous blogs and in Ryan ALM research that can be found at RyanALM.com.

We remain huge fans of the traditional defined benefit plan, but have never been fans of the focus on the return on assets assumption (ROA) as the primary pension objective. Public pension systems cannot afford the volatility that the current approach produces, especially in this environment. Adopt this strategy that was once the only game in town and you will improve liquidity to meet benefit payments, eliminate interest rate risk, reduce the volatility of the funded status and contribution expenses, while extending the investing horizon for all of the alternative assets that have been injected into these plans.

Let’s stop riding that asset allocation roller coaster before we are all wet. Oh, as I sit at my desk in New Jersey today, I am reminded that the picture above was from Super Storm Sandy (October 2012). Ironically, we are under a tropical storm warning from Isaias. Stay safe, everyone.

We Can and MUST do Better!

On January 11, 2017 I penned a blog post titled “Perpetual Doesn’t Mean Sustainable”, which addressed my concerns about the fact that the idea that public pension systems were perpetual might just be a fallacy. In fact, the funding status for public pension DB plans was deteriorating and I was questioning their sustainability. Little has changed since that January day. I was attending an Opal conference in Arizona when I wrote the post so I can’t lay claim to a cold January day.

Recently, a friend from our industry shared with me the output from the Melbourne Mercer Global Pension Index (MMGPI) to showcase which countries are best equipped to support their older citizens, and which ones aren’t. Why older citizens? According to the study, one-sixth of the world’s population will be over 65-years-old by 2050 making the soundness of a country’s pension system so critically important.

The analysis uses a number of factors, which are then put into three sub-indexes:

  1. Adequacy – the base-level of income
  2. Sustainability – The state pension age, the level of advanced funding from government, and the level of government debt.
  3. Integrity – Regulations and governance put in place to protect plan members

These certainly seem to be reasonable. These measures were used to evaluate the pension systems for 37 countries (including the US) covering more than 60% of the world’s population. The Netherlands ranked highest with a combined score of 81, while Thailand ranked poorest at 39. Regrettably, the US ranks 17th in this global index placing behind Malaysia and only slightly ahead of France, Peru, and Columbia, which complete the top 20.

While each of the 3 sub categories is important, Sustainability is likely the most important given the aging trends that we are witnessing globally. As I wrote several years ago, perpetual doesn’t mean sustainable, and if we don’t change our approach to managing public pension systems, we will truly be challenging the premise that these entities are in fact sustainable.

DB plans are too important to the US plan participant to see them fail. A pay-as-you-go pension system is not sustainable, yet that is exactly what we have for a number of US states at this time. The Covid-19 crisis has impacted state revenues to such an extent that contributing the annual required contribution in 2020 is likely a pipe dream for many systems further destabilizing these plans.

Pension systems were much better funded years ago when the focus was on the plan’s liabilities. As plans began to focus more attention on the return on asset assumption (ROA) as the primary goal greater volatility in the funded status and contribution expense was realized. It is time to get back to basics before it is too late.

The Cost of a PRT is Rising

During June, the estimated cost to transfer retiree pension risk to an insurer rose 70 basis points, from 103.9% of a plan’s total liabilities to 104.6% of those liabilities according to the Milliman Pension Buyout Index (MPBI). The historically low interest rate environment for annuities is fueling this cost increase. Milliman’s MPBI uses the FTSE Above Median AA Curve, along with annuity purchase composite interest rates from insurers, to estimate the average cost of a PRT annuity de-risking strategy.

“Since April, accounting discount rates have dropped approximately 30%,” says Mary Leong, a consulting actuary with Milliman. There are many factors that go into the pricing of pension risk transfers (PRT) including the size of the potential transaction, the composition of the retiree base, the complexity of the deal, and the competitiveness of the market.

DB pension systems might be better off keeping the liability on their books by exploring the use of a cash flow matching strategy to defease the retired lives liability. Analysis performed by Ryan ALM estimates that cost savings of 15% to 20% are highly likely when compared to a PRT.

So Out Of Touch!

In another classic example of being out of touch with what is truly happening to American workers, US Senate Republicans have introduced a new bill: the Addressing Missed-savings Opportunities for Retirement due to an Epidemic Act (AMORE) Act. Senators Ted Cruz, R-TX, Thom Tillis, R-NC, David Perdue, R-GA, and Kelly Loeffler, R-GA proposed this legislation, which calls for make-up contributions for individuals who weren’t able to contribute to their plans (401(k), 403(b), IRAs, etc.) in 2020.

But, just how many people do they think this will help? According to a Vanguard study from 2017, only 13% of their participants maxed out contributions that year, while a similar Fidelity study revealed that 9.1% of their participants hit maximum thresholds. Furthermore, those that weren’t likely to contribute were part of the roughly 50 million Americans who have filed for initial jobless benefits so far in 2020. If they presently aren’t among the 17 million or so still struggling to find a job, do you really think that they will have enough disposable income to make catch-up contributions?

According to Federal Reserve Chairman Jay Powell, if you were an American worker earning $40,000 or less you had a 40% chance of losing your job this year. Yes, 40% – outrageous! This cohort was clearly struggling to cover basic living expenses; so thinking that they were making regular contributions into a retirement account is a pipe dream. Oh, and the Vanguard study that I mentioned above, they expanded on the characteristics of the 13% that were fortunate to max out contributions, and not surprisingly, these participants were older, made more money, and were longer-tenured in their jobs. What a shock!

So instead of addressing truly critical needs such as pension reform, enhanced unemployment benefits, education, and worker protections during the age of Covid-19, we get another example of our “leadership” being totally out of touch with what our workforce is dealing with on a day-to-day basis. It is well beyond the time that we finally begin to elect representatives that can relate to the struggles that MOST Americans are facing and stop electing individuals who only reside in ivory towers.

This Is Not The Reason

Recent news reports have indicated that New Jersey’s funding of their upcoming pension contribution ($3.75 billion) is going to be negatively impacted by a decline in lottery revenues. Although that is a true statement, NJ’s issues go well beyond the impact of an 11.6% decline in lottery revenue, which if the full amount had been generated was only going to cover 26.7% of the contribution in the first place. No, NJ has many issues, the least of which is a minor (given the Covid-19 environment) shortfall in lottery revenues.

First, I’m not sure that NJ has made a full payment of the annual required contribution since George Washington slept here. Second, Governor Murphy and the state legislature are today in front of the NJ supreme court trying to convince this august body that approving a $9.9 billion loan from the Federal government without a referendum was perfectly legal. Please understand that they are seeking to borrow $9.9 billion on a current budget of just over $38.7 billion (2019-2020) or roughly 25.6% of the current outlay. Also, understand that they extended fiscal year 2020 an additional 3-months through September 30th by passing an appropriations bill for $7.6 billion. A formal budget for 2021 is not likely before 9/30.

With forecast revenues for state income and sales expected to plummet, while expenditures rise as a result of Covid-19 activities, NJ is in no position to once again pay their full ARC. Given NJ’s funded status any shortfall in making the ARC is devastating. NJ’s pension system is on a slippery slope to becoming a pay-as-you-go system, with some estimates pegging 2028 as the year in which this occurs. The annual cash flow out of the system (benefit payments) will dwarf current ARC requirements placing additional and perhaps unmanageable burdens on the State’s budget.

There is NO WAY that NJ can invest their way to success given the funded status is roughly 23% when valuing liabilities on a mark-to-market basis as opposed to the ROA under GASB. The only way that NJ’s pension system survives is to arrange a loan from the Federal government large enough to cover the Retired Lives liability that will secure the promised benefits, while buying time for the current assets and future contributions to exceed future liability growth.

Nearly 800,000 (or 9% of the roughly 8.88 million residents) NJ public workers participate in the pension system either as retirees or active participants. Failure to protect and preserve the promised benefits will be catastrophic for NJ’s economy, as we know from studies that a significant percentage of benefits received are spent locally. Easy for me to suggest that the Federal government should be willing to provide low-interest loans to states such as NJ, IL, KY, and CT, but failure to secure these promised benefits will create a social and economic nightmare for the economy and country. One caveat, if any of these states are successful in arranging for such a loan, the proceeds MUST be used to defease the plan’s current liability and not invested in a more traditional asset allocation.

If this strategy sounds familiar: it is! This implementation is mandated in the Butch Lewis Act to help preserve Critical and Declining multiemployer plans.

Maximize The Efficiency of The Asset Allocation

There is a lot of volatility in a normal asset allocation in short time frames. We’ve seen this unfold dramatically in a number of cases during the last couple of decades. At Ryan ALM we are guiding pension clients to adopt a cash flow driven investing approach (CDI) that can significantly reduce the volatility associated with a traditional asset allocation.

As the graph above reflects, the Ryan ALM asset allocation (5% cash, 5% international equities, 55% domestic equities, and 35% bonds) has produced an average 1-year return for the last 20 years (monthly moving average) of 6.03% with a 1 standard deviation (68% of the observations) of +/- 10.5%. A 2 SD observation would have that average 6% return showing a 95% confidence band of +27% to -14%. You can drive a couple of semis through that gaping hole!

I suspect that no plan sponsor would ever tolerate hearing their consultant remark that “your fund was down 12.5% during the last 12-months, but don’t worry, as it isn’t statistically significant”. Our primary goal is to get plan sponsors securing the promised benefits net of contributions for the next 10 years. If we can use the current bond and cash allocation to accomplish this objective, we can significantly reduce the volatility inherent in this traditional asset allocation.

As the chart above highlights, by separating the assets into two buckets – beta (the red square) and alpha, we can secure the promised benefits through a CDI implementation that extends the investing horizon for the alpha assets that now have time to grow unencumbered. In a traditional asset allocation, all assets are on hand to fund benefits net of contributions. During periods of market turmoil, liquidity may not be as abundant as usual and often assets are sold at less than ideal times. This forced selling exacerbates the underperformance experienced by the fund.

As you also see by the graph above, extending the investing horizon has substantially lessened the volatility through time. Where a 1-year period had a 1 SD observation of +/-10.5%, a 1 SD observation for the 10-year period is only +/-3.9%, which significantly enhances the probability of success for the plan. In our asset allocation example, the average 10-year return during the last 20 years was 8.55%. Thus, a 2 SD observation of the results would have a 95% confidence band of 0.75% to 15.35%: far more tolerable than living with the volatility of a 1-year horizon.

The alpha assets (highlighted by the green box) that presumably have a liquidity premium associated with them now have the time necessary to grow without being disturbed. Furthermore, the alpha bucket can invest in all sorts of assets other than traditional fixed income assets that are too highly correlated to plan liabilities. This process should result in much more stable contribution expenses and funded ratios. As the plan moves through time, it is highly recommended that the sponsor and their consultant contribute the necessary amount to keep the beta bucket defeasing the next 10-years of plan liabilities.

As we move through this incredible period for markets many participants are naturally worried that their promised benefits may be at risk. For those plans that have adopted a CDI approach such as ours, sponsors can safely tell their participants not to worry as their promised benefits are secured for the next 10-years. Furthermore, plans don’t have to worry about raising liquidity to meet those net benefit payments, as the cash flow from the CDI portfolio will be there every month to meet the next month’s payments. Don’t you think that your participants want to hear such a message?

Rightly So.

On June 23, 2020, the Department of Labor (DOL) announced a proposed rule to provide further guidance for Employee Retirement Income Security Act (ERISA) plan fiduciaries interested in environmental, social, and governance (ESG) investing. These ESG strategies must be chosen based on their financial merits and CANNOT be selected solely for ethical investing purposes if they are to gain access to defined benefit (DB) and defined contribution (DC) plans. I couldn’t agree more.

The securing of the promised benefits needs to be the number one priority for DB plans. Selecting investment programs/strategies that even marginally reduces the chance to accomplish that objective should not be considered. Furthermore, despite the growing popularity of the ESG strategies, I haven’t seen any evidence that they are producing superior results to traditional active strategies.

Given the extremely crowded investing field, I can’t help but to think that highlighting an ESG capability is just one way to further differentiate one firm from the next. However, I’ve witnessed to many fads during my nearly four decades in the business to think that ESG investing isn’t just another one for the history books.

DB plans need to be protected and preserved as the primary retirement vehicle for the majority of American workers. Let’s get back to basics in securing the promised benefits for DB participants. There are other pockets of money that can explore all the investing fads that they want.

No Fairy Tale

Once upon a time in a land not so far from here, defined benefit pension systems were over funded and cash flow positive. Yes, really! As recently as 1999, most DB pension plans were showing strong funded ratios and were at least cash flow neutral. Oh, how 20 years can dramatically alter the landscape. What happened?

Unfortunately, neither the US interest rate environment nor global equity markets cooperated. US interest rates collapsed until long Treasuries were sitting at historically low levels (US 30-year Treasury Bond is 1.34% today), while we tried to migrate through equity market gyrations (’01-’02, ’07-’09, Q4’18, and 1Q’20) that would have Elvis Presley’s hips jealous.

As a result, we have an environment that has corporate DB plans doing their best impression of a dinosaur, roughly 130 multiemployer plans that are on life support impacting the financial future of an estimated 1.4 million American workers, and a public pension system that still believes that their programs are perpetual despite several examples of plans with funded ratios below 20%. All we need is for Freddie Krueger to start showing up at industry events!

We don’t have a retirement system without DB plans. We can kid ourselves about DC plans being a viable alternative, but asking untrained individuals to fund, manage, and disburse this “benefit” is poor policy and nothing more than a pipe dream. As an industry we need to get back to basics. This means that we once again focus on why these plans exist in the first place, which is to pay the promise that was made to the employee when they were first hired. It means managing to this promise every day. It means securing the promised benefits for some extended time so that the plan doesn’t have to force liquidity in environments where it doesn’t exist.

What it doesn’t mean is that plan sponsors and their consultants have to redo their ROA target or asset allocation framework. We can get pension America back to the basics by just converting the plan’s current fixed income exposure into a cash flow driven investing (CDI) strategy. It is an implementation that provides the necessary cash flow for the next 10 years to pay the plan’s monthly benefits and expenses.

By utilizing a CDI approach, plans will see dramatically improved liquidity, the elimination of interest rate risk, the extension of the investing horizon for the balance of the plan’s assets, and an 10% to 20% savings relative to the current pay as you go approach to meeting monthly benefit payments. Furthermore, the savings is realized immediately, and those assets which are not needed to support the CDI portfolio can be used in the alpha portfolio to meet future liabilities.

Corporate America has done a much better job of managing the volatility of both the funded status and contribution expenses. Perhaps the reason is that they are forced to under more stringent accounting rules. But, given their relative success, why aren’t publics and multis embracing these tools? Again, we don’t have a true retirement system without DB plans, but we are just kidding ourselves if we think that these plans will survive without a change in course. Benefits need to be paid. A CDI approach is the only strategy that actually secures those promised benefits. Isn’t it time?