But, Is It The Smartest Beta?

It seems that Smart Beta strategies are all the rage these days. What used to be alpha factors (momentum, size, quality, low-vol, etc.) are now being isolated as smart beta factors leading to indexes being reweighted to take advantage of these exposures. But, in reweighting the index exposures are they not engaging in active strategies? One should be asking if these factor exposures always outperform, and of course, the answer is an unequivocal NO! Furthermore, what is the capacity of some of these exposures?

If one wants to truly engage in a beta exercise, shouldn’t they identify the “smartest beta” portfolio, which is the portfolio that best matches and achieves the true client objective with the least amount of risk and cost? Risk is best measured as the uncertainty of achieving the objective. Cost is the amount required to fund the objective. The true objective of most institutions and even individuals is some type of liability (annuities, banks, insurance, lotteries, NDT, OPEB, pensions, etc.). The absolute level of volatility of returns is not risk given a liability objective.

The most appropriate and smartest beta portfolio is the one that matches the liabilities cash flow.  In essence, the smartest beta portfolio is a custom liability index fund. Such a portfolio should be the core portfolio for any liability objective.  By matching the liability term structure the uncertainty of matching liabilities is eliminated and interest rate sensitivity is neutralized. By matching the liability term structure with bonds that have higher yields and lower present values (price) than the discount rates used will lead to cost savings. Since the accounting rules (ASC 715, IASB, and PPA) use AA zero-coupon discount rates then a liability beta portfolio of As and BBBs will produce higher yields and lower costs that will lead to cost savings of approximately 10% to 15%. Thus, the smartest beta portfolio is a liability cash flow matched portfolio!

 

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The Pension Objective

The pension objective is to secure benefits in a cost-efficient manner.

New York city employees retirement system (NYCERS) defines the pension objective well in the first sentence of their actuarial report:

“The financial objective of the New York City Employees Retirement System (the “Plan”) is to fund members’ retirement benefits during their active service and to establish employer normal contribution rates that, expressed as a percentage of active member annualized covered payroll, would remain approximately level over the future working lifetimes of those active members and, together with member contributions and investment income, would ultimately be sufficient to accumulate assets to pay benefits when due”.

As NYCERS attests, the true pension objective is to fund benefits such that contribution costs are stable. Unfortunately, since 1999, most defined benefit pensions have been hard hit by spiking contribution costs, which are perhaps 10x higher than 1999 (NYCERS has actually witnessed a shocking 43x higher expense). Such increased contribution costs have become the pension crisis that Ryan ALM has documented and monitored for decades. Reducing and stabilizing contribution costs would be a much-needed solution to this pension dilemma.

We will be producing a series of blog posts on how one can reduce pension costs. In the meantime, if you can’t wait to get the answers you can always reach out to us (rkamp@ryanalm.com).

The Problem with De-risking Hedges

Many plan sponsors are coming to realize that subjecting their pension system’s assets to the whims of the market may not be the most prudent action to be taken. As a result, they are actively searching for strategies that might aide them in taking risk off the table in an attempt to stabilize their plan’s funded status and contribution expense. Unfortunately, they have in many cases pursued duration-matching strategies (Immunization), Interest Rate Swaps, futures, derivatives, risk overlays, etc. which are all hedging tools to help assets match the liability growth rate. Regrettably, they are NOT de-risking strategies since they do not match the liability cash flows (benefit payments). Duration matching hedges have several difficult data gathering choices particularly with determining the average duration of a plan’s liabilities.

Importantly, where do you get the average duration of liabilities? Most, if not all, actuarial reports do not provide this calculation. Furthermore, they do not provide the projected liability benefit payment schedule, which you would need to calculate duration. In addition, the fact that actuarial reports are lagged (3-6 months) annual reports there would be seriously delayed information. In addition, the duration calculation coincides with a precise moment in time. As time and interest rates change, so will the duration calculation. Only A Custom Liability Index (CLI) based on each pension’s unique liability benefit payment schedule could provide an accurate and monthly duration profile from which to accurately de-risk a pension plan.

A Whole Lot of Nothing

There appeared an article in P&I that reviewed recently implemented asset allocation changes of a massive nature for CalPERS. The largest U.S. public fund ($376.3 billion) shifted more than $150 billion in assets, including investing 15% in new products such as factor-weighted equities. In addition, they added a 3% commitment to high yield and a 1% allocation to a liquidity bucket that could range from 3% to -6% depending on opportunities provided by the market. Yes, leverage may be used if the markets provide unique opportunities.

We’ve discussed these allocation moves before (not specific to CalPERS) as nothing more than shifting deck chairs on the Titanic. The costs associated with shifting $150 billion in assets (commission, market impact, and opportunity cost) must have been massive. Given that they have failed to achieve their primary return objective for 1-, 3-, 5-, and 10-years through fiscal 2019 certainly speaks to needing to do something, but focusing exclusively on the return side of the equation remains the wrong strategy.

This statement attributed to Eric Baggesen, managing investment director for asset allocation, who said that he “expects the system to conduct a mid-cycle asset liability review”, confuses me. I’m not sure what a mid-cycle asset liability review is, but the fact that plans continue to allocate assets without the knowledge of what their liabilities look like or are performing is just silly. You wouldn’t be able to play a sport if you didn’t know how your opponent was performing, but that is precisely what happens in DB pension land every day.

Despite strong market returns for many asset classes in 2019, asset growth is barely exceeding liability growth as U.S. interest rates continue to plummet. Plans that have cash-flow matched their bond exposure to near-term liabilities (Retired lives) have actually insulated themselves from these unprecedented moves in rates by improving liquidity and removing interest rate sensitivity while extending the investing horizon for the alpha (growth) portfolio that is used to beat future liability growth.

Do they really believe that shifting assets among a variety of products and asset classes will stabilize the funded status and contribution expense? Glad to see that they have acknowledged that the plan has liabilities, but not managing to them on a regular basis does little to improve their fate.

Categorically Wrong!

There has been another article written by Rachel Greszler this one appearing in the Daily Signal that attacks legislative efforts to save struggling multiemployer pension plans. I have many issues with this article, such as the claim that H.R. 397, which is now before the Senate, would put taxpayers on the hook for $638 billion. That sum is a ridiculous exaggeration. That value is assuming that all multiemployer plans fail while using a risk-free discount rate to determine the potential unfunded liability.

She also claims “insolvent union pension plans would receive taxpayer dollars to invest in the stock market, as well as loans to cover their broken pension promises.” This is just not correct! Plans that are designated as in Critical and Declining status can file for a loan. The amount of the loan will be determined by the cost to defease all of the retired lives. The proceeds from the loan MUST be used to immunize those retired lives. The proceeds will not be used in a traditional asset allocation like the proceeds from pension obligation bonds (POBs). Plans are NOT allowed to play the arbitrage game between the interest rate charged on the loans and the targeted ROA.

I find it very funny that she can complain about the legislation’s $48 billion price tag spread over 10 years, but little is heard from her regarding the $1+ trillion deficits that the Republican Senate continues to create on an annual basis. Does she forget that the failure to provide this earned benefit will push most of these pensioners onto the Federal safety net? The cost of a pay-as-you-go safety net is far greater than providing a lifeline through a loan program in which nearly all of the plans are expected to repay the loan in 30 years.  The original analysis done by Cheiron had only three plans needing additional assistance through the PBGC.

There are problems in how these plans have been managed over the years, but much of that has been the fault of the accounting standards that forced plans to operate in a certain way.  For anyone who doubts this impact, I would encourage you to please read Ronald J. Ryan’s outstanding book, “The U.S. Pension Crisis”.

Unfortunately, we live with the consequences.  However, we now must address this major problem, and the loan program within H.R. 397 is the very best plan to solve this crisis before roughly 1.3 million American workers find that the promise that they were given is totally empty!

What Is Your Objective?

On August 6th we wrote a post titled, “Not The Correct Objective”, which received a lot of positive feedback. One of the commenters shared the following:

An older gentleman currently retired and living in Boca Raton, Florida was asked how he was able to retire to such a lovely place, and he responded that he was fortunate to have saved some money and made some good investments during his working years. The person asking the questions then asked if his investments had beaten the market. Our retiree quickly commented that he had no idea, but he didn’t think it mattered since he was able to retire to Boca.  We agree!

A plan sponsor shouldn’t be overly concerned with achieving the ROA if in fact her plan has built enough assets (through investments and contributions) to meet the promised benefits. As we’ve mentioned many times, the present value of future liabilities will rise and fall with changes in U.S. interest rates. In a flat to rising interest rate environment, asset growth doesn’t have to exceed the ROA objective to be able to beat liability growth. Unfortunately, most pension plans don’t see how the liabilities are performing on a quarterly basis, so comparing assets to liabilities, the only thing that matters, is an impossible exercise.  That is regrettable.

That Seems Aggressive

According to the Boston College Center for Retirement Research, state and local pensions now have on average 77% of their pension assets in equities or alternative investments, such as private equity and real estate. This is a dramatic change from 2001 when the average plan only had 67%. The significant move into equity-like strategies is likely fueled by the need to boost returns in a challenging environment for increasing contributions. Unfortunately, the increased exposure guarantees more risk, but not necessarily the corresponding return.

Who knows whether or not this lengthy bull market for equities is nearing its end (I certainly don’t), but pension systems that are in significantly negative cash flow conditions cannot afford the consequences from another devastating market correction.  By converting the current fixed income exposure to a cash flow matching strategy designed to match the nearest benefit payment as far out as the exposure will permit, a plan can significantly reduce the negative impact of a market decline on the equity exposure that no longer is a source of liquidity.

It makes no sense to continue to put all your chips on the table when just a little tweak to the portfolio can help reduce the risk of a major correction crushing the plan’s funded status. Public pension systems’ contribution rates are already testing taxpayer resolve in a number of situations. Let’s not give them more fuel for their fire!