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!