World Math Day

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.

Not Necessarily!

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.

Why A Dual Asset Allocation Makes Sense

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.

https://ei.marketwatch.com/Multimedia/2017/08/21/Photos/NS/MW-FS750_vangua_20170821154702_NS.jpg?uuid=80811e26-86a9-11e7-9829-9c8e992d421e

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.

Ryan ALM Quarterly Newsletter through 9/30/19

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 DB Plans faired in 2019?

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.

 

Operation Homerun

In keeping with the baseball season, we want to introduce Operation Homerun for defined benefit pension plans. We have a four base strategy for helping plan sponsors circle the bases while securing a pension victory.

First base: Separate Retired Lives (RL) from Active Lives (AL) – RL and AL are two distinctly different liabilities. RL are the most important, most imminent and most certain liabilities while AL are the more volatile causing actuarial noise. Your actuary can easily provide projected benefits for Retired Lives separate from Active Lives.

Second Base: Liability Beta Portfolio (LBP) – Contributions are the first source to fund RL benefits so current assets fund NET RL. Since the pension objective is to secure benefits in a cost efficient manner, only cash flow matching liabilities with bonds can accomplish this objective. We recommend cash flow matching the first 10 years of NET RL.  This will de-risk the plan gradually and buy time for residual assets to fund residual liabilities. Our LBP is a cash flow matching product that will also reduce funding costs by about 4%. The LBP will be an investment-grade corporate bond portfolio that will out-yield a traditional fixed income portfolio. As a result, the plan’s ability to achieve the return on asset assumption (ROA) will not be impaired.

Third base: Asset Exhaustion Test (AET) –  The AET will calculate the economic ROA that is necessary to fully fund all residual liabilities (RL past 10 years + AL). This is in contrast to the AET that is required by GASB 67/68 every two years, but it is recommended that the plan’s conduct the study more frequently. The GASB AET subtracts contributions from projected benefits. This net liability is then funded by current assets at the current ROA to determine solvency. If at some point the assets are exhausted and can no longer fund net liabilities, the discount rate from that point forward will be a 20-year AA municipal bond rate.

Home Plate: Alpha assets – Once the calculated economic ROA is known, the plan sponsor and consultant allocate the remaining Alpha assets (growth assets) with the goal of fully funding residual liabilities by earning the economic ROA. Bonds are removed from this asset allocation since they were used as the Beta assets. exceeding the ROA objective and future liability growth. Importantly, the assets should be allocated to products that have a low correlation with traditional fixed income, as liabilities are bond-like in nature and highly correlated to changes in interest rates. This is the final step of the process. Home plate has been reached and the plan has created a successful asset allocation strategy designed to stabilize the funded status and contribution expense. There is now a glide path in place to further de-risk the plan. As the return generated by the Alpha growth assets exceeds liability growth the excess profits should be ported over to the Beta cash flow matched portfolio which can now be extended to meet more of the Retired Lives liabilities.

Scoreboard: Custom Liability Index (CLI)– To keep score requires a Custom Liability Index (CLI), which calculates the economic liability growth rate while also measuring and monitoring  a plan’s specific liabilities (YTM, duration, interest rate sensitivity, etc.). With this information, the plan sponsor and their consultant can now understand the true funded status and the relative score of assets versus liabilities growth.

We hope that you are enjoying our national pastime’s post-season, and while you are watching we would encourage you to reach out to us for more details regarding our Operation Homerun. It is a winning strategy.

Use of Callable Bonds in a Cash Flow Matched Portfolio

We recently got a question from one of our client’s consultants regarding the use of Callable Bonds in our cash flow matched bond portfolio. The consultant seemed surprised that we would include them in the universe of acceptable investment-grade bonds to use in an immunized portfolio.  Here is the answer from our head of trading that we provided.

“These day’s it is very difficult to find Corporate bonds that do not have a call feature.  The majority of them have call provisions.  The calls are most often “Make-Whole” call provisions. 

A makewhole call provision is a call provision attached to a bond, whereby the borrower must make a payment to the lender in an amount equal to the net present value of the coupon payments that the lender will forgo if the borrower pays the bonds off early.

The call provisions usually can be exercised until three months before the bond’s maturity date.

Although we do not have much choice these days, buying callable bonds is actually a good strategy when one thinks interest rates will stay relatively stable to maybe going down a little too possibly going up.

This is because an investor receives extra yield at the time of purchase over and above the yield on a non-callable bond plus the investor will receive a premium or prepayment penalty when the bond is called due to the Make-Whole call provision. 

The extra yield from a callable bond acts as a cushion if interest rates rise.   

If interest rates stay flat or go sideways no-harm-no-foul because the investor just reinvests into a new bond at about the same yield that he started with plus the investor received the extra yield at purchase plus the premium at the time of the call.  This means a pickup in income over a non-call bond.

If interest rates go down a little say 25 to 50 basis points then the extra yield received upfront at purchase plus the premium at the time of the call will offset some of the loss in yield due to having to reinvest into a lower-yielding bond.

Finally, the Liability Beta Portfolio cash flow matching strategy is 100% focused on income and not total return.  It is true that a non-callable bond will have better total return performance in a declining interest-rate environment but only if one sells the bond before maturity.  And then if an investor sold her non-call bond before maturity to collect a price gain she would effectively be imposing a self-call because then she would have to reinvest into that lower interest rate environment the same as a callable bond investor would.”