Happy Thanksgiving!

I want to wish you and yours a Happy Thanksgiving holiday from my family and me (sorry, Calvin Russell Kamp, our youngest grandchild who didn’t make it into this picture). May the beginning of this holiday season be truly memorable! I wish that I could thank each person individually who has played such an important and meaningful role in who I am today, but there are just so many. THANK YOU! Your support and encouragement have been amazing.

As a nation, we are blessed in so many ways, but there are many among us who are in need of assistance at this time. During this holiday season, let us ALL strive to do just a little more to help our family members, friends, neighbors, and perfect strangers overcome their unique challenges.

In 1863, President Abraham Lincoln proclaimed that a day should be set aside to reflect on all our blessings. Lincoln saw the reason for thanks despite trying times (the country was in the grip of the Civil War). Given the challenging times that many in our country have faced this year (pandemic, fires, floods, hurricanes, poverty, etc.), a day such as Thanksgiving is critically important for all of us. Let us collectively make tomorrow better for all and as good as possible!

This is No Time to be Greedy

The WSJ’s Heather Gillers has published an article today highlighting the potential risk of a liquidity crunch due to asset allocation decisions that have significantly reduced both fixed income and cash, as more aggressive exposure to alternatives – private equity and debt, real estate, infrastructure, etc. – are pursued. We’ve seen this scenario play out before, and it wasn’t pretty, as E&Fs were forced to liquidate less liquid investments in alternatives to fund their spending needs during the 2007-2009 Great Financial Crisis (GFC). That activity exacerbated the selling pressure and lead to the development of secondary markets for many of the alternative investment categories. Are we nearing a similar liquidity cliff?

According to Heather and several sources including both Boston College and Boston Consulting Group, fixed income allocations have fallen on average from 33% to 24% within the public fund universe, while average cash reserves are <1% today. The thought that fixed-income assets could be a source of liquidity when equity investments were under pressure was a very reasonable assumption during the last 39 years of a bull market for bonds. However, the next equity market crash may be driven by inflationary pressures forcing US interest rates higher. In that case, all bets are off as to the ease by which bonds can be sold and cash raised!

The WSJ article quotes Ash Williams, the recently retired and renowned (rightly so) pension officer for Florida’s Retirement system, who stated “finding a strategy that can accomplish what bonds once did, providing yield in good times and accessible cash in bad, is “not a problem with an easy solution.”” We agree that using fixed income as a total return vehicle is the wrong use for bonds in today’s environment. However, we disagree that there isn’t an easy solution – sorry, Ash. Bonds should be used for their value… the certainty of their cash flow – period! A cash flow matching investment (CDI) would allow for plan sponsors to use less fixed income, while dramatically improving the liquidity to fund benefits and expenses while buying time for non-CDI assets to grow unencumbered.

Bifurcating the plan’s assets into beta (liquidity) and alpha (growth) assets ensures that the liquidity necessary to meet monthly benefit payments is readily available without having to force liquidity during turbulent market environments. The CDI implementation will use roughly 80% fewer assets to meet the projected benefits than a traditional bond portfolio, as the funding of benefits and expenses comes from yield, principal, and unused reinvested income. This is a much more efficient asset allocation implementation than the current practice of sweeping cash from wherever it can be found. It allows all of those alternative investments to grow unencumbered as they are no longer a source of liquidity. An additional benefit includes the elimination of interest rate risk on the portion of the portfolio that is being defeased through CDI, as cash flows are funding future benefits which aren’t interest-rate sensitive.

The primary objective in managing a defined benefit plan is to SECURE the promised benefits in a cost-efficient manner and with prudent risk. Putting all of your eggs in an alternative bucket and hoping to find liquidity when it is needed doesn’t seem to fit this definition. Equity markets are expensive through the lens of any traditional valuation. Searching for liquidity during difficult markets may prove more challenging this time and it may be necessary sooner than one thinks.

Leverage – A Double-edged Sword

There have been many investment strategies over the years that have incorporated some aspect of leverage, but it is rare to see a public pension system decide to use leverage as an overlay on its plan’s asset allocation. The CalPERS Board of Directors recently adopted a new policy in a 7-4 vote permitting the use of leverage at 5% of the plan’s total assets. This strategy certainly comes with risk and it is the risk that needs to be evaluated relative to the potential gains.

I find it interesting that CalPERS has only recently reduced the long-term (20-years) expected return on assets (ROA) to 6.8% from 7% earlier in the year. In a WSJ article written by Heather Gillers, the writer refers to a CalPERS presentation that highlighted the fact that the current asset mix would only provide a 6.2% return going forward, which is clearly short of the new return objective. She also states that the use of leverage “reflects the dimming prospects for safe publicly traded investments by households and institutions alike and sets a tone for increased risk-taking by pension funds around the country”. But does it? Are more plans going to use leverage to create greater exposure to certain asset classes given the “dimming prospects”? We would certainly hope not, especially given the current investing landscape in terms of valuations and fundamentals.

As a reminder, the S&P 500 declined by nearly 50% during two major market drawdowns to start this century. As a result, the funded status for pension America collapsed, while contribution expenses skyrocketed! Using leverage at 5% of CalPERS’ current asset level means that potentially $25 billion in greater exposure will be created synthetically. Can you imagine what will happen to contribution expenses should this implementation results in greater losses WHEN the market corrects? In addition to approving the use of leverage, the Board also increased exposure to both private equity and private debt, but there are no guarantees that these strategies will achieve their forecasted returns.

The primary objective in managing a defined benefit plan is to SECURE the benefits at low cost and with prudent risk. Do the additions of leverage and greater exposure to both private equity and debt accomplish this objective? I think not!

Funded Status Improvement – Now What?

PlanSponsor magazine is reporting on the improved funded status of DB plans following strong asset growth that offset a more modest rise in plan liabilities during October. Several organizations, including Ryan ALM, have “pension monitors” that are all reflecting similar improvements. In fact, each of the studies is estimating a funded status for corporate America in the neighborhood of 94% to 95% funded. In most cases, the reduction in the funded ratio during September’s market sell-off in equities was mostly reversed during the last month.

Now what? We believe that asset allocation strategies need to be dynamic or responsive and that decisions should be based on the plan’s funded status, with better-funded plans taking risk off the table, while those less-well funded maintain more risky implementations. Importantly, being responsive does not mean tactical. Trying to “time” market moves has proven incredibly difficult for nearly all market participants. Plan sponsors and their advisors should take full advantage of the improved funding to lock in the gains. We espouse using a cash flow matching (CDI) implementation to SECURE the promised benefits and plan expenses chronologically for as far out as the allocation will allow. This enables the plan to maintain exposure to more risky assets, as they now can grow unencumbered, but they are no longer a source of liquidity.

As the plan’s funded status/ratio improves port additional “profits” (portable alpha) from the alpha or risk assets to the CDI portfolio extending the period of Retired Lives liabilities that are being defeased. This process secures more of the promised benefits and reduces the volatility in the funded status that we’ve witnessed on multiple occasions during the last couple of decades.

Pension Stabilization – What is it?

We recently read an article (actually a paid commercial) from a large asset management organization that declared that traditional LDI was dead and that “pension stabilization” was to become LDI 3.0. For those interested, LDI 1.0 was the investment by corporate America in long corporate credit. An LDI 2.0 strategy consisted of “customized hedging strategies” including adding derivatives, SWAPs, completion funds, etc. LDI 3.0 is according to this firm a means to re-introduce alpha-seeking assets in lieu of “low returning and increasingly inefficient LDI programs”. They refer to it as a more balanced approach. A careful blending of modest excess return and low volatility.

We, at Ryan ALM, are flattered by this pronouncement, since we have been espousing a strategy very similar to LDI 3.0 for decades. We have recommended separating liquidity or Beta assets from growth or Alpha assets forever.  The Beta assets’ job is to fund benefits chronologically while buying time for the Alpha assets to grow unencumbered. Given the improved funding for pension plans, particularly private plans, we believe that sponsors should de-risk even more than before by adding to the Beta assets to de-risk liabilities chronologically. We absolutely agree with this asset management organization when they recommend that continuing to hold long-corporate credit is not a wise solution at the current level of US interest rates. Given the 39-year bull market in US bonds, we certainly don’t see much upside in holding long bonds that don’t necessarily provide the best hedge possible for DB plans. We remind everyone that the value in bonds is the certainty of their cash flows. The best way to apply this value is to cash flow match liability cash flows chronologically.

As a reminder, we believe that the primary pension objective should be to SECURE benefits at low cost and with prudent risk. Duration strategies don’t secure the promised benefits. They actually don’t even do a great job of matching liability durations with asset durations because durations change continuously and individual bonds are not impacted the same with changes in rates. The ONLY way to secure the promised benefits is either through a pension risk transfer (PRT) or through a cash flow matching (CDI) implementation. The CDI approach matches liability cash flows with asset cash flow in chronological fashion so that each month’s benefits (and expenses) are secured for as many months out as the allocation to the strategy will permit.

By implementing a CDI program (Beta assets) the pension system has improved liquidity to meet those monthly obligations, mitigated interest rate risk for the assets in the CDI program, reduced funding costs, and extended the investing horizon (bought time) for the alpha bucket to perform up to expectation. Furthermore, the CDI program (usually 1-10 years of benefit payments) will be far less sensitive to rising interest rates than the long-duration corporate credit used in LDI 1.0 helping to reduce the potential impact on the portfolio. We love the idea of creating a “sleep well at night strategy” that affords the plan sponsor and their advisors the comfort of knowing that liquidity is available when needed without having to force it during periods of market dislocation.

DB pension plans are critically important to the plan participant. Access to one is often the difference between possibly retiring or retiring with dignity. Great strides have been made to improve pension funding in all plan sponsor types since the Great Financial Crisis. It would be sinful to see this improved funding wasted by not reconfiguring the plan’s asset allocation to reflect the current market environment of excessive valuations for many asset classes. Keep your bond allocation short to intermediate given the current inflationary environment, secure your plan’s benefits, while buying time for the alpha assets to grow unencumbered. If this is pension stabilization – great! As indicated earlier, we’ve been doing this for decades. If you want to learn more we are always available to discuss. Good luck!

Is it Time to Go Back to the Future?

I haven’t had the opportunity to speak with Michael J. Fox, but I believe that he’d agree with John Lowell. According to the latest JOLTS release, there are approximately 10.4 million job openings in the US at the end of August 2021. US companies are clearly having a challenging time hiring and retaining their employees. Wage growth, which had been stagnant for decades, is finally providing some real growth, but wages alone don’t seem to be accomplishing the objective of “securing” new employees.

I referenced John Lowell above. John is an Atlanta-based actuary and partner with October Three Consulting LLC. He has more than 35 years of experience consulting on corporate retirement plans. His recent article in Benefits Pro is spot on! John has put his finger on three key areas of focus for corporate HR professionals, including:

  1. Recruiting and retention
  2. Diversity, Equity, and Inclusion (DEI)
  3. Guaranteed lifetime income for employees who fear outliving their savings

He further states that the most important of these from an employee’s standpoint may just be #3, as a retirement industry providing access to only DC plans is fraught with danger and disappointment. John understands that corporate America has pretty much put defined benefits in their rearview mirrors, but does that decision make sense in today’s environment? Both John and I think not! Anyone who reads this blog on a regular basis knows that I am a staunch supporter of DB plans, as asking untrained individuals to fund, manage, and then disburse a “retirement benefit” through a DC plan is an exercise in futility for many.

I hope that you’ll take the time (3-4 minutes) to read John’s article. His years of experience are shining through his words, which HR departments and corporate leaders would be wise to heed. Thanks, John!

They Got the Vote!

As mentioned earlier this week in a previous blog post, Norwich, CT sought support from town residents to approve a $145 million Pension Obligation Bond (POB). I’m happy to report that the community supported this initiative. Now the challenging part begins. How will they invest the proceeds? Will they inject the new contribution into the existing asset allocation and subject those funds to the whims of the markets or will they try to secure the promised benefits by defeasing the Retired Lives liability as far out as the allocation permits? As a reminder, we believe that the primary objective in managing a defined benefit plan is to SECURE the benefits at a low cost and with prudent risk. Defeasing the plan’s liabilities accomplishes this objective! It will be interesting to watch this story unfold. This one and the other 90+ municipalities that have issued >$10 billion in pension debt in 2021.

Pension Fund to be Stable in 22 Years – Really?

I can’t tell you how many times I’ve read articles about underfunded pension systems that are “on track” to be fully funded in x # of years. The most recent one claims that the fund will be stable in 22-years. However, what they fail to discuss are the actions required to achieving a fully funded status. First, the plan sponsor must make all annual actuarially determined contributions, which usually increase every year. Second, the assets must earn the actuarially determined ROA consistently for the next 22 years. But those are big ifs, especially when one looks at the fact that we are at historic lows in US interest rates and at historic highs in equity markets on basically any valuation tool.

What is the probability that the ROA will be achieved? Furthermore, the sequencing of returns can play a meaningful role in whether the return objective is met, especially since this is a closed plan that will have greater outflows tomorrow than 20 years from now. What this plan needs to do is to secure the promised benefits for the next 10 years or so. This action will insulate the plan from adverse market conditions that would harm the plan’s alpha assets. Buying time for these growth assets permits them to grow unencumbered, as they are no longer a source of liquidity.

Buying time would enhance the probabililty of achieving the actual ROA of these growth assets since they are not diluted to make benefit payments. The history of the S&P 500 tells us that dividends reinvested account for 48% of the total return on a rolling 10-year horizon since 1940 and it is even greater for 20-year periods.

Actuaries do a terrific job despite all of the uncertainty in forecasting benefit payments and expenses far into the future. But they aren’t magicians. There should be an expectation built into their forecast that not all of the inputs will be achieved as predicted. We’ve seen this situation play out time and time again. Given this understanding, perhaps a greater emphasis should be placed on the contributions, which reduces the reliance on markets thus improving the likelihood of success. Just a thought!

Norwich, CT POB – Will it Get Voter Support?

Norwich, CT residents (population 40,000) are going to the polls today to vote on a Pension Obligation Bond (POB) of $145 million. The pension system currently has a 59% funded ratio (under GASB accounting). The “need” to issue a POB is based on the fact that retirement costs have nearly tripled in the last decade. The city is proposing this issuance given the historically low interest-rate environment. City officials believe that they will be able to complete the sale of the bonds at a roughly 3% yield.

The issuance of POB debt in 2021 is near historic levels. In fact, 93 municipalities have issued debt year-to-date surpassing the total in every year since data was first kept in 1999. The $11.4 billion raised is eclipsed by only 2003’s total debt, which included Illinois’s $10 billion POB. We, at Ryan ALM, agree that the current rate environment makes POB issuance particularly attractive, but only if the proceeds are used to defease the Retired Lives liability. Historically, POB proceeds have been injected into the plan’s current asset allocation subjecting these new assets to the whims of the market. We have never liked this strategy and are particularly concerned at this point given US equity valuations, which are stretched no matter what metric is used.

The primary object of a defined benefit pension plan should be to secure the promised benefits at low cost and with prudent risk. It is not to take a flier on the markets HOPING to achieve an arbitrage between the bond’s cost and the targeted ROA, which in Norwich’s case is 7.25%. The drafters of the original Butch Lewis Act understood this concept that mandated that the loan provisions should be used solely to defease pension liabilities for as far out as the allocation would permit. We think that this is a prudent approach that minimizes the risk to the pension system, its participants, and the municipality’s taxpayers. We would be happy to provide interested readers with our turnkey system on how this is accomplished.

The Genie is Out of the Bottle!

We’ve talked about Bitcoin in previous posts. We’ve wondered what this instrument is in terms of an asset category because we think that the volatility in pricing would suggest that it isn’t a currency. Unlike the US $ and other fiat currencies, there is no willingness from these countries to accept Bitcoin as a payment of taxes due. Is it a commodity? I suspect that many supporters of Bitcoin and other cryptocurrencies would suggest that it is new age gold, but is it? What is the underlying value of a Bitcoin? At least gold has a use in the manufacturing of jewelry and in electronics. What can you do with a Bitcoin?

I bring this subject up once more because it has been announced that a public pension plan has invested $25 million in Bitcoin and Ethereum. The allocation to each has not been disclosed. The CIO believes that there will be long-term value-add from an investment in this cryptocurrency and believes that it does a better job of providing an inflation hedge than other asset categories. Bitcoin has been around for roughly 11 years. It has gone through a number of boom and bust cycles, but it hasn’t “lived” through an inflationary environment. I’m not sure how one can make a determination that it is the best inflation hedge let alone an adequate one.

Given the fact that there is no underlying value to a Bitcoin or any other cryptocurrency, the “investing” of $25 million is a purely speculative investment. But advocates would claim that Bitcoin has a limited issuance. That is true, but there are dozens and dozens of cryptocurrencies with no barriers to entry keeping others from being issued. Just look at Dogecoin for how easy it is to issue a crypto. So, cryptocurrencies in their entirety are hardly rare and limited.

Should pension plans be permitted to invest in purely speculative investments? Will this plan’s willingness to dive into the crypto pool open the floodgates to others following suit? We’ve recently seen the first Bitcoin ETF launched (the ProShares Bitcoin Strategy ETF) with great market fanfare. However, this vehicle isn’t buying Bitcoin, but derivatives that are designed to closely track the price movement. What’s next? As a reminder, the primary objective for a pension plan should be to secure the promised benefits at a low cost and at reasonable risk. Does investing in this instrument fit that objective?