Ryan ALM’s Q4’20 Newsletter

We are pleased to share with you Ryan ALM’s latest insights related to how pension assets and liabilities performed in 2020. As you will note, despite a very strong rally in equities during the final 8 months of the year, liability growth (under FASB accounting rules) outpaced asset growth once again.

In addition to our views on pension liabilities, there are numerous blog posts and research ideas contained in this newsletter covering other topics of interest. As always, please don’t hesitate to reach out to us with any questions and/or comments. We welcome your feedback.

Fundamentals Can Become Disconnected

There are multiple examples throughout time when the price of an “investible” item has gotten tremendously out of whack from the underlying fundamentals. There are examples of prices rising well beyond what the underlying story would justify and examples of when prices have collapsed in anticipation of a changing fundamental landscape. We likely have a couple of such stories developing today – perhaps Bitcoin and some of our technology stocks on the upside and many value stocks that have been pummeled representing attractive opportunities to explore on the downside.

One opportunity that presented itself early in 2020 reversed course so quickly that one would have to have been in the positions already and hung on or an investor would have to have been so agile to move quickly to take advantage of the opportunity. For most U.S. pension systems that dynamic capability just doesn’t exist. As the chart below indicates, yield spreads for U.S. corporate bonds blew out versus comparable maturity U.S. Treasuries in March of 2020. The sell-off in those bonds and the subsequent widening of yield spreads occurred nearly overnight. However, the rally and tightening of yield spreads has been nearly as rapid.

Investment grade corporate yields currently sit at just under 100 bps of spread versus Treasuries. This is about as tight as they’ve been in the past decade or so. However, that yield advantage still provides a very nice cushion should a rare default occur. In addition, that premium yield compounds each year of any bond’s existence. As you may recall, Ryan ALM uses corporate bonds almost exclusively in implementing our cash flow matched portfolios of assets versus pension liabilities. We were recently retained by a corporate plan to provide a cash flow matching portfolio for a vertical slice of the plan’s liabilities (about 12% of projected liabilities over 80 years). Because of our yield advantage we were able to create an incredible 30%+ funding cost savings on the future value of the plan’s liabilities.

The U.S. investment-grade corporate bond market has changed dramatically over the years. Long gone are the days of multiple AAA rated securities. Today we have nearly 70% of new issuance being BBB, and that has led to an investment-grade universe with more than 50% in BBBs at this time. Fortunately, defaults remain rare, but that doesn’t mean that strong credit research isn’t imperative – it absolutely is. Given that bond yields in general are near historic lows, bonds should not be viewed as performance generating instruments in this environment. They should be used for the cash flow that they generate through coupon, reinvestment of the coupon, and maturity. Now’s the time to adjust your asset allocation to reflect this reality and use cash flow matching with investment grade bonds as the liquidity core portfolio. Call us – we’ll help you think through an appropriate strategy.

Is There A Correlation?

Who needs cellular tracking when you have United Van Lines? The U.S.’s largest moving company keeps track of moving patterns and produces the results in an annual survey each January called the National Movers Study. Anyone who keeps up on the news will have a general idea of where people are going to and leaving from, and for a variety of reasons, but this study lays it all out there for everyone to see. For instance, is it surprising to read that Idaho led the country this year in inbound migration given some of the issues facing their neighbors to the West?

I got excited for a moment when I read that New Jersey was ranked only 48th until I realized that Alaska and Hawaii were not included in the study. Vermont wasn’t included either because of the small sample size, and they were replaced by the District of Columbia. So, NJ is in fact last in this category. Oh, it is good to be king!

Because I am always focused on pensions and pension-related issues, I began to wonder if there might be a correlation between the funded status of each state’s public pension system and their rank in the inbound/outbound tables. The funded status data that I was able to gather is through December 31, 2018. There does seem to be a pattern, but it may just be coincidental. For instance, the top 10 inbound destinations had an average funded ratio of 52.9% while the bottom 10 (includes #39 Maryland) had an average funded ratio of just 41.6%. If you eliminate from each data set one state that seems not to belong (NY at 60% from the outbound list and SC at 34% from the inbound list) you get a difference that grows to 15.4% (55% versus 39.6%).

In reality, how many citizens are staying up on pension deficits and the impact that those might have on current and future tax policy? Then again, they may have already been feeling the effects of higher taxes (sales, income, property, etc.) from escalating contribution rates in places like NJ, CT, IL, etc. As you know, I am a huge fan of DB pension systems, but that doesn’t mean that I don’t think that there shouldn’t be changes in how they are managed on a day-to-day basis, especially when it comes to asset allocation decisions. By focusing more attention on the plan’s promise (liabilities) to their participants, asset allocation can be more responsive to changes in the asset/liability relationship. By bifurcating plan assets into both beta (bonds) and alpha (everything else) buckets, a plan can improve liquidity, eliminate interest rate risk, extend the investing horizon for the alpha assets, and use bonds more appropriately for their cash flows, while also stabilizing the funded status and contribution expenses.

There are no guarantees, of course, but a little change in the funded status of your state’s public pension plan may just encourage your residents to stay, while attracting others from around the U.S. Why not give it a try?

Please, Please DON’T

I read something recently that had me shaking. Someone was suggesting that the recent run-up in the price of a Bitcoin was being driven by demand from pension plans. Please tell me that isn’t the case. The US pension system is in difficult enough straits from a funding stand-point. We don’t need to be gambling on Bitcoin’s price movement or any other cryptocurrency for that matter. Oh, and by the way, Bitcoin’s recent ascent to $42,000 per coin over the weekend was short-lived as the price this morning (10:15 am EST) is $34,557 for a quick 18% loss in just a couple of days. Please also remember that we’ve seen this roller-coaster ride before, as Bitcoin rose to >$19,000 only to fall rather quickly back to earth and settle at <$3,200 within 12-months ending December 2018.

6 in 10 – Outrageous!

According to a new Kiplinger survey, nearly 6 in 10 Americans withdrew or borrowed money from their 401(k) “retirement” funds. Of that 60%, 58% withdrew or borrowed from $50,000 to $100,000. These are shocking statistics! I’ve claimed for years that the transition that occurred in our retirement industry from company sponsored defined benefit plans to defined contribution plans was going to create a huge crisis, and here is the proof! Defined contribution plans are nothing more than glorified savings accounts masking as retirement plans. They were never intended to be anyone’s primary retirement vehicle, as they were designed to be supplemental to a traditional pension plan.

Not only did Americans withdraw huge sums from these plans, but many companies ceased contributing matching funds once the pandemic hit. This double whammy has about 1/3 of respondents to the Kiplinger survey contemplating staying in the labor force longer. In fact, 55% now expect to work beyond 65-years-old. However, according to AARP (2/19) only 20% of Americans 65-years-old or older are actually working or looking for work at this time, which is double from 1985. What is the likelihood that 55% of older Americans would be able to secure work to help supplement their retirement income?

Of further concern regarding the management of defined contribution plans is the fact that roughly 70% of those surveyed indicated that they had a least 20-years left of work until retirement. Yet the average asset allocation to stocks/equities was only 35.7%. Unfortunately, cash was the second largest allocation at 23.8% and bonds third at 17.3%. Federal Reserve policy has certainly crushed cash and bonds from providing meaningful returns. Furthermore, 41% of those polled changed their allocation to stocks during the pandemic, with only a small percentage indicating that they had increased exposure after the significant sell-off in March. Why should we expect any other outcome? Why do we think that these participants are going to be able to fund, manage, and then disburse this “retirement” benefit with limited education and experience in this subject?

At the same time that retirement dreams of those stuck with a DC plan are being dashed because of Covid-19 and the impact that has had on our economy and labor force, we have Congress neglecting to address the pension crisis within multiemployer plans, despite the fact that outstanding legislation passed through the House of Representatives in July 2019. What a mess. If you think that income inequality between the haves and have-nots is great today. Just wait to you see what it looks like when there are no longer any DB plans – public or private – and the only way to potentially retire is through a DC offering. Can it get any uglier?

Another in the Series of Ryan ALM’s, “Believe It Or Not!”

The graph above compares major asset class index benchmarks versus the Ryan U.S. Treasury STRIPS indexes as a yield curve of 30 distinct indexes. This analysis provides a picture (more than 1,000 words in my humble opinion) of the relative risk/reward of each asset class versus the risk-free Treasury STRIPS yield curve. Since liabilities are to be priced as zero-coupon bonds, the Ryan Treasury STRIPS yield curve indexes are a good proxy for the economic risk/reward behavior of pension liabilities. Importantly, please note there are no equity index benchmarks that have outperformed liabilities for the same relative volatility (i.e. risk) for the last 20-years through December 31, 2020.  Foreign equity exposure, as measured by EAFE, has dramatically underperformed during this time.

The only indexes to outperform STRIPS during this 20-year period are fixed income related. But, here’s the rub: most plan sponsors have been reducing their exposure to fixed income during this lengthy period of falling interest rates fearing that lower bond yields would create lower future returns and become a drag on the total pension fund’s ability to achieve the return on asset assumption (ROA). The primary reason to own bonds, despite a 20-year period of outperformance, is for their cash flows. Separating the plan assets into Beta (bonds) and Alpha (non bonds) assets helps pension plans to improve and designate liquidity to meet the promised benefits, eliminate interest rate risk, buy time for the alpha assets to perform (and they may need 20+ years, as we see from above), and stabilize the funded status. That is a strong array of benefits from a minor tweak in strategy.

Given where equity valuations are at this time, does it really make sense to continue to look at the asset allocation as a single bucket? Separate your assets Beta (liquidity) and Alpha (growth) and buy time for your portfolio to potentially recover from periods of underperformance. The last thing anyone wants to do is force liquidity into the portfolio to meet benefit payments when asset prices are falling. That strategy failed miserably in 2000 – ’02 and certainly 2008. It won’t do any better during the next major correction.

The Difference between Ryan ALM and Ryan Labs

Founder Ronald J. Ryan explains: In answer to several requests and obvious confusion, I would like to clarify the difference between Ryan ALM, Inc. and Ryan Labs, Inc.

I was the Director of Fixed Income Research and Strategy at Lehman Bros. from 1977 thru 1982. There I designed the popular Lehman bond indexes, which became the industry benchmarks (and still are as Bloomberg Barclay indexes). In 1983, I started my first company Ryan Financial Strategy Group (RFSG) to continue doing fixed income research and helping investment advisors understand the Lehman indexes and bond math. We created an on-line research system called The Knowledge Network which analyzed the bond market thoroughly. RFSG was sold to Sanwa Bank in 1987.

In 1988 I founded Ryan Labs as a fixed income investment advisor specializing in bond index fund management. We did quite well and when I left in 2004, we had nearly $19 billion in fixed income assets under management. Ryan Labs was dear to my heart but overtime I knew that my future was in asset liability management. I strongly believe that the true objective of a pension is asset cash flows versus liability cash flows. Given our great success I knew it would be difficult and not fair to our investors to change the focus of our firm.

So, I left Ryan Labs and started on June 15, 2004 Ryan ALM, Inc. which as the name implies is dedicated to asset liability management (ALM). Our mission is to fund liabilities and secure benefits in a cost-efficient manner. We have built a series of innovative products to become a turnkey system to best achieve the true client liability objective. Our Liability Beta Portfolio (LBP) is a cost optimization model that will cash flow match liabilities at low cost and low risk. Our Custom Liability Index (CLI) will calculate all of the data needed for the LBP to work effectively. The CLI is truly the proper benchmark for any liability objective. The Ryan ALM web site is full of our topical research and newsletters to better explain how we solve many of the issues facing pensions and endowments & foundations today.

Sincerely,

Ronald J. Ryan, CFA    

WHY TIPS? They Don’t Hedge Pension Inflation!

Ryan ALM has written a lot on the subject of pension inflation and why it doesn’t make sense to have an allocation to TIPS in your pension plan since they don’t hedge pension inflation. Our extensive research on this subject can be found at Ryan ALM.com. That said, I wanted to highlight why in this environment it makes absolutely no sense to have an allocation to TIPS. Presently, TIPS at all maturities are offering a negative yield. For the 30-year maturity the yield is -0.36%. So, a plan is paying to own these bonds, as opposed to owning an investment grade corporate credit (BBB) that would pay roughly 3.11%, which is based on our universe of BBB bonds with maturities between 28-30 years.

Steve DeVito, Ryan ALM’s Head Trader, stated “it’s a gamble that inflation will rise significantly enough to provide a positive yield.” Furthermore, “after X number of years earning a negative yield how big of a positive yield and for how many years will an investor need to make up for lost income and do better than just breakeven?” Good question, Steve!

We’ve written a lot on the subject of maximizing the efficiency of the plan’s asset allocation. In all honesty, there is nothing efficient in allocating <3% to any strategy and thinking that it will provide value-added to 100% of a pension plan. In the case of TIPS, a <3% allocation is just creating opportunity cost, while becoming a drag on achieving the ROA or any other goal for that matter.

2020 – The Year Of The Long-bond – Again!

It won’t come as a surprise to many pension investors that Bonds have enjoyed an historic run. In fact, for most of my career, which now spans 39+ years, bonds have enjoyed a significant tailwind of falling interest rates. Unfortunately, this tremendous bull market run coincided with a significant decline in exposure to fixed income within both public and multiemployer pension plans, while corporate plans have increased their exposure as de-risking strategies ramped up. What may come as a surprise is the fact that 2020 has once again proven to be the year of the bond, not James, but the long bond and specifically, 30-year STRIPS.

Ron Ryan and his team were the first to create a U.S. Treasury yield curve index series back in 1983. When STRIPS were born in 1985, the Ryan team were again the first to create a U.S. Treasury STRIPS yield curve index series. According to our analysis at Ryan ALM, the U.S. 30-year Treasury auction index and the 30-year Treasury STRIPS index both outperformed the S&P 500 for calendar year 2020. The Treasury 30-year index gained 19.7% and 30-year STRIPS index was up 25.4% versus the S&P 500 at 18.4%. The return for the S&P 500 was quite impressive given the significant market correction experienced during the first quarter, but it once again paled in comparison to long-bonds.

Do you think that this was a one-off result? Hardly. For the 20-year period ending December 31, 2020, the 30-year Treasury index outperformed the S&P 500 by 0.7% / annum (8.0% vs. 7.3%). Given the historically low level of interest rates, long bonds may not continue to be the performance drivers that they have been historically. But we believe that the intrinsic value in bonds is the certainty of their cash flow. We highly recommend bonds as the “core portfolio” to cash flow match liabilities chronologically. In addition, equities may be overvalued given the historic high P/E multiples that they currently carry.

Most defined benefit pension plans are in significant negative cash flow situations in which benefit payments dwarf contributions. These mature plans need liquidity and forcing liquidity to meet those monthly payments may result in a pension plan trying to raise liquidity through the sale of equities and other performance assets. As a solution, a cash flow driven investing (CDI) bond strategy is just the right prescription for your liquidity needs that will buy time for your performance assets to grow unencumbered. Please don’t hesitate to reach out to us to learn more about improving liquidity in your plan

CDI: Growing Momentum, But Confusion still Reigns

There recently appeared on the Global Banking and Finance Review website an article on cash flow-driven investing (YES!), titled “How Can DB pension Schemes Make Effective use of Cashflow-driven investing?” The article summarized a whitepaper from CAMRADATA based on insights shared by industry experts that attended a virtual conference in October.

Sean Thompson, Managing Director, CAMRADATA said, “Cashflow Driven Investing (CDI) is predominantly a bond-focused approach which can be used to try and generate cashflows and increase returns. It can also help reduce funding volatility.” We agree with most of what Mr. Thompson shared. Where we differ relates to his comment about “increase returns.” CDI is all about generating cash flows used to match pension liability payments. A plan sponsor engages in this activity to secure the promised benefit while reducing the funding volatility. The use of CDI should not be driven by the hope of enhanced returns.

In addition to Mr. Thompson’s thoughts expressed above, other key takeaways are listed below. I’ve included the Ryan ALM thoughts on these points in bold, and as you’ll read, we do have a differing opinion on several of these insights. 

               • As many defined benefit pension schemes are now cash flow negative CDI has become much more important. (We couldn’t agree more.)

               • The primary benefit of CDI is the increased certainty of the outcome. (Absolutely) One guest emphasized that for most of their clients, managing short term cash flows was not a challenge. The big uncertainties instead lie five years out and beyond. (We recommend using a CDI approach to cash flow match the next 1-10 years of benefits and expenses. Liquidity is not always available during market disruptions. Why exacerbate a potential loss by forcing liquidity where it may not exist?)

               • The breadth of research from managers is important because it brings diversification into the portfolio. (I don’t really know what this means?)

               • One guest thought that there would be new developments in CDI pooled products and noted that they were working on new pooled CDI products for smaller schemes that would be well diversified by combining public and private debt, next year. (We disagree… a CDI approach is tailored specifically to a plan’s liabilities, and every liability stream is as unique as a snowflake. It makes little sense to commingle assets when each client has very different liability cash flows.)

               • Allocation to illiquid private assets might not suit schemes that are very close (say two years) to the endgame of buyout, but for many other smaller schemes that are further from such an endgame, private assets could be very helpful. (We agree! The use of a CDI approach makes for a more efficient asset allocation by buying time for the alpha or growth assets to grow unencumbered.)

               • They pointed out that the probability of default has gone up. This is relevant to CDI and brought the conversation back to credit research and having the expertise to properly stock pick. Credit researchers these days are gold dust: adding that portfolio managers need real-time updates. (Ryan ALM uses mostly corporate bonds in its CDI portfolios providing for enhanced yields and lower cost. However, it does require a commitment to on-going credit research, which is important in any market environment. Ryan ALM puts corporate bonds through a series of solvency filters to determine an approved list of credits.)

               • A final point was made on collaborations, with one panelist pointing out that they had been working with a range of pension fund consultancies, to provide more than just fund management to help clients with their de-risking journey towards the endgame. CDI is one path to that ultimate destination. (CDI is the most prudent and appropriate strategy for de-risking a pension since it creates the certainty of asset cash flows with a focus on future value matching of liability cash flows. Duration matching strategies focus on present value matching, which creates an uncertain future value to MATCH benefit payments chronologically.)

As I stated earlier, we are very pleased to see the growing interest in CDI, but there are as many different approaches as there are managers implementing them. As with any investment idea, the strategy is only as good as the firm that implements it. Ron Ryan, and now Ryan ALM, has been engaged in this activity for 4+ decades. We’d be happy to share with you our thoughts on the subject and our unique skills.