Milliman’s Q1’22 Public Fund Update

By: Russ Kamp, managing Director, Ryan ALM, Inc.

The Milliman organization produces an outstanding report each quarter that covers changes in the funding levels for both corporate as well as public pension systems. The Public Pension Funding Index (PPFI) report was released recently and it covers the top 100 public pension defined benefit plans through March 31, 2022. According to Milliman, the top public pension systems recorded investment losses of roughly 3.4% during those three months resulting in a funded status deterioration of $167 billion. The collective funded ratio declined from 85.5% at the end of 2021 to 82.7% on March 31, 2022.

Public pension systems operate under GASB accounting standards which allow pension liabilities to be valued using the return on asset assumption (ROA) as the discount rate to price liabilities. This discount rate is static and doesn’t reflect changes in the US interest rate environment. The good news for public pension systems is that pension liabilities are like bonds. The present value of those liabilities would fall in a rising rate environment if priced on a market value (economic) basis. Yes, pension assets have struggled so far in 2022, but we believe that the average public pension system’s longer duration liabilities would have struggled more. As a result, the $167 billion estimated loss in funded status may not be correct and may actually have improved on an economic basis despite the struggles in the capital markets. Ryan ALM provides a quarterly Newsletter on pension funding. You can check out our Q1’22 report at 

ARPA Update through May 20, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Happy to report that there was some more activity related to ARPA and the rescue of struggling multiemployer plans during the last week. As of this writing, there have been 25 ARPA SFA applications approved by the PBGC including two more last week. The newly approved applications were for the Management-Labor Pension Fund Local 1730 ILA and Iron Workers Local 17 Pension Fund which collectively covers 2,378 plan participants. The funds are seeking roughly $110 million in SFA grant money. Since the inception of the ARPA program, 13 funds have received grants totaling just under $2.4 billion.

Two more plans filed their initial SFA applications last week. There are currently 12 applications with the PBGC awaiting action. To date, none of the previous applications that have been filed were rejected. As I reported this morning, it appears that we are getting close to receiving the Final, Final Rules from the PBGC on how this legislation should be enacted. Perhaps news of that development will inspire those Priority groups, 1, 2, and 3 plans that have remained on the sidelines to finally file. More to come! Have a great week.

An Answer from the PBGC – Finally?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Good morning to all my friends in multiemployer pension systems that have filed or will soon file applications with the PBGC to receive Special Financial Assistance (SFA) grants under ARPA. I have just been informed that the PBGC’s Final, Final Rules are with the Office of Management and Budget (OMB). This has always been an important step in the process of getting the final guidelines from the PBGC approved. Let’s hope that this review process can be handled swiftly. Equally important, let’s hope that these final rules don’t create potential harm.

What do I mean by that? I’ve been very consistent in expressing my opinions that the intent of the legislation was to SECURE the promised benefits for as long as possible. The securing of benefits chronologically can only occur through a cash flow matching defeasement strategy, as bonds are the only asset that has a known terminal value (par) and a set of future income cash flows (semi-annual interest). These asset cash flows can be used to match and fund liability cash flows (benefit payments). Let’s not bring uncertainty into this process by expanding the restricted investment list to include stocks, real estate, private equity, etc. These assets don’t do anything to secure the promised benefits. They bring greater volatility and uncertainty, which goes against the legislation’s intent.

This pension legislation is potentially helping millions of Americans gain (regain) more retirement security. It is the first real rescue of the promises made to pension participants in a long time. I am praying that the updated guidelines don’t set this effort backward.

Why is Buying Time so Critical?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

As most investors appreciate, trying to time the markets can prove to be a fool’s game. We know that timing the tops, bottoms, and dips is incredibly challenging and often leads to excessive turnover coupled with transaction costs that can erode potential value-added. As a result, it is best to remain in the equity markets through thick and thin, but does that mean you do nothing? Of course not. The graph below only goes through August 2019, but it dates back to 1970 and clearly demonstrates the impact on the total return to the S&P 500 when missing just a couple of handfuls of trading days.

Do you have the strategy in place to remain patient?

First, the plan’s investment policy statement (IPS) must clearly highlight a targeted allocation for equities (S&P 500 in this case) with an appropriate range above and below that target used for rebalancing purposes (+/- 5%?). The graph above highlights the impact of an all-or-nothing strategy, which pension systems would likely never engage in, but they should bring discipline to the asset allocation process by taking profits when equities have demonstrated enough outperformance relative to other asset classes to have the allocation reach the upper band. Equally important is the realization that stocks will provide value over the long term. Forcing a buy decision at the bottom of an allocation band, although it may not be easy, is the right decision in the long run.

That said, we have a tendency in our industry to seek liquidity wherever it can be found in order to meet the required monthly benefit payments and expenses. This often leads to assets having to be sold when enough liquidity cannot be found. Unfortunately, this may lead to selling equities near the bottom of their market cycle instead of buying them at that point. One way to avoid this unfortunate occurrence is to put in place an asset allocation strategy that divides the assets into liquidity (beta) and growth (alpha) buckets that each have a specific role within the portfolio.

In our model, the liquidity bucket uses investment grade fixed income to meet all of the plan’s cash flow needs. Bonds are the only asset with a known semi-annual cash flow (interest payment) and terminal value at maturity (par) which is why bonds have always been used to defease liabilities (pensions, lotteries, NDTs, OPEBs, and insurance companies). This liquidity bucket will be used to meet all of your ongoing liability cash flows as long as the allocation lasts. We recommend sustaining a 10-year allocation, if possible, by back-filling (rebalancing) the bond cash flow matched portfolio on an annual basis.

Creating a liquidity bucket will permit the alpha assets to grow unencumbered. There will be no forced selling of these assets during periods of challenged liquidity. During market downturns similar to what we are currently experiencing, there will be no temptation to sell, as you’ve built a 10-year horizon for your equities to wade through the troubled waters. Importantly, your fund gets to reinvest the dividends back into the equity market instead of using them as a cash proxy. Studies that we’ve highlighted previously suggest that the S&P 500 derives a significant percentage of its total return from dividends and the reinvestment of those dividends (as much as 48% on a 10-year moving average).

Having all of your eggs (assets) in an asset allocation basket singularly focused on a return on asset (ROA) assumption, as our industry continues to do, has created volatility of returns but no guarantee of success. We believe that the primary objective in managing a DB pension plan is to secure the promised benefits in a cost-efficient manner and with prudent risk. It is not the achieving of the ROA. Split your assets into two buckets. Allow the liquidity bucket to take care of all your funding. Doing so will allow you to sleep better at night knowing that you have the participants’ benefits covered and you’ve now bought time for your equity assets to grow unencumbered. It is a win, win!

This Result shouldn’t Be Surprising

By: Russ Kamp, Managing Director, Ryan ALM, Inc

Everyone knows that this has been a very challenging year for traditional fixed-income programs. In fact, it has been the most challenging year in the past 40-years. As of yesterday, May 16, 2022, the Bloomberg Barclays Aggregate index is down -9.52% YTD. With US Treasury yields rising across the yield curve today, that Agg index will be off some more. It still seems like everyone uses the Aggregate index as the primary benchmark to compare Core and Core+ fixed income managers. As a reminder, my colleague, Ron Ryan, created the index back in the ’80s when he was the Director of Research at Lehman Brothers.

What does the index look like today? The Aggregate is a very large and diversified portfolio of bonds with the following summary statistics as of March 31, 2022:

# of issues9,982Treasury39.80%AAA68.92%
Duration6.58 yrs.Mtg. Backed29.90%A11.16%
Avg Maturity8.78 yrs.Corporates26.30%BBB15.38%
BB Aggregate Index as of March 31, 2022

This poor performance result has been created despite the heavy emphasis on AAA-rated securities and a fairly modest duration of only 6.58 years. As a result of the higher quality emphasis, the yield to maturity (YTM) is only 2.92%. If the US Federal Reserve is true to its recent pronouncements, there is likely much more pain ahead for both fixed income advisors and plan sponsors. In addition to the potentially large negative return, fixed income portfolios are a source to fund benefits and expenses. Because most traditional fixed income products are return-focused and not cash flow matched to the pension system’s liability cash flows, bonds in these accounts will likely be sold at losses and this cost to transact may escalate in a rising rate environment where liquidity is not abundant.

Now, let’s compare that scenario to a cash flow matched portfolio used to SECURE the promised benefits. Ryan ALM just constructed a cash flow matched portfolio for a multiemployer plan that is expecting to receive SFA grant assets. The size of the allocation and the current rising interest rate environment allowed us to fully defease 29-years of benefit payments with the SFA proceeds! A homerun! Furthermore, the YTM of our portfolio is 4.68%, or 176 bps greater than the yield on the Aggregate index. Although the modified duration is slightly longer at 8.84 years, our portfolio is defeasing future values (benefit payments) that are not interest-rate sensitive. The plan’s liabilities and these assets will move in lockstep. That is certainly not guaranteed when using a traditional total return fixed income mandate.

Those advantages alone are incredible and certainly favor using a cash flow matching strategy to secure the promised benefits, but when you also factor in the greater liquidity (no forced selling) and the “buying” of time for the remainder of your assets to wade through choppy markets, the decision to use a cash flow matching strategy instead of a total return mandate becomes a no-brainer.

Spread Widening – It’s been Significant

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I suspect that most participants in the capital markets are aware of the implications of rising US inflation and the impact it has had on US interest rates so far in 2022. The US Federal Reserve has certainly raised awareness by twice elevating the Federal Funds Rate by a total of 75 basis points so far with a clear message that more is to come. Perhaps much more! What might be less apparent to the average investor is the impact of widening corporate credit spreads relative to Treasury securities.

My colleague and Ryan ALM’s Head Trader, Steven DeVito, has put together the following chart highlighting the major widening (yield change in the right two columns) that has occurred this year:

How wide will they go?

What we have witnessed so far is a widening of AA versus comparable Treasuries, but more important is the credit spread widening of BBBs versus AA. What was a 58 bps difference has ballooned to 90 bps as of last Friday. This action can have a profound impact on total return bond programs especially if there is a need for liquidity in the portfolio. On the other hand, credit spread widening has little to no impact on existing cash flow matching portfolios as the bonds are held to maturity.

On a positive note, wider spreads reduce the cost of defeasing pension liabilities when constructing new portfolios. As we’ve mentioned in previous blog posts, higher US interest rates and wider corporate credit spreads are creating an environment in which the cost to defease a pension liability stream is falling and in some cases, depending on the maturity of the program, quite significantly! We’ve just created a Liability Beta Portfolio™ for an SFA recipient that covers 30-years (to 2051) and generates a >40% savings on the cost of those future benefit payments. Who wouldn’t be pleased with that result?

Steve has promised to continue to monitor this widening situation. It will be interesting to see how high US interest rates go and just how wide the corporate spreads get. We may be able to provide benefit security for pennies on the $.

ARPA Update as of May 13, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Following a flurry of activity during the previous three weeks, the PBGC and Special Financial Assistance (SFA) candidates took a well-deserved breather, as no new applications were either filed or approved. In addition, none of the 13 approved plans waiting to receive the SFA received those payments last week. There remain 12 applications still to be approved, including Priority Group 3 member the Central States, Southeast & Southwest Areas Pension Plan that covers nearly 365,000 plan participants. To date, nearly $6.5 billion in SFA has been approved and just over $2 billion awarded. Those sums will look quite paltry once the Central States plan gets its approval, as they have filed for a grant in excess of $35 billion.

Perhaps this will be the week that we get the Final, Final Rules from the PBGC. While we’ve waited for the final implementation criteria, we have seen US interest rates rise substantially. The good news: the cost to defease (and secure) the promised benefits has fallen allowing for potentially more benefits to be paid from the SFA grants and for longer. This is one of the few benefits of a rising interest rate environment.

Message for ARPA SFA recipients: Beware of What Fixed Income Securities You Buy!

By: Ronald J. Ryan, CFA, CEO, Ryan ALM, Inc.

The American Rescue Plan Act became legal as of March 11, 2021. Section 9704 of ARPA provides Special Financial Assistance (SFA) to pension plans who are in critical funding status as follows:

“The amount of financial assistance… shall be such amount required for the plan to pay all benefits due during the period beginning on the date of payment of the special financial assistance payment under this section and ending on the last day of the plan year ending in 2051, with no reduction in a participant’s or beneficiary’s accrued benefit…”.

It seems apparent that the SFA section of ARPA requires the funding of benefits beginning on the date of the SFA payment. This means funding benefits chronologically as far out as the SFA grant can fund. Based on how the SFA is calculated, plans will not come close to securing 30-years of benefits, but they should strive to defease and secure as many years as possible chronologically.

What we know:

  • The SFA assets must be segregated from the fund’s legacy assets
  • Based on the Interim Final Rules, only Investment-grade bonds can be used for investment purposes

Funding and Securing the promised benefits:

The only way to secure the promised benefits for as long as possible is to use a cash flow matching strategy (currently called cash flow driven investments (CDI)) that matches and funds liability cash flows with asset cash flows (income, principal, and re-invested income) chronologically.

WARNING: Managing bonds to a generic bond index will NOT cash flow match liability cash flows. Every pension plan has unique projected benefits (and expenses). No generic bond index could possibly have asset cash flows that match the unique liability cash flows of any plan sponsor.

The Ryan ALM turnkey process:

Ryan ALM starts with the plan sponsor’s actuarial projections to create a Custom Liability Index (CLI) that best measures and monitors the plan liability cash flows and should become… the plan’s index benchmark!

We then produce a cost-optimized cash flow matching portfolio (Liability Beta Portfolio™ or LBP) that will maximize the SFA assets by securing the promised benefits at the lowest cost to the plan through our model. Importantly, bond math drives the cost optimization model. The longer the maturity and the higher the yield… the lower the cost to fund liability cash flows. The longest maturity in the LBP will not exceed the longest benefit payment that is to be cash flow matched. 

Based on the CLI data, Ryan ALM will build an LBP portfolio by overweighting longer maturity, higher-yielding investment-grade bonds (skewed to A/BBB+) within the area funded and in compliance with the client’s investment policy constraints. For instance, if the SFA can secure 8-years of benefits based on the output from the CLI, the longest maturity in our portfolio will be 8-years. The LBP will be carefully crafted to match the liability cash flow needs chronologically as far out as the SFA allocation will support. The portfolio will be 100% corporate investment-grade bonds with a heavy emphasis on A/BBB+ rated bonds to optimize cost savings (higher yields produce > cost savings). It should be noted that the corporate bond investment-grade universe is heavily skewed to A/BBB which provides our LBP with a great selection of securities.

Once the LBP has been constructed, the plan’s assets and liabilities will move in lockstep. It does not matter the direction of interest rates as the cash flows are matching future values which are not interest-rate sensitive. This is a significant advantage of using a cash flow matching approach instead of a total return-oriented bond product.

Why one shouldn’t use a total return-oriented bond program:

Bonds are interest-rate sensitive. The longer the maturity the greater the interest rate risk. Bond prices fall when interest rates rise. After a 39-year bull market for bonds and historically low-interest rates, it is highly likely that interest rates will continue to rise from current levels especially given current inflation trends and Fed monetary policy. If the SFA assets are managed against a generic bond index and rates continue to rise, there is a serious mismatch of asset cash flows versus the liability cash flows as well as negative returns on the bond holdings. As a result, it is likely that some of the portfolio’s holdings will have to be liquidated each month to meet cash flow needs causing losses on the bonds and subjecting the portfolio to liquidity risk. The most popular bond index benchmark (Aggregate) is heavily skewed to very low-yielding Treasury/Agency/AAA bonds with a high percentage in long-maturity bonds. As a result, using bonds for a total return focus certainly doesn’t fund and secure benefit payments in a cost-efficient manner.

Proper Fixed Income Strategy To conform to SFA requirements, adopt a cash flow matching approach for the grant proceeds which will secure the promised benefits chronologically in a cost-efficient manner. Avoid adopting a total return focus of bonds managed to a generic bond index which will mismatch asset cash flows versus liability cash flows. Avoid taking losses for immediate liquidity needs. Using bonds as required under SFA can eliminate the need for a bond allocation in the legacy assets that can now grow unencumbered to meet liabilities past the horizon that the SFA funds. This should enhance the ROA and the funded status which could reduce contribution costs.

Given the wrong index objective… you will get the wrong risk/reward!

He Said What?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Ryan ALM is a (THE) leading voice within the US Pension community regarding the need to protect and preserve defined benefit (DB) pension plans through de-risking strategies. We’ve been imploring plan sponsors to adjust their focus away from the return on asset (ROA) assumption as the primary goal to one where SECURING the promised benefits at a reasonable cost and with prudent risk. Our fear continues to be associated with the asset allocation roller-coaster that pension systems ride. We are currently on the downward slope of another trip and for how long and how far is anyone’s guess. At what level of funding will the plan be at when the cart begins its journey back up?

Institutional Investor is out with a recent article highlighting the fact that Q1’22 produced the largest $ amount of pension risk transfer (PRT) activity ever at $5.5 billion and those involved in the conversation expected that robust trend to continue and perhaps accelerate given what is transpiring in our capital markets. They were focused on the asset side of the equation coming under pressure from a number of influences such as inflation, rising US interest rates, the war in Ukraine, etc. There was very little discussion focused on the fact that funded ratios improved during the quarter as a result of higher US rates impacting the discounting of pension liabilities to a greater extent than markets impacted asset levels.

What grabbed my attention the most, however, had to do with the points that were made by Serge Agres, Managing Director, Cambridge Associates. Serge to his credit said that “plan terminations are expensive.” He believes that plan sponsors may be “overpaying for a minuscule amount of risk protection”. Importantly, Agres believes that the best option for plan sponsors is to manage risk through asset allocation. We at Ryan ALM have been saying for years that a carefully constructed cash flow matching strategy can dramatically reduce the cost of securing future benefits and expenses. In fact, we believe that we can save the plan sponsor roughly 20-25% of the cost that would be associated with a PRT or lift-out. Of note is the recent Milliman study showing that corporate pensions are now so well funded that they have turned pension expenses into pension income for the first time since the 1990s. If the main reason for a pension risk transfer (PRT) was the cost hit to an income statement, then this “problem” may have now become a positive effect on income statements.

Agres further stated that “a good liability hedging strategy…can reduce a lot of your risk from things like equity markets or interest rates.” Hear, hear! We couldn’t agree more! As we’ve stated, bi-furcate the plan’s assets into liquidity (beta) and growth (alpha) buckets. The liquidity bucket will consist of bonds, whose cash flows of principal, interest, and re-invested interest will match and fund the plan’s liability cash flows chronologically from the next payment as far out as the allocation will go. The alpha bucket is everything else that is found in your fund. The alpha assets now have time to grow unencumbered. The splitting of assets into these two buckets will mitigate interest rate risk as future benefit payments are not interest-rate sensitive. Liquidity is certainly improved, as all the payments are met by the beta bucket.

We applaud Agres for thinking outside the box when it comes to pension management. Again, these plans need to be protected and preserved. Shifting the pension liabilities to an insurance company doesn’t accomplish that objective and it is expensive. We recommend that you maintain your plan. The rising US interest rates may just provide the corporate plan sponsor with pension earnings, as opposed to pension expenses. Lastly, keeping a DB pension plan alive may just be a way to minimize the impact of the “Great Resignation”.

It is only 1/2 the Story!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There appears in today’s WSJ an article titled, “Pensions’ Bad Year Poised to Get Worse”. The writer of the article, Heather Gillers, references data from the Wilshire Trust Universe Comparison Service (TUCS). As she describes, the first quarter of 2022 for public pension systems was the most challenging from a return standpoint since before the pandemic with the median fund producing a -4.1% return. Performance has obviously continued to deteriorate since the end of the quarter with both bonds and stocks recording double-digit declines. But is that the full story?

Yes, the asset side of the pension equation has performed poorly recently. However, pension plan liability growth has been even more negative. You’ll find that public pension funding has actually improved when one uses a discount rate that is more responsive to changes in the interest rate environment, such as FASB’s ASC 715 rates (AA corporate yield curve) rather than the return on asset assumption (ROA) used under GASB accounting. The appropriateness of the discount rate is a major issue with public pensions. Given GASB accounting rules, public pension liabilities have been habitually understated since US interest rates fell below the ROA target (@ 1988). As a result, the true cost of offering these pension promises has been masked as US interest rates fell to historically low levels.

Now, the relationship of assets vs. liabilities (funded status) may be entering a more favorable environment despite the lower asset values witnessed so far in 2022. The duration of a public pension’s liabilities is likely 12-15 years. A 1% move up in rates creates a significant negative return for pension liabilities, which are bond-like in nature. Assets don’t need to achieve the ROA in such an environment. A -4.1% asset return may look just fine compared to a reduction in the economic present value of plan liabilities that decline by 10% or more.

With all due respect to Heather and all the reporters covering Pension America, there should be no reporting of pension asset performance without the context of how the liability side is performing, too. As a reminder, we believe that the primary objective in managing a pension plan should be to secure the promised benefits at both reasonable cost and with prudent risk. The pension objective is not achieving a specified return (ROA). With this understanding comes the ability to make more informed decisions regarding asset allocation, asset management, and performance measurement.