We are working with a public fund prospect on a cash flow matching project to secure benefit payments as far out as the current fixed income allocation will permit. In our normal implementation we would cash flow match each monthly benefit payment (and expenses, if desired) chronologically. This particular project is unique in that this plan is cash flow positive through 2028. The current allocation to fixed income would allow for the matching of benefits from 2029 to 2033. Given the positive cash flow situation we were asked why the plan sponsor should implement the strategy now as opposed to waiting until they become cash flow negative. Good question. Here, I hope, is a better answer.
Ron Ryan, CEO, Ryan ALM, preaches to me and others that the longer the bond, the lower the cost. In addition, the higher the yield, the lower the cost. By implementing our CDI approach in 2021 instead of waiting until 2028, we are able to save substantially more for that four year period then we would if we waited. In fact, by investing in bonds with maturities of 8-12 years, as opposed to 0-4 years, we are getting substantially more yield resulting in cost savings equal to 24.5% on the future benefit payments. A current 4-year implementation beginning one-month out would result in “savings” of only 3-5% given the historically low-interest rates in the 0-4 year range. It is important to note that the savings is realized upfront allowing for the savings to be invested in alpha assets.
Speaking of alpha assets, the plan sponsor can now extend the investing horizon 12-years for the non-bond assets to grow unencumbered. This lengthening of the investment horizon allows for the greater use of less liquid assets since they are no longer a source of cash flow. It should also result in a higher probability of success in achieving the required return on asset assumption (ROA) since bonds will be used exclusively for their cash flows and not as a source of performance.
Cash flow driven investing approaches have been around for many decades. They are the backbone of many insurance products and lottery systems, and once were the dominant strategy to ensure that the promised pension benefit was funded with little to no risk. Unfortunately, we as an industry moved away from this effective strategy and began to focus more on return than low cost and low risk. We believe that CDI strategies work in every market environment, but we believe that they are especially important in today’s low-interest-rate environment in which bonds are not performance drivers.
LOGIC: Uncertainty is risk. It is always more prudent to be able to budget expenses now than to wait for a better opportunity to come along, which just might not.
US Senators Patty Murray and Bobby Scott have written to the Government Accountability Office (GAO) requesting that they conduct a review of target Date funds (TDFs), as they have grown to more than $1.5 trillion in AUM within 401(k)s and other defined contribution plans. The GAO last conducted a study on these investment strategies in 2011. Murray and Scott are concerned about the potential deviation in performance, fees, risk management, and asset allocation among the various providers that can dramatically impact participants, especially as they near retirement. I personally think that this is a critical issue that needs to be thoroughly vetted, especially since TDFs are now the QDIA for most DC plans.
According to a recent NY Times article, “many of the major target-date funds tailored for people retiring in 2020, for example, had roughly 50 to 55 percent of their investments in stock funds.” One 2020 TDF, which has over $16 billion in assets, is reportedly 60 percent invested in stocks. Furthermore, dynamic adjustments in asset allocation are rarely witnessed. Is a conservative (heavier bond exposure) implementation really conservative in this environment of near-historic low-interest-rates?
The review consists of having the GAO respond to 10 questions. I’m particularly interested in eventually reading the response to question 6: What percentage of plan sponsors (and their consultants) select off-the-shelf TDFs? What percentage of plan sponsors select custom TDFs? Is there a material difference in the performance of off-the-shelf versus custom TDFs?
Like many asset categories in our industry, the biggest, not necessarily the best, firms seem to attract the most assets. There seems to be a similar bias among TDF selections. As mentioned previously, the GAO has been asked to evaluate this space out of concern for the wide variances in performance and other important characteristics. As the chart below reflects, they should be alarmed that near-term retirees could be impacted so harshly. In 2008, many 401(k)s became 201(k)s. That isn’t acceptable under any circumstance, but it is outright criminal for the 2009 retiree.
Let’s hope that the GAO’s review leads to some important action regarding defined contribution plans and TDFs. If we don’t have the ability as an industry to sustain defined benefit plans, let’s at least make DC plans more palatable.
Bonds have enjoyed an incredible bull market run since 1982. Is the rally finally done? Unfortunately, my crystal ball is no better than anyone else’s so I don’t know when bonds will finally enter a bear market, but I can surmise that we are much closer to that happening than at any time in the last 30+ years, as inflation is beginning to present itself throughout our economy. In fact, the WSJ is reporting this morning that consumer prices surged 4.2% in April from one year ago to the highest level since 2008. In addition, we have the chart below from the BLS highlighting the fact that significant segments of our economy have seen huge spikes in cost since 2000, and given the significant stimulus, 2021 continues to fuel these trends.
Given where U.S. interest rates are today, traditional core fixed income programs are NOT sources of return (performance). Exposure to bonds will likely weigh on pension plan sponsors and their asset consultants in their pursuit of an asset allocation strategy that will help them achieve the desired return on assets (ROA), as yields hover far below the median ROA objective. What should pension plans do? They should use their bonds (fixed income exposure) as a source of cash flow, as bonds are the only assets with a known cash flow AND terminal value. Plan sponsors should take advantage of these positive attributes to build a cash flow matching strategy (CDI) to defease pension liabilities, improve liquidity, eliminate interest rate risk, and extend the investing horizon for the non-bond assets (alpha assets). Another benefit here is that if interest rates rise as a trend, a CDI strategy can reinvest at lower cost and earn more income while fixed income performance strategies suffer especially on long bonds.
A CDI approach will also allow for less fixed income exposure than a typical asset allocation strategy, while achieving the benefits highlighted above. With less dependence on traditional fixed income approaches, more of the plan’s assets can be invested in products/assets designed to generate greater returns. A CDI strategy also buys time since it defeases liabilities chronologically. By extending the investing horizon, these higher octane products can grow unencumbered as they are no longer a source of liquidity to meet benefit payments and plan expenses. History tells us that given time the S&P 500 performs better and better. Moreover, dividends reinvested represent over 50% of the S&P 500 growth since 1980. Thus, a CDI implementation creates a much more efficient asset allocation for the plan sponsor.
The Bloomberg Barclays Aggregate index declined -2.6% on a year-to-date basis through April 30th, even with a 0.8% “rally” in April. Long-bonds (>10-years) produced at least a -10% return for the four months. It could get really ugly, and fast! Rising rates will not negatively impact a CDI’s efficacy, as both assets and liabilities will move in lock-step. This is certainly more palatable than witnessing significant underperformance from a traditional fixed income strategy.
I read with interest about a public pension system approving the issuance of a pension obligation bond (POB) to sure up their plan’s poor funding (this is not unusual in today’s environment). I applaud them for doing so, as the historically low-interest rates are providing a unique opportunity. However, the proposed implementation leaves a lot to be desired in my humble opinion.
As we’ve written before, POBs that have failed have done so because they have not captured the potential arbitrage that existed between the plan’s return on assets assumption (ROA) and the interest rate on the POB. That failure has led to increased costs when both the bond’s interest and the loss on the bond’s proceeds have to be paid. We believe that this failure has been caused by injecting the POB’s proceeds into the plan’s existing asset allocation subjecting those assets to the whims of the markets. Given the current fundamentals for both stocks and bonds, the risk of the markets working against this asset allocation is greater than it is being supportive.
The plan that I’m referencing recognized this issue and they plan to invest 1/6th of the assets each quarter hoping that dollar-cost averaging will smooth the returns and reduce the risk that they are injecting a significant sum of money at the peak of the market’s cycle. I’m glad to see that someone is thinking outside the box, but this strategy comes with the potential for significant opportunity cost, as the POB’s non-invested proceeds will be kept in very short-term instruments. This will clearly have an impact on the plan’s ability to achieve the ROA during the next couple of years.
We, at Ryan ALM, would suggest that the POB’s proceeds be used to cash flow match or defease the plan’s benefits and expenses for the next 10-years or more through cash flow matching with investment-grade bonds. This is where the bond allocation belongs, as a liquidity strategy. This strategy would provide for an enhanced yield relative to cash (cash flow match through a corporate bond portfolio) while securing the benefits and reducing the cost of future benefits through the defeasement. Furthermore, it is likely that only a modest portion of the POB’s proceeds would be needed to accomplish this objective. The remainder of the assets (we call alpha or growth assets) would then be used in concert with the existing corpus and future contributions to meet the plan’s future liabilities. Importantly, the cash flow matching creates an extended investing horizon for the growth assets to grow unencumbered, as they are no longer a source of liquidity. These Alpha assets can be managed more aggressively in strategies without bonds that provide a liquidity premium.
The longer the investment horizon the greater the probability of success. The S&P 500 doesn’t outperform bonds in every 10-year period, but they do so more than 80% of the time. Creating that extended horizon and removing the bond allocation improves the odds that the ROA will be achieved longer-term, if not enhanced. Furthermore, being able to secure the plan’s benefits and expenses for the next 10-years reduces the volatility of both the funded status and contribution expense. To repeat, our strategy secures benefits and expenses, reduces the future cost of these benefits through the defeasement, extends the investing horizon improving the odds that the ROA will be achieved while reducing the volatility of the funded status and contributions. Seems almost too good to be true: but it isn’t!
Ryan ALM has produced a position brief on various ALM strategies, including cash flow matching (CDI) and duration matching, but with a twist.
The purpose of duration matching is an attempt to match the interest rate risk sensitivity of assets to liabilities. The objective is to have the market value or present value (PV) changes (growth rate) in the bond portfolio match the market value or PV changes (growth rate) in liabilities for a given change in interest rates. But duration matching is only accurate for smallparallel shifts in the yield curve. However, the yield curve rarely moves an equal number of basis points at every point along the curve. For more info, Ron Ryan wrote a research paper “The Seven Flaws of Duration” while he was the head of Ryan Labs.
Fortunately, bond management evolved to remedy these flaws by using Key Rate Durations, which attempt to match the duration of multiple points along the yield curve. Key Rate Duration is an improvement over using a single average duration, but it still has several deficiencies, including the fact that duration is a present value calculation requiring pricing each projected benefit with a discount rate yield curve (i.e., ASC 715 discount rates). As a result, 30 annual benefit payments require 30 separate discount rates.
Further evolution within fixed income has brought us to Dollar Duration Matching (DDM). DDM matches the Dollar Value change per basis point change in yield for assets with the Dollar Value change per basis point change in yield for liabilities. When the Dollar Duration of assets is matched to the Dollar Duration of liabilities for every year in the term structure of liabilities, then DDM is the most preciseform of Key Rate duration matching because it matches the Key Rate durations at every point along the liabilities yield cure or benefits payment schedule (30 years = 30 key rate durations).
The Ryan ALM DDM approach greatly improves the accuracy of Key Rate duration matching by matching the Dollar Value changes in liabilities with the Dollar Value changes in assets across the term structure and yield curve for both assets and liabilities. The liabilities are represented by using a Custom Liability Index (CLI) to more precisely measure and monitor the dollar value movement in liabilities given any movement in interest rates.
Pension plans need to pay more attention to their plan’s specific liabilities. Using either CDI or DDM is a step in the right direction to securing the promised benefits, while reducing cost. Please don’t hesitate to reach out to Ryan ALM with any questions that you might have on either of these disciplines that we bring to asset/liability management.
We are pleased to share with you the Ryan ALM quarterly newsletter for Q1’21. As you will read, a terrific quarter was logged for both private and public pension systems that benefited from rising rates (liabilities down) and strong markets (assets up). The combination lead to improved funded ratios and funded status. We hope that you find our insights beneficial. As always, please don’t hesitate to reach out to us at (561) 656-2014 or visit us at ryanalm.com or kampconsultingblog.com. Thank you for your on-going support.
The WSJ has published an article today titled, “Corporate Bond Gauge Signals Dwindling Economic Risk”, in which they speculate that the narrowing of spreads for non-investment grade bonds (High Yield) relative to Treasuries reveals confidence in the economy’s rebound. But does it really?
“The average extra yield, or spread, investors demand to hold speculative-grade corporate bonds over U.S. Treasuries dropped below 3 percentage points this month to as low as 2.90 percentage points for the first time since 2007, when it set a record of 2.33 percentage points, according to Bloomberg Barclays data” (WSJ). As we mentioned the other day in our post, Private Pension Alert: Lock it in! Any reference to an event last accomplished in 2007 sends shivers down my spine.
I would say that there are a number of factors leading to this trend, including the need for yield in a low-interest-rate environment among retirees/pension plans. I would suggest that a spread this narrow signifies a market that has gotten ahead of itself from a fundamental perspective. Again, we are discussing non-investment grade bonds in this case. They are rated this way for a reason. Despite the fact that there has been a decline in the default rates recently, we live in an ever-changing landscape. According to S&P, “even though we expect very low funding costs through 2021, higher leverage and a large share of vulnerable corporates are likely to induce further defaults, resulting in the 12-month speculative-grade default rate rising to around 9% in the U.S.” Do you really want so little relative yield to navigate through such a challenging environment as the one described by S&P? I certainly don’t.
Again, we would suggest that one use investment grade fixed income for its cash flows and defease pension liabilities chronologically for the next 10 years. Don’t chase yield in when you aren’t getting paid to do so. This strategy will provide a longer investing horizon for the balance of your assets that will now have time to work through the uncertainties brought about by the global pandemic. 2007 may have started off on a strong footing, but we certainly know how it ended. Let’s not repeat the mistakes of the past.
Great funding progress has been made by the average US private pension plan that has benefited during the last 12 months from rising equity values and rising bond yields. As the chart below suggests (thanks, Mercer), the funded status for corporate America now stands at 95%, having risen from a low of 70% in 2012 and 77% just 12-months ago. Given this great progress, now is not the time to sit on one’s laurels. With equity valuations at all-time highs, we believe that corporations would be best served by locking in these tremendous funding gains, even if the goal isn’t to freeze, terminate, and/or engage in a pension risk transfer for your specific pension plan.
Despite the fact that US interest rates continue to be near their lows, a cash flow matching strategy designed to defease the plan’s Retired Lives Liabilities will secure benefits chronologically and protect the funded status even in a rising rate environment, as assets AND liabilities will move in lock-step. Continuing with a traditional asset allocation potentially risks underperformance from both equities and core fixed income, given the latter’s interest rate sensitivity. Furthermore, a cash flow matching strategy can be accomplished with cash bonds and doesn’t need to involve more esoteric instruments, such as swaps and derivatives, which can introduce a different set of risks and provide no cash flows.
The last time that corporate America enjoyed a funding surplus was 2007. We know what soon transpired. It would be tragic if market declines once again sabotaged the funded status. We also got close to full-funding in 2013, but a significant decline in interest rates conspired to drive the collective funded status much lower. We don’t know when or by how much markets will move, but given their current valuations, there is likely less upside than downside. Secure your gains! Just like in Las Vegas, when you win BIG… take chips off the table!
Fidelity Investments is out with their 2021 State of Retirement Planning Study. Given the impact of Covid-19 on many Americans, in terms of health, employment, etc. it isn’t surprising to read that pre-pandemic retirement plans may have been altered. What is surprising is the percentage of responders that indicated a negative impact. In fact, Fidelity is reporting that 82% of Americans said that their retirement plans have been impacted, with 55% indicating that retirement was likely pushed back by at least 2 years, and another 33% indicated that the delay may be 3-years or more. Ouch!
Importantly, 79% of the survey responders indicated that they had re-evaluated their priorities, as a result of the pandemic and many (36%) remain stressed about their ability to maintain a retirement nest egg: and they should be given the low level of US interest rates and significantly inflated multiples for equities that have been fueled by the short-term benefits from stimulus. That combination doesn’t bode well for future returns. Couple the investment concerns with the lack of longevity protection and professional management, and you have the basis for a lot of STRESS.
The demise of the traditional DB plan has created a lot of issues for Americans hoping to retire one day. Sure, some higher earning Americans have been able to stash away “significant” sums of money in a DC retirement account, but that certainly isn’t the norm for a majority of American workers. Furthermore, that balance is subject to great risk should markets experience similar results as those realized in 2000-2002 and 2007-2009 when 401(k)s became 201(k)s seemingly overnight. DC plans were originally contemplated as supplemental retirement vehicles. They should once again assume that role allowing for defined benefit plans to be the true retirement plan that it is.
I am pleased to share that I recently completed a webcast on behalf of the IFEBP. The topic was “Rethinking Pension Obligation Bonds”. POBs have gotten a bad reputation since their introduction in 1985, and several organizations, including the GFOA, continue to warn their members to steer clear. Given Ryan ALM’s unique implementation of the POB proceeds, we believe that our strategy increases the probability that the POB will be successful.
Important: Please note that the webcast is only available to members of the International Foundation. If you are a member, please log onto the IFEBP’s website and view the presentation there.
Please don’t hesitate to reach out to us at Ryan ALM if you’d like to learn more about our approach.