Round Two

I am pleased to report that the Butch Lewis Act presentation to the Senate staff went well yesterday. This follows the presentation to the House staff last Friday. Both meetings were well attended, and the audience was engaged while asking many good questions. Importantly, these presentations were delivered prior to the first meeting being held by the Joint Select Committee on the Insolvency of Multiemployer plans, which is to meet today in Washington DC.

The Butch Lewis Act should be the foundation of any legislation that emanates from this Committee. There are many benefits to this legislation.  But first and foremost it is intended to preserve and protect the pension benefits for roughly 3.5 million plan participants currently in plans designated as “Critical and Declining”. Furthermore, it is the only proposed legislation that does not call for a benefits reduction.

 

Benefits from the Butch Lewis Act and the Pension Rehabilitation Administration

Enhances Solvency while reducing risk

  •        Maintains current benefit levels
  • Secures Retired Lives thru Defeasance strategy (100% funded)
  • Defeasement funded thru PRA loan (and in a few cases the PBGC)
  • A Significant shift within the Plan’s asset allocation to greater use of fixed income

Reduces Cost to fund Retired Lives

  •        Three possible strategies to defease the Retired Lives
  •        Cash Flow Matching, Duration Matching, and Annuities
  •        Cash Flow Matching approximately 9% less costly than Annuities
  •        Asset Management fees reduced from 30-40 bps on average to 10 bps

Buys Time for the pension plan and plan participants

  •        Current assets + contributions fund Active Lives + PRA Loan
  •        Much longer liabilities than Retired Lives
  •        Given time, risky assets tend to perform (capture liquidity premium)

Reduces ROA Hurdle Rate

  •        Replaces Retired Lives ROA (@7.50%) with PRA Loan (@3%)
  •        Defeasement cost savings transferred to current assets
  •        Asset management fee savings supports current assets
  •        The savings help fund future liabilities and the repayment of the loan

PRA Loan Should be Profitable

  •        PRA receives 30-year Treasury financing (@3%) into Trust Fund
  •        Trust Fund provides PRA loans at 25 bps yield spread profit
  •        25 bps spread = $2.5 million profit margin per $1 billion loan
  •        $60 billion PRA loans = $150 million profit margin annually

On the other hand, the Butch Lewis Act is neither a “bail-out” nor a windfall for Wall Street. These loans must be paid back, and current contribution levels must be sustained or there are severe withdrawal penalties levied on the plans/employers.  In addition, the significant shift within the plan’s asset allocation toward greater use of fixed income will significantly reduce asset management fees. For most of these plans, Retired Lives make up more than 50% of the liabilities, which means that more than 50% of the assets will now be allocated to fixed income, which carries much lower average asset management fees than do equities, real estate, alternatives, etc.

 

DB Plans Are Great, But Some Tweaks Are Necessary

Mary Williams Walsh, NY Times reporter, produced an article this past weekend, titled “A $76,000 Monthly Pension: Why States and Cities Are Short on Cash”.  She described a number of situations in which municipalities were unable to pay for basic services as a result of ballooning pension contributions. The effect of these growing pension expenditures was to crowd out other local services impacting school systems, police forces, infrastructure, etc.

At KCS, our mission is to protect and preserve defined benefit plans, but it isn’t at any cost. We recognize the need to get these systems operating on a more prudent footing, that will allow all employees to be treated in an equal way, and not the current system that favors retirees or current employees in more favorable light relative to future employees.

We believe that the benefit should be based on an employees final “average” salary. It allows the actuary to more appropriately calculate the future benefit while making sure that annual contributions reflect that estimate. The spiking of benefits through the inclusion of overtime, sick or vacation pay, and any other means is nearly impossible to fund on an on-going basis. Benefits need to be based on wages – period!

Retirement ages need to reflect that American workers are living longer. Many public fund systems have retirement ages that are well below those found in the private sector.  These workers in the public sector may enjoy retirements that are longer than their working careers placing further burdens on the pension system.

But, the changes shouldn’t only impact the participant. There are many practices among plan sponsors that need to change, too. First, the annual required contribution (ARC) must be paid.  I don’t think that New Jersey has made the full ARC since George Washington slept there. Furthermore,  we must once again manage these critically important benefits with a cost objective and not one focused on return.

Defined benefit plans were once managed against their specific liabilities (the promise). In the early 1980s, the plan’s primary objective became the return on asset assumption (ROA). It isn’t shocking that funding volatility has ramped up tremendously since then, but funding success hasn’t followed. All DB plans should be on a glide path to full funding. They should be managed with a risk-reducing mandate, seeking opportunities to defease plan liabilities whenever possible.  The ROA is NOT the Holy Grail.

The investment management community isn’t without fault, too. Fees are incredibly high, and the payment of an asset-based fee with no promise of delivery is just not right. Plan sponsors and their consultants should use performance-based fees more often, especially in more traditional long-only mandates. Why are performance-based fees acceptable in an alternative product, but not more traditional long-only mandates?

Regular readers of the KCS blog know that we are fighting tooth and nail for DB benefit plans and their participants (see the Butch Lewis Act). By tweaking a few practices, these plans can be saved/secured without burdening the communities and states that provide funding support.

 

Butch Lewis Act Math Shared with Members of the House

Last Friday, members of the team behind the Butch Lewis Act had their first opportunity to present the “numbers” to House staff members.  We were very pleased with the extremely positive reaction to the presentation.  Tomorrow, Tuesday, April 17th, the same team will present the analysis to Senate staff members, and we are hoping for an equally successful result.

It was very important for this information to have been presented when it was, as the Joint Select Committee on Solvency of Multiemployer Pension Plans will meet on Wednesday, April 18, 2018, at 2:00 p.m., in 215 Dirksen Senate Office Building, to hear testimony on “The History and Structure of the Multiemployer Pension System.”

As you may recall from previous blog posts, this Joint Select Committee is tasked with developing a plan to address the unfolding retirement crisis within multi-employer plans before year-end. How broad is this issue? There are 114 multi-employer plans that have been designated “Critical and Declining”, meaning that they are <65% funded and will likely face insolvency within 20 years.  These 114 plans have promised benefits to roughly 3.5 million participants, and those benefits are unfortunately very much at risk.

 

Did you know?

As a follow-up to our blog post from this morning on expanding U.S. deficits being good for future growth, my former Invesco colleague, Charles DuBois, has shared the following:

There have been over 100 government defaults on public debt in the past couple of centuries.  However, for nations with their own free-floating currency and no foreign debt – there have been none. This fact is, of course, overlooked and not mentioned when you hear about the coming ‘fiscal crisis”.  As you know, since at least the 1930s, we have been told the crisis (in the U.S.) is “right around the corner”.   Ha ha.  Chicken Little is alive and well.
Thank you, Chuck, as always!

Wider U.S. Deficits To Be Good For Growth

The WSJ is reporting today on a Congressional Budget Office (CBO) study indicating that this year’s budget deficit will be 43% greater than originally forecast.  Furthermore, future deficits beginning in 2020 will exceed $1 trillion per year.

According to the WSJ article, “economic growth will jump above 3% this year thanks to the fiscal stimulus, the CBO said, but the agency predicted the acceleration will prove largely fleeting. Larger deficits will add to the national debt: Debt held by the public will hit $28.7 trillion at the end of fiscal 2028, or 96.2% of the gross domestic product, up from 78% of GDP in 2018.”

“Such high and rising debt would have serious negative consequences for the budget and the nation; in particular, the likelihood of a fiscal crisis in the United States would increase,” CBO Director Keith Hall told reporters (as reported by the WSJ).

We disagree with Mr. Hall’s forecast that the benefit of the stimulus will be fleeting, believing that the additional fiscal boost will remain an economic catalyst well into the future provided that the additional demand for goods and services created from this deficit spend will be met by the economy’s ability to meet that demand.  If production can meet this heightened demand then we should witness above-average economic growth.  If not, then inflation will likely reappear in earnest.

One must remember that the Federal deficit is a liability of the U.S. government, but an asset of the private sector. Our economy (and citizens) has benefited tremendously from the Federal Government’s ability to deficit spend, especially during those periods when the private sector is incapable of stimulating growth.

 

 

What’s The Issue?

There are many deniers within the U.S. retirement system that would have you believe that there isn’t a retirement crisis unfolding. The demise of the defined benefit plan has been most notable within the private sector, but multiemployer and public pension plans are certainly not immune to the problem, and the situation is likely to get worse before too long.

Let’s just take a look at the current environment within the multiemployer landscape:

  • 130 multiemployer plans projected to be insolvent over the next 20 years (there are roughly 1,300 plans)
  • 200 additional plans in PPA critical status (<65% funded)
  • 3.5 million plan participants with pension benefits at risk
  • PBGC financial exposure to multiemployer plans at $65 billion as of 2017
  • PBGC multiemployer insurance program projected to be insolvent in 2025
  • Even with a solvent PBGC their maximum guaranteed benefit still results in major benefit cuts to participants
  • Multiemployer Pension Reform Act of 2014 (MPRA) has failed to arrest the multiemployer funding crisis

This situation is deeply concerning, but not impossible to overcome if we act now. As we’ve discussed on many occasions within this blog, Federal legislation (The Butch Lewis Act) is being considered that would provide low-interest loans to “Critical and Declining” status plans that would help protect the promised pension benefits for the millions of plan participants. Our failure to act will create profoundly negative social and economic implications.  This legislation needs to be enacted.

Omaha Public Schools POB Denied

The Nebraska Legislature on Wednesday rejected authorizing the Omaha Public Schools (OPS) to issue $300 million in bonds to shore up its poorly funded pension fund. The pension obligation bonds (POBs) would have sought to take advantage of the margin between interest rates and the return on asset assumption (ROA).

According to Henry J. Cordes, writer, Omaha World-Herald, “proponents said the bonds could spare cuts in the classroom while also saving district taxpayers millions.” But they could not overcome concerns that the “bonds could prove a risky investment, would limit the district’s financial flexibility, and would not have required voter approval.” The legislation fell three votes short of the 25 needed to advance, failing 22-17.

Without assistance from the POB, OPS must cut its schools budget by $18 million — roughly 3% — and divert those dollars into the underfunded pension fund. That figure is projected to escalate annually, reaching $27 million by 2022.

Some in the Legislature questioned the wisdom of borrowing money with the hopes of making more on the margin between interest rates and investment returns. “I don’t think borrowing money to make money is ever a good idea,” said Sen. Lou Ann Linehan of Omaha.

According to the article, the vast majority of the shortfall “developed over the past decade due to a combination of poor investment decisions, poor economic conditions, benefits for retirees that were more generous than those for other school employees in the state, and the district’s failure to make extra payments into the fund.”

At KCS, we are favorably inclined to use POBs to close funding gaps in DB plans, provided that the proceeds from the bonds are used to defease the plan’s retired lives. We, too, believe that injecting these assets into a traditional asset allocation is risky. There are too many examples of POBs that are now underwater further damaging the funded status of those plans.

Utilizing a defeasement strategy is the foundation of the Butch Lewis legislation that is currently before Congress. Managing a pension plan should be about providing the promise (benefit) at the lowest cost and not the highest return.  Injecting more risk into the process guarantees volatility in returns, but not funding success.