Massive shift to Risk Assets – Are DB Plans Better Off?

As the chart below depicts, there has been a massive shift in the asset allocation of DB plans since the mid-50s from mostly fixed income allocations to significant exposure to risk assets.I suspect that most of the motivation has been driven by the plan sponsors desire/need to achieve a target return or hurdle rate (ROA). The idea is if the ROA is achieved then contribution costs remain as projected…but has this goal been achieved?

Actuaries do a wonderful job (very difficult task) of forecasting the plan’s liabilities despite ever changing inputs, such as life expectancy, which fortunately has expanded leaps and bounds since the 1950s. I often say that my crystal ball is no better than anyone else’s if not worse. Actuaries can’t afford to have a crystal ball that is foggy. Their forecasts of future benefit costs are amazingly accurate despite the many inputs that drive their calculations. Given the reliability of their data and the importance of meeting those future expenditures, why aren’t plan sponsors and their consultants using these insights to drive asset allocation and investment structure decisions?

Most DB plans were well overfunded in 1999. They had the opportunity to remove substantial risk from their portfolios by defeasing the plan’s Retired Lives Liabilities and securing the funded status. To achieve the ROA, asset allocation models did the opposite! As a result, their increased equity exposure got crushed when significant market corrections occurred in 2000-02 and again in 2007-09. Did we learn anything? It doesn’t appear that we did, as equity exposures continue to ratchet higher despite the appearance of dramatic overvaluation. Could it be that fixed income, after an historic 39-year bull market, scares plan sponsors and their consultants to a greater extent? Could be. However, as we’ve stated on several occasions, bonds should not be viewed as performance or Alpha assets in this environment. They should be used exclusively for the certainty of cash flows that they generate as liquidity assets or Beta assets.

We believe that a cash flow matching implementation that defeases a plan’s net benefit payments chronologically from next month’s needs to as far out as the allocation will permit will provide many benefits, including: 1) improved liquidity, 2) elimination of interest rate risk on the bonds that are used to defease liabilities, 3) buys time for all of the equity exposure now in DB plans, and 4) allow the alpha assets (non-bonds) to grow unencumbered, as the re-investment of dividends is critical to the long-term success of investments, such as the S&P 500.

Increasing equity exposure in the hope that a greater return will reduce the need for future contributions hasn’t yet proven to be true. It has ensured that total expenses (management fees) have gone up, as well as the overall volatility of the funded status, but success hasn’t been guaranteed. Given where valuations currently reside, either dramatically reduce the equity exposure or reconfigure your fixed income exposure from a total return seeking mandate to a cash flow matching implementation that now allows time for the alpha assets to recover after the next equity market correction. There will be one.

Ryan ALM Pension Monitor for 3Q’21

Each quarter, Ryan ALM produces the “Pension Monitor” to reflect how pension liabilities are behaving versus plan assets. We believe that pension plan liabilities need to be measured and monitored regularly. Without knowledge of plan liabilities, the allocation of plan assets cannot be done appropriately. 

The funded ratio/status of pension plans are present value calculations. Each type of plan is governed by accounting rules and actuarial practices, which determine the discount rate used to calculate the present value of liabilities. Single employer corporate plans are under ASC 715 (FASB) discount rates (AA corporate zero-coupon yield curve); multiemployer plans and public plans use the ROA (return on asset assumption) as the liability discount rate. The difference in liability growth between these plans can be quite significant, which will affect funded status and contribution levels. 

Although the third quarter of 2021 saw funded ratios decline marginally, the strong rebound in markets following the onset of Covid-19, has enabled a plan’s total assets to outperform liabilities during the last 18 months. Whether the plan is a public, corporate, or multiemployer plan, assets have been aided by strong global equity markets and liability growth has been tempered by rising interest rates. This combination has been great for pensions that have witnessed strengthening funded ratios and improved funded status, especially for corporate plans that utilize a discount rate more reflective of the current market environment. We believe that the time is right for plan sponsors to take some risk out of their pension plans.

Please don’t hesitate to reach out to us if we can answer any questions related to asset/liability management.

Biggest Increase in 40-years

The Social Security Administration has just announced that SS recipients would see the greatest annual increase in 40 years. As we reported back in June, the COLA is based on the inflation rate during the three Summer months. It was just announce that the increase will be 5.9% for 2022. The average recipient will see a monthly increase of $92 for a total of $1,657 per month or $19,884 per year. Let’s hope that inflation does prove transitory providing our senior citizens and those receiving disability benefits the opportunity to get ahead just a little bit.

ASOP 4 – Third draft of the standard was approved in June

The Actuarial Standards Board (ASB) is responsible for setting standards for actuarial practice in the United States and they accomplish that objective through the development of Actuarial Standards of Practice (ASOPs). One such standard, ASOP No. 4 addresses “measuring pension obligations and determining pension plan costs or contributions”. This guideline is not specific to either FASB or GASB, so this standard should be applied by all actuaries when performing the following tasks:

Measurement of pension obligations, funded status, solvency risk, and the pricing of benefits. There are several other areas of focus, but the assessment of a Low-Default-Risk Obligation Measure was the one that grabbed our attention. Section 3.11 of ASOP No. 4 states that “when performing a funding valuation, the actuary should calculate and disclose a low-default-risk obligation measure of the benefits earned or costs accrued as of the measurement date”. When calculating this measure, the actuary should select a discount rate derived from low-default-risk fixed income securities whose cash flows are reasonably consistent with the pattern of benefits to be paid in the future. Sounds like cash flow matching to us. Examples of permitted discount rates include, US Treasury yields, rates implicit in the settlement of pension obligations, yields on corporate bonds of the two highest ratings given by recognized rating agencies, multiemployer current liability rates, and non-stabilized ERISA funding rates for a single employer plan. Notice that the return on asset assumption (ROA) is not one of the approved rates.

The actuary should provide commentary to help plan sponsors AND participants understand the significance of the low-default-risk obligation measure with respect to the funded status of the plan, future contributions, and importantly, the security of participant benefits. It is up to the actuary to use their professional judgement when producing the commentary. This measurement is not intended to highlight one discount rate as being the most appropriate. It is intended to provide a more transparent view of the current financial condition of the plan with respect to its future commitments. Final comments on this third draft are due by October 15th.

Ryan ALM is one of the few vendors that provide U.S. Treasury STRIPS and AA corporate zero-coupon (ASC 715 requirement) discount rates. We also created and provide a Custom Liability Index (CLI) as a monthly report that calculates: Future Value (grows and net of contributions), Present Value, Growth Rate, Interest Rate Sensitivity, and Statistical Summary (average YTM, duration, etc.) of the plan’s liabilities.

Credit Ratings Migration Downward

Most participants in the US pension industry know that the credit rating downgrade trend has been occurring for quite some time, but they may not necessarily appreciate the magnitude. The US bond market has shifted heavily toward BBB from AA and A rated bonds as nearly 70% of new issuance has been BBB (see chart below).

At the conclusion of 1990 roughly 11% of the corporate bond market was rated AAA. Today, there are exactly 2 corporate bonds – Microsoft and Johnson & Johnson – that maintain a AAA rating. Incidentally, this rating remains one notch higher than the US government, which has had a AA+ rating from S&P since 2011. The BBB segment of the US bond market was roughly 25% of the investment grade (IG) universe in 1990. Today, more than 50% of the IG universe is BBB and there doesn’t seem to be any let up at this time, as cheap financing has led to this borrowing craze.

Fortunately, default rates have remained incredibly low since the Great Financial Crisis for all credit ratings within the IG universe. We, at Ryan ALM, have taken full advantage of the growing BBB segment within our cash flow matching portfolios providing our clients with a terrific yield advantage relative to the pricing of their plan’s liabilities (ASC 715 AA corporate bond yield curve discount rates). Also, it should be pointed out that credit spreads for AA bonds have tightened significantly relative to BBB bonds elevating credit spread duration risk for that segment of the IG universe.

Highly unlikely!

According to the Department of Labor, the median wage in the US in 2002 was $38,655 (adjusted for inflation). In 2019, the median wage had “rocketed” all the way to $39,101! Amazingly, we have ONLY seen inflation adjusted wages grow by $546 since 2002. Oh, my! During that nearly two decades we’ve witnessed further deterioration in the use of defined benefit plans (DB) and the greater emphasis on defined contribution plans (DC) that require individuals to fund, manage, and then disburse a retirement benefit. Do you really think that this is feasible given the modest growth in wages? Furthermore, we have seen housing costs (both purchase and rent), educational costs (look at student loan debt), healthcare, and health insurance premiums explode with each outpacing the CPI. This experiment will end in catastrophe.

Regrettably, many Americans don’t have access to an employer sponsored retirement benefit of any kind. We know from studies that most Americans don’t save outside of their employer-sponsored plan. For those that do have an employer capable of providing their employees with a plan, only about 70% of the employees take advantage of the savings vehicle. Furthermore, most aren’t coming close to maximizing their full deduction, and who can blame them given the meager wages. It costs a certain amount to provide for oneself and many Americans aren’t earning enough to meet that threshold. Why do we think that saving for a future retirement is even possible – it isn’t!

Why have we allowed this development to occur? Why have we determined that it is okay for DB plans to be frozen and terminated in favor of DC offerings that don’t come close to providing individuals with the necessary assets to enjoy a retirement, let alone one that is dignified. This social experiment will be a failure! I don’t think that we really need more time to see that insignificant DC balances will be adequate to keep Americans from falling onto the social safety net of our federal government. It is time to embrace the use of state-sponsored defined benefit plans. If corporate America doesn’t want to own the pension liability – fine! But they should at least be mandated to make a contribution on behalf of an employee into a state run defined benefit plan that is professionally managed, low cost, and one that provides a monthly annuity upon retirement.

Like A Bridge Over Troubled Water

As a young man growing up in Palisades Park, NJ, I loved the folk duo Simon and Garfunkel, and one of my absolute favorite songs was “Bridge Over Troubled Water” (released in January 1970). Much to the chagrin of my family, I will still belt out that song when I hear it. However, until yesterday I would not have thought that I’d use this song as a metaphor for potential issues in the pension/investment industry, but Ryan ALM’s Head Trader, Steve DeVito, provided us with the following chart and title that is just perfect for what we try to do for DB pension plans.

As the graph highlights, the decade of the ’00s was tragic for pension America. As we recently reported, the decade of the ’90s ended with most pension plans fully-funded if not in surplus funded status. But those funded ratios soon plummeted as the result of two incredible drawdowns in the S&P 500 (8/20 – 9/02 and 10/07 – 2/09). Had pension America engaged in a de-risking strategy when pension plans were fully funded in the 1990s, such as cash flow matching that would have protected what had been earned, the impact of those two major market declines would have been somewhat muted. First, DB plans would have maintained a greater allocation to fixed income, which performed superbly during that decade when equities truly suffered, while importantly matching the growth rate of the plan’s liabilities. Second, a cash flow matching bond strategy buys time for the alpha assets (non-fixed income) to grow unencumbered. Why is that important? The graph below highlights the fact that it took thirteen years for the S&P 500 to recover it’s $ value as of 1999.

By permitting the assets to grow without being a source of liquidity, equities benefit from the reinvestment of dividends. Studies have shown that more than 50% of the S&P 500’s return over 20+ rolling year periods is from dividend reinvestment. Furthermore, by establishing a cash flow matching program that provides for the payment of benefits and expenses, a plan is not forced to raise liquidity from equities when valuations have already been driven lower. Lastly, it also protects plans from making improper asset allocation decisions during periods of distress.

Pension America has benefited from an amazing period of performance since the Great Financial Crisis ended in early 2009. Funded ratios have improved for all DB plan types. It would be sinful to see this improved funding wasted as a result of inaction. It is time to secure the plan’s cash flow needs, funded ratio, and contribution expenses. A pension plan should covert the current fixed income allocation from a return seeking instrument to one that focuses on a bond’s cash flows. In a rising interest-rate environment such as the one that we might be experiencing, traditional fixed income strategies will likely generate negative total returns with as little as a 30 basis point move upward in rates. That could happen very easily. However, in a cash flow matching strategy, where we carefully match maturing principal and income cash flows with benefits and expenses, we are ensuring that the plan’s liquidity needs are being met and that interest rate risk is being eliminated, as future values are NOT interest rate sensitive.

Defined benefit plans need to be protected and preserved for the millions of plan participants who are counting on that promised benefit. Let’s not give those supporting these plans ammunition to seek their destruction. Risk reduction and the securing of benefits should be at the top of every plan’s working agenda. I’m not smart enough to know when the equity markets (perhaps bonds, too) will crater. I just know that history DOES repeat itself in the pension industry.

A little DB Pension History

At the end of 1999, the average US public pension plan had a funded ratio >100%. Yes, just a couple of short decades ago the average public pension plan was overfunded thanks to great equity returns during most of the 1990s. Wow! During the 1990s asset allocation models reduced their allocations to bonds as interest rates kept going down so by 1999 they had the lowest allocation to bonds in modern history.  Why? Well, when the yield on bonds went below the ROA target (8.0%+) starting in 1989, it was perceived that any exposure to fixed income would jeopardize a plan’s ability to achieve the ROA. If only a plan’s liabilities, and not its ROA, were top of mind in 1999 we wouldn’t have the pension issues that we do for many state and municipal plans.

According to several actuarial firms that track the funded status for public DB plans, the average funded ratio for a public fund is now in the low 70% range, when applying GASB accounting rules, which means that the discounting of liabilities uses the ROA rate instead of FASB that calls for a AA corporate bond rate to be used. The current yield on the 10-year US Treasury note is at 27% of the 5.65% (12/31/99 US Treasury note) yield that was deemed too low to be meaningful. Had plans focused on the liabilities by driving asset allocation through a liability lens, plans would have defeased their Retired Lives liabilities through cash flow matching when they were fully funded thereby securing benefits and low contribution costs. That exposure should have been used to defease the Retired Lives Liability. This action would have stabilized the plan’s funded status and contribution expenses, while also buying time for the alpha assets to work through some very challenging times, such as the Dot-Com bubble burst and the Great Financial Crisis.

As we discussed in a recent blog post, US public pension plans do have exposure to fixed income, primarily to provide the cash necessary to fund benefits and expenses. However, in a rising rate environment, traditional fixed income programs will see the value of their assets decline, producing a likely negative return for the plan. It is far better to cash flow match bonds with the plan’s liabilities ensuring that the cash necessary to meet the promised benefits will be kept. Furthermore, future values of promised benefits are not interest rate sensitive.

Instead of driving asset allocation decisions through a ROA lens, let’s adopt a return to traditional pension management that views the plan’s liabilities as the most important variable in the asset allocation decision tree. It makes no sense that a plan that is funded at 60% should have the same asset allocation as one funded at 90%, but this happens all the time, as these plans are focused on achieving the same 7.25% ROA. Given the improved funding that we’ve witnessed, it is time to focus on securing the promised benefits at low cost and with prudent risk. 

Irrational Exuberance: ? or !

Remember when Alan Greenspan uttered this famous phrase? He spoke these two words at an American Enterprise Institute event in the 1990s. It was a reference to the stock market’s valuation during the Dot-Com go-go era. It was interpreted as a warning to investors that things had gotten too overheated. He was ultimately proven correct!

We think that pension plan sponsors, as well as any other type of investor, should heed this warning once again, as Irrational Exuberance seems to be everywhere today.

Stock market – Historically high multiples based on any fundamental analysis.

Bond market – 39-year bull market dating to July 1982

Single family homes – The median cost for a single-family detached house last month was $391,250, compared with $307,220 a year before (+27.4%)

Cryptocurrencies – What is it? It isn’t a currency. So, let’s pay $42,866.40 for one bitcoin that has no underlying value.

Also, let us not forget meme stocks, which are stocks that have seen an increase in volume NOT because of the company’s performance, but rather because of hype on social media. Now there’s an investment strategy for you!

Any one of these might give you pause, but all of them at the same time – oh, my! As we’ve stated on many occasions, after a successful run at a Vegas casino one should take some risk off the table. Pension plans would be wise to follow the same course of action. There is little from that list above that is suggesting to us that pension systems will be able to generate the types of returns that we’ve witnessed since the Great Financial Crisis and that they are banking on to reduce contribution expenses.

Now is the time to cash in those gains while simultaneously protecting the improved funded status/funded ratios. Defease your plan’s Retired Lives Liability as far out as possible providing your plan the opportunity to wade through potentially troubling markets in the foreseeable future. It would be a shame to see this funding progress wasted through complacency, or worse, neglect.

What’s The Impact Should Rates Rise?

The US Federal Reserve has just released a report stating that inflation is running “hotter” than expected. That probably won’t come as a surprise to anyone buying nearly anything today. So, what happens to your fixed-income portfolio should we get continuing inflation that ultimately leads to higher rates? Well, if your pension plan is invested in a traditional fixed income product managed to a generic index, your bond portfolio’s principal will decline in value by 1% for every one-year of duration and every 1% increase in yields. Invested in a 5-year duration strategy, your portfolio will decline by 5% should interest rates back up 1%. Given where interest rates are your fund’s total return isn’t going to be protected much through income. We’ve been in a protracted bull market environment for US bonds since roughly July 1982. Fixed income managers and their clients have benefited tremendously from this tailwind. Is the bond party nearing its conclusion?

Plan sponsors of pension plans need fixed income if for no other reason than to have the cash necessary to meet monthly benefit and expense needs. Is there an alternative to sitting in a portfolio that will likely suffer principal and total return losses? There sure is! A portfolio of investment-grade corporate fixed income cash flow matched to your plan’s liabilities and expenses will provide significant protection from interest rate risk, as both the assets and liabilities will move in lock-step with one another. Actuarial projected benefits and expenses are future values which are not interest rate sensitive. By cash flow matching liabilities with bonds, you have eliminated interest rate risk which is by far the dominant risk in bonds.The Ryan ALM cash flow matching model (Liability Beta Portfolio™) is a corporate bond portfolio skewed to A/BBB+ securities. This LBP will outyield liabilities when discounted using ASC 715 rates of AA corporate bonds. This will produce some Alpha by the difference in yield (+/- 50 bps).

Furthermore, the cash flow matching portfolio (CDI) provides additional benefits. Importantly, because your cash flow needs are now taken care of for some period of time – we recommend 10-years – the non-bond assets (alpha assets) can now grow unencumbered, as they are no longer a source of liquidity. Studies have shown that the reinvestment of dividends is a major contributor to the S&P 500’s return over time. In fact, some studies that I’ve seen allocate 50% to 60% of the return coming from dividend reinvestment over periods greater than 20 years. In addition, both the funded status and contribution expenses should be more stable given this approach.

A pension plan’s asset allocation should be dynamic. It should be driven by the plan’s funded status and projected liabilities and not the return on asset assumption (ROA). There has been terrific progress made by many pension systems as a result of out-sized performance during the period since the Great Financial Crisis. It would be truly devastating to have those wonderful gains lost because we remained complacent thinking that yesterday’s great results were likely to happen once again. Now is the time to convert your fixed-income exposure from an allocation that will work against your fund should rates rise to one that insulates your portfolio against this great risk. Oh, and as rates rise, the CDI investment strategy gets to reinvest excess income at higher interest rates. That’s another benefit to adopting this approach. Call us. We’ve written the book or at least the chapter on CDI (Frank Fabozzi’s latest book).