Milliman is reporting that the aggregate funded ratio for the U.S. Multiemployer pension system improved to 82% from 74% during the first six months, as they estimated that the average plan’s investment gain was 13.4%. It has been a great start to the year for investments, but this metric masks what has truly happened to Pension America in general and multiemployer plans specifically.
As we reported in our October 8, 2019 blog post “How Have DB Plans Faired in 2019”, our fairly conservative asset mix is up 15.7% through September 30th. Regrettably, multiemployer plans (as well as public funds) continue to discount plan liabilities at the ROA (roughly 7.25%). Of course, a dramatic outperformance by the asset side of the equation looks great versus a static discount rate, but the reality is much different. We know that U.S. interest rates have plummeted this year. According to Ryan ALM, valuing liabilities using the U.S. Treasury STRIPS curve has liability growth at 17.6% YTD (9/19). With this view, we see that pension system asset allocations have actually failed to keep pace with the liability side of the equation. In this case, there is no way that the funded ratios have improved, let alone dramatically.
Why is this important? First, asset allocation decisions should reflect the funded status of a plan, and as plans get better funded they should take risk off the table. Doing this based on incorrect information compounds the problem. Second, plans often review benefit decisions (enhancements) when a plan’s funded status sits at certain levels. Thinking that your plan is better funded than it actually is would likely lead to inappropriate decisions. I first witnessed this when I was a consultant to a large state plan in the late 1980s – this issue continues today.
Milliman is also reporting that those plans currently identified as critical and declining did not show the same relative improvement. This is not surprising given their significant call on capital each and every year. As we’ve argued for many years, these plans need a significant infusion of capital in order to survive. They can’t grow their way to success with a significantly declining asset base let alone discounting liabilities at a true rate.
The fact that we still operate under multiple accounting rules for discounting liabilities is just wrong. There may be pain initially with a true accounting for the value of the promises, but once that data is known we can begin to solve the true problem. Pretending that liabilities are X when they are in fact some factor greater than X needs to stop. It is time to wake up and face the truth.
As regular readers of our blog know, we spend most of our effort focusing on pension-related issues generally and the importance of knowing one’s liabilities more specifically. However, we do depart from our mission periodically to bring to our readers interesting and hopefully timely topics. One such topic is currency management. As U.S. institutional clients have gotten more comfortable investing overseas in a variety of strategies, the management of currencies has taken on greater importance. The fact that the U.S. $ has continued to strengthen versus most foreign currencies creates a bit of urgency for the U.S. investor.
For years, I’ve been under the impression (incorrectly, I now realize) that currencies wash out over time and as a result, they shouldn’t be a primary concern. Well, like most relationships in our investment world, cycles can be rather lengthy providing the investor with ample opportunity to capture potential alpha from these currency cycles. I’ve recently uncovered a terrific paper from 2016 by Mark Astley, CEO, Millennium Global Investments on the subject of currency management, and I thought that it should be shared. Please don’t reach out to me with any questions as you would be barking up the wrong tree, but I suspect that they would be more than happy to respond. I hope that you find this article as useful as I did.
There is a day designated for almost everything that we can imagine, so I shouldn’t have been surprised to read that today is World Math Day. Let’s celebrate! Another fact that I didn’t know is that those living in NJ hate Math??? According to the folks at Brainly, a math tutoring company, NJ ranks just behind Tennessee as the state whose residents hate Math the most. Rounding out the top five states with the most Math haters would be Virginia, Arizona, and Maryland.
Now, we have often railed about the demise of DB plans in favor of DC plans because we are asking a lot of our citizens when it comes to funding, managing, and then disbursing a retirement benefit. We’ve commented that it is a difficult math problem for even those that like Math at places such as MIT. Trying to figure out how much to put aside, if there is anything to put aside from one’s paycheck after all the necessities have been covered, so that an appropriate nest egg may be accumulated is very difficult. In years past, workers were generally confident that they had some control over their careers, but as we have found out, one’s employer may have a very different expectation as you enter the later stages of your working life.
Couple the funding challenge with myriad options for investing your hard-earned contributions and you have a second difficult challenge. Yes, I understand that target-date-funds (TDFs) have made it somewhat easier for the average individual, but these vehicles come in all shapes and sizes, and they aren’t cheap by any stretch of the imagination. I still have a problem understanding how an individual’s allocation has gotten more conservative later in life when most of the assets are plowed into fixed income when the 10-year U.S. Treasury Note has a yield of only 1.74% (as of 10/15) and bonds have enjoyed a 30+ year bull market, but that is what seems to be the general course of action.
Finally, we have the mind-numbing issue of how to spend down your accumulated retirement benefit. Many people are leery of spending it too quickly. But for many others there is the fear of the unknown. How long am I going to live? What will my medical expenses be as I age? Will I (or my spouse) need a residential facility later in life? We know how ridiculously expensive long-term care can be. The traditional DB pension plan protected those fortunate to have one by providing a monthly check that eliminated the need to address many of the uncertainties as we age.
I like Math, but more importantly, I’ve spent 38 years in the investment management industry so the daunting task of managing a DC plan is less stressful for someone like me. Unfortunately, it isn’t for the average worker. Our citizens have enough to worry about. They shouldn’t have to wonder if a proper retirement will ever be in the cards.
I stumbled on an article in The Orange County (CA) Register, titled “Pension Obligation Bonds Are A Poor Fix For Pension Debts”. The gist of the argument is that by engaging in the use of a POB, one is simply transferring the debt from the public pension system to the sponsoring municipality, while basically kicking the can down the road to a future generation to pay for the current liability. While there is some truth to the fact that utilizing a POB doesn’t necessarily tackle the underlying issues that got the plan to this point, POBs aren’t necessarily bad on the surface. I believe that they have been implemented incorrectly which has given them the poor reputation that they have in many circles.
Trying to play the arbitrage between the bonds interest rate (say 3.5%) and the plan’s return on asset assumption (ROA at 7.5%) has led to many of the issues. Trying to time markets is inherently difficult. If a POB is injected into a traditional asset allocation at the top of a market cycle, the sponsoring entity might just realize a significant loss on top of having to repay the bond. The Center for Retirement Research at Boston College has done extensive work on POBs and the aftermath.
We believe that the proceeds from a POB should be used to defease the Retired Lives liability ensuring that the promised benefits are now absolutely protected. The current corpus and future contributions will now go to fund any residual Retired Lives, terminated vested and Active Lives liabilities. Importantly, the plan sponsor now has the benefit of an extended investing horizon in order to generate the necessary return to accomplish the objective, while covering near-term liabilities with the proceeds from the POB. There are no timing games to be played. No lost benefits (multi-employer plans are facing this currently) due to deteriorating funded status.
This cash flow matching defeasement strategy is the backbone of the Butch Lewis Act legislation (H.R. 397) that has passed through the House of Representatives but now awaits action within the Senate. We’d be pleased to share with you our expertise on how one implements a cash flow matching strategy, and why we think that it is superior to injecting POB assets into a traditional asset allocation with the HOPE that markets will behave appropriately.
I am looking forward to speaking at the upcoming IFEBP in San Diego. I’ve been asked to speak about “Modern Asset Allocation”, which is a great topic. One of the key points that I will make is that plan sponsors should be looking to separate their Retired Lives from Active Lives liabilities and as a result, they should split the assets into beta and alpha assets resulting in two very different asset allocations. Historically, assets have been managed within the construct of one asset allocation and for the specific purpose of besting the return on asset assumption. That approach has generally failed, as the primary objective in managing a DB plan should be to SECURE the benefits and not eclipse a ROA target that is a made-up number in the first place.
Retired Lives are the most imminent and most certain liabilities. They are best funded by cash flow matching with bonds. On the other hand, Active Lives liabilities are the longest dated and most uncertain, and as you can imagine, come with a lot of actuarial noise. These assets need time and as a result, they are best funded with Alpha assets, which are your growth assets that are lowly correlated to bonds, as liabilities are very bond-like in nature.
In our modeling, we recommend that Retired Lives liabilities be cash flow matched for the first 10 years. This strategy creates an extended investing horizon for your growth assets (Alpha) that benefit from the passage of time. As the chart below highlights, stocks will outperform bonds over longer investing periods – not always – but with a high probability of success.
The Active Lives liabilities will now be matched against a higher octane portfolio of assets that benefit from the fact that they will no longer be a source of liquidity in the portfolio. As year one passes, extend the beta portfolio back to 10 years and keep this process going each and every year. This strategy works for plans that are well-funded as well as those that are less well funded. Intrigued? Call us.
We are pleased to share with you the latest Ryan ALM quarterly newsletter (9/30/19). As you will see, despite strong market returns achieved so far in 2019, DB pension liabilities have witnessed rapid growth as U.S. interest rates continue to fall, especially in longer maturities. See how pension liabilities have dramatically outperformed asset growth since the end of 1999. This is one of the primary reasons that pension America has seen an amazing exodus from offering DB plans in favor of DC offerings.
We have some other good stuff in this edition. Furthermore, we are always encouraging feedback and challenges to our ideas. Please don’t be shy. We are here to answer any of your questions.
How have defined benefit plans faired in 2019? That depends very much on how you measure pension liabilities. If you believe that liabilities and assets grow at the same rate (the ROA under GASB), then 2019 is a very strong year for pension America’s public funds and multiemployer plans. If, however, you believe that liabilities should be measured on an economic value basis, 2019 is proving to be a challenging year once again.
Let’s take a look at the numbers. Using a generic, and fairly conservative, asset allocation to represent pension assets of cash (5%), bonds (30%), domestic equities (60%) and international equities (5%), one gets a return of 15.7% year-to-date through September 30th. For plans that use GASB to measure and monitor liabilities, a 7.5% ROA objective would have liabilities appreciating by 5.6% YTD. Under that microscope, Pension America would be enjoying a banner year.
However, the Society of Actuaries produced a seminal piece in 2004 titled, “Principals underlying Asset Liability Management (ALM)” that stated the following: “Accounting and actuarial measures can sometimes distort economic reality and produce results inconsistent with economic value.” Given their desire to see the facts, and nothing but the facts (thanks, Sergeant Friday), let’s look at how pension America would be doing this year if plan liabilities were shown on an economic basis. According to Ryan ALM, liabilities valued at the Treasury STRIPS curve would produce a 17.6% year-to-date return exceeding asset growth by 1.9% so far.
For corporate America, the year is even more challenging, as liability growth under ASC 715/FAS 158 would be 21.6% YTD. Ouch! What is right? Do we truly believe that assets and liabilities grow at the same rate? We know that liabilities are highly interest-rate sensitive and are bond-like in their price movement. Do we value equities and bonds at the same growth rate? Of course not. Given the recent significant move down in U.S. rates, liability growth has been robust. What we need is a protracted and sustained period of economic growth, a bit more inflation, and finally rising rates to keep liability growth in check. In that environment liability growth could actually produce a negative return, making it far easier for assets to outperform liabilities. Regrettably, inflation isn’t on the horizon, economic growth is waning globally, and U.S. interest rates are not likely to rise substantially from these depressed levels. But, pretending that your liabilities have only grown by 5.6% YTD is very ostrich-like.