House Ways and Means Chairman Richard Neal, D-Mass., confirmed that pension bill H.R. 397 (Butch Lewis Act) is ready for a floor vote. Some are estimating that the cost of the legislation could be roughly $65 billion, although the proposed loan program could actually be revenue neutral if each of the recipients of the loans pays back the principal in year 30.

If the legislation passes through the House of Representatives, the U.S. Senate must agree to take up the legislation.  During the review of the legislation by the Ways and Means and Education and Labor Committees, Democrats had rejected 12 amendments along party-line votes. There are roughly 13 additional amendments that were withdrawn with an eye toward bringing them forward for consideration in a final Bill.

As we’ve highlighted many times, inaction at this time is unacceptable. Failure to support these critically important pension systems jeopardizes the economic future for more than 1.3 million American workers and retirees. A pay-as-you-go approach is far more expensive than one that has a 30-year lifeline to meet future obligations.

In order to understand the basics of actuarial methods of valuing pension liabilities, one must consider the fundamental equation of pension plan funding, which is:

C+I=B+E

Where (C) Contributions + (I) Income = (B) Benefits + (E) Expenses

First, actuaries will calculate the future benefits to be paid.  With this information actuaries are able to calculate contribution rates based on a Return on Assets (ROA) forecast for investment income (returns). However, if investment income or contributions fail to meet expectations, the stability of the plan may be affected and benefits may have to be adjusted. Please note that the actuary has no input for asset growth to exceed liability growth since they both have the same ROA forecast (error). Given the same forecasted growth rate (ROA) any deficit would also grow at the ROA causing higher projected contributions (not acceptable).

Prefunded defined benefit plans allow for assets to be built up funding future benefits. The more “income” earned the less the need for contributions. In order to determine future benefits an actuarial valuation is calculated. There are many factors in an actuarial calculation, but the most important is likely the discount rate. Actuaries, guided by plan sponsors and investment professionals/consultants, use a discount rate to value future benefits. In public pension funds, actuaries generally use the forecasted return on investments (GASB), whereas corporate plans using guidelines from FASB value future benefits at market rates using a discount rate yield curve of Corporate AA zero-coupon bonds.

When discussing multiemployer defined benefit plans, their funding is not as straightforward.  The benefits in DB plans subject to ERISA are required to be prefunded, which means that in the current year the plan sponsor sets aside adequate funds, taking into account expected future investment returns, for pension benefits earned in that year.

Plan sponsors may also be required to make additional contributions for investment losses that occurred in previous years and increases in the present value of future plan obligations (actuarial losses). Plan participants receive their monthly benefit in retirement from these funds that have been set aside. The required contributions for employers in multiemployer DB pension plans are negotiated and tend to fixed for several years as established in collective bargaining agreements. Given that contributions are negotiated, “make up” contributions are not always available should investment returns fall short of expectations.

Two significant market declines during the last 19 years have been one of the major factors in creating a funding shortfall among multiemployer pension plans in Critical and Declining status. The focus on earning the ROA as the target asset return as a means to control contribution expense has lead many plans to strive for outsized return expectations. This more aggressive return profile increases the volatility associated with the plan’s asset allocation and subjects the plan to greater downside risk.

Within H.R. 397, the proposed legislation calls for the loan proceeds to be used to defease the plan’s Retired Lives and Terminated Vested Liabilities through one of three possible implementations: 1) annuities, 2) duration matching, or 3) cash flow matching. Ryan ALM and KCS have for years written about the benefits of cash flow matching to meet near-term liabilities chronologically. This strategy enables the plan to extend the investing horizon for those assets not deployed to meet liabilities, reduce interest rate sensitivity from traditional bonds, and improve liquidity to meet the promised benefits. If implemented successfully, a cash flow matching strategy should defease Retired Lives, help to stabilize both the plan’s funded status and contribution expense, while setting the plan on a de-risking path toward full funding. There are only two ways to truly defease liabilities, which are insurance buyout annuities (IBA) and cash flow matching. Since IBA is expensive, cash flow matching is the only practical way to defease Retired Lives.

As you may have heard or read, the House of Representatives’ Ways and Means Committee has passed H.R. 397 (July 10th) joining the Education and Labor Committee that voted to support this proposed legislation in June. A third committee, Appropriations, will soon begin their review prior to a vote. As a reminder, H.R. 397 is basically the Butch Lewis Act that was first introduced in November 2017, but not approved.

Unfortunately, the votes have followed party lines with Democrats supporting the proposal to provide low-interest rate loans to multiemployer plans deemed to be in Critical and Declining status, while Republicans continue to treat the legislation as nothing more than a bailout. If the legislation passes through the Appropriations Committee it will then be brought to the House for a full vote.

It has been assumed by most that the House, under Democrat control, would pass this legislation. The significant challenge/hurdle will be getting the Senate to follow suit. At present there are no competing bills to help struggling multiemployer plans survive, but rumors persist that the Republicans are preparing a bill that will strengthen the PBGC with greater oversight and finances. Of course, time will tell, but we don’t currently have the luxury of time! Something needs to be done in this Congressional session or we will begin to see the significant damage that delay has inflicted.

“Public pension accounting methodologies devised by the Governmental Accounting Standards Board (GASB) produce flawed results and are in urgent need of improvement, according to an independent study released by the National Conference on Public Employee Retirement Systems, wrote Hank Kim, Executive Director for NCPERS. Amen, we say to that!

For more than eight years, we have crisscrossed the U.S. highlighting the fact that public pensions are being negatively impacted because of GASB accounting standards. “When things go awry for some pension plans, it is often not because the accounting rules are ignored but because they are followed,” the study’s author, Brown University researcher Tom Sgouros, wrote in “The Case for New Pension Accounting Standards.” Sgouros also stated, “GASB rules can mislead decision-makers’ views as to the health of a pension system, prompting poor decisions, the study found. The study recommended developing different rules that will address some of these shortcomings.”

Ron Ryan, Ryan ALM, highlighted several years ago the negative impact of accounting rules on pensions in his outstanding book, titled “The U.S. Pension Crisis”. One of his points was the fact that future contributions should be treated as an asset of the plan when calculating the funded status. Sgouros highlights the same issue in his study. “One of the many quirks of today’s pension accounting rules is that they value the promise of future contributions at zero, which is unlike any other government obligation, from revenue bonds to purchase orders,” Sgouros said. “As a result, the strength of the economy behind the pension plan counts for nothing from an accounting perspective. That is clearly a disservice to pension plan participants.”

Managing a pension plan is difficult under the best of circumstances. Let’s eliminate the many impediments that are created through accounting standards that mask the truth. We stand ready to share our insights on where other opportunities for improvement exist. Are you?

Gene Kalwarski, CEO, Cheiron, a leading pension actuarial firm has penned a response to Olivia Mitchell’s article regarding the multiemployer pensions crisis and the legislation that is currently before the House (H.R. 397). Gene, Peter Hardcastle and the team at Cheiron did the heavy lifting in completing the analysis to determine future solvency on each of the 114 Critical and Declining plans that existed in 2017 when the Butch Lewis Act was first presented to both the House and Senate. Gene’s response is excellent, and the complete article follows.

“Just days ahead of the House Ways and Means Committee’s planned markup of legislation that would offer government loans for struggling multiemployer pension plans, conservative academics have launched an all-out attack on the bill.

The legislation, The Rehabilitation for Multiemployer Pensions Act, is a rebranding of the Butch Lewis Act introduced in November 2017 by Rep. Richard Neal (D-Mass.) and Sen. Sherrod Brown (D-Ohio).

In a June 27 commentary in the Hill, Olivia Mitchell, an economist who teaches at the Wharton School, called the legislation “A step in the wrong direction.” Far from it.

Well before Neal and Brown introduced the bill, they asked the company where I am CEO, Cheiron Inc., to prepare actuarial projections to determine how effective the legislation would be in stemming insolvencies of struggling multiemployer pension plans.

Our projections – which have been reviewed by congressional staff, pension experts on Wall Street and other actuaries – show that the legislation would protect 1.3 million plan participants from insolvency, eliminate the need for as much as $65 billion in financial help from the Pension Benefit Guaranty Corp. and prevent insolvencies for at least 30 years.

Conservative economists maintain that the multiemployer pension crisis is more than 10 times larger than the $54 billion estimate, and that Congress would be wasting taxpayer money by lending money to struggling pension plans.

But even if all the troubled multiemployer pension plans were to become insolvent, their underfunding would be less than half that amount, according to their 2017 annual filings with regulators. That’s based on even more conservative assumptions than single-employer plans.

Conservative economists blame labor unions and employers for the financial troubles of multiemployer pension and for not contributing enough to multiemployer pension plans.

But during the 1980s and 1990s, it was the IRS tax code that limited employers’ tax-deductible contributions to multiemployer pension plans. Because the plans were constrained from contributing more to the plans while earning double-digit returns and generating large surpluses, they were forced to increase pension benefits or stop making contributions.

Conservative academics say that multiemployer pension plans pay far too low premiums to the PBGC compared with single-employer pension plans. But this ignores that the top PBGC guarantee for participants in single-employer plans is $67,295.40 a year or about five times as much as the $12,870 a year that full-career participants in multiemployer plans would receive. 

Critics assert that while corporate plans that go out of business are required to cover pension promises out of company assets, bankrupt employers in multiemployer pension get a pass. But federal pension law lets corporate pension sponsors use Chapter 11 of the Bankruptcy Code to offload pension obligations on the PBGC, as hundreds of companies have done. Multiemployer plans don’t have this option under pension law. When an employer contributing to a multiemployer goes bankrupt the remaining employers and, ultimately, the participants are saddled with its unfunded liabilities.

Conservative critics argue that the Butch Lewis Act would make the multiemployer pension crisis worse by allowing struggling plans to make new pension promises and leave taxpayers on the hook if they can’t repay the federal loans.”

Great job, Gene.

As discussed in our previous blog post, many, if not most, public fund and multiemployer plans have injected greater risk into their investment processes by allocating significantly more assets to equities and alternatives in an attempt to best the return on asset assumption (ROA). On the surface, that decision is fine depending on the plan’s investing time horizon.  However, given that many of these plans have significant negative cash flow situations (paying out more in benefits than they are receiving in contributions) the greater use of these asset classes brings about less liquidity while forcing the plan to have a shorter time horizon.

When it comes to evaluating market risk, one’s time horizon is a key factor to consider. As a general rule, shorter time horizons require more caution than do longer ones. Yet, plan sponsors have adopted an entirely different approach. The dilemma: how does a plan meet its liabilities in the short-term while creating a potential return that can beat both the ROA and liability growth longer-term.

Investing for the long-term eliminates the “noise” of short-term market moves and the longer-term averages get one closer to an expected return that is more realistic. In the current construct for most DB plans, a single asset allocation is used to create a return that will exceed the ROA, but performance results are looked at quarterly, making long-term investing difficult to achieve.

Ryan ALM produces performance results quarterly for a generic asset allocation of 60% domestic equities, 5% MSCI EAFE, 30% Bloomberg Barclay Aggregate, and 5% cash.  When looking at annualized monthly returns since 12/99 (222 12-month periods), the average return is 6.02% and the standard deviation of those returns is +/- 10.8. Wouldn’t it be great to have an asset allocation that can successfully achieve both desired outcomes of meeting near-term liquidity needs while producing fairly consistent longer-term results?  If successful, both the funded status and contribution expense would be more stable.

I am pleased to write that there is a way to achieve these two important objectives in managing a pension system.  First, asset allocation should be bifurcated. There should be two buckets for the assets, which will have very different objectives. In order to meet near-term liquidity needs a cash flow matching strategy should be built through investment grade (and in some cases high yield) corporate bonds to meet monthly benefit payments in chronological order from nearest payment as far out as possible. Second, the remainder of the assets should be invested in instruments that are lowly correlated to traditional bonds, as liabilities are bond-like in nature.

As mentioned above, the one-year return for that generic asset allocation had a 10.8% standard deviation meaning that 68% of the time that annual return since 12/99 could have been as good as 16.8% or as poor as -4.8%.  Furthermore, extending to 2 standard deviations (95% of the observations) would produce a range of results that has one seeing equal chance of a 27.6% return to one at – 15.6% or more than 43% from top to bottom. Tough to manage a pension plan with that type of volatility, yet that is precisely where we are today.

If one had the resources to dedicate enough assets to the cash flow matching portfolio the standard deviation of returns falls precipitously from 10.8% to less than 1/2 at 5 years (5.05) and to nearly 1/3 of the risk at 10 years (3.6), increasing the odds that the expected return will be achieved, the required benefits paid, and a glide path established toward full-funding.

Does this sound to good to be true? Hardly, as cash flow matching strategies have been used for more than 7 decades to achieve the desired goals stated above. Furthermore, it is one of only three strategies (along with annuities and duration-matching) to be considered as part of the Butch Lewis Act (H.R. 397) regarding how the loan proceeds can be invested. Many alternative investments are designed to provide good long-term results, but they need time to capture the liquidity premium that exists. Only through an extended investing horizon will this be accomplished.

While many private sector DB pension systems have reduced risk in their portfolios as they approached full-funding, many public and multiemployer pension systems have taken on more risk trying to enhance returns to help close their pension deficits. Both public and multiemployer plans have strategically allocated significant assets into both equities and alternatives since the Great Financial Crisis, and the total combined exposure is now greater than it was prior to the 2008 meltdown. For those plans riding greater exposure to equities and alternatives, 2019 must be a phenomenal year. Everything is up! Just look at the S&P 500, which is up a very strong 18.5% for the first 6 months.

The markets have rewarded plan sponsors for their aggressive asset allocation, but not to the extent that most sponsors and their consultants would have had you believe. How is that possible? Well, plan liabilities have grown rapidly, too. Ryan ALM has produced performance numbers for a generic asset allocation of 60% S&P 500 (18.5%), 30% Bloomberg Barclay Aggregate Index (6.1%), 5% MSCI EAFE (14.5%) and cash (1.5%) the combination produces a very solid, and ROA beating, 13.8% year-to-date return. But, managing a pension plan isn’t about beating the ROA, but eclipsing plan liability growth, which is up a robust 10.1% YTD (according to Ryan ALM) when using the U.S. Treasury STRIPS curve. If one were operating under FAS 158 accounting liability growth would be even stronger at 14.3% YTD or 0.5% greater than the generic asset allocation cited above.

Why has liability growth been so robust? Most plans have a duration on their liabilities somewhere between 10-15 years. Long U.S. interest rates have plummeted since November 2018. In fact, as of today (7/8), the U.S. 10-year Treasury’s yield is down 121 bps since 11/8/18, while the U.S. 30-year Treasury’s yield has fallen 100 bps from its peak on 11/2/18.

Why is this important? Pension liabilities are bond-like (when marked-to-market) and the present value of liabilities grows as yields fall. For a plan with a liability duration of 12 years, liabilities will have grown somewhere between 12-15% since the latest peak in yields just on price movement alone.

Unfortunately, this follows the very poor fourth quarter of 2018 when asset growth underperformed a generic pension plan liability by more than 13%. I suspect that most plan sponsors are feeling great about recent asset performance, but when overlaid onto plan liabilities the story isn’t nearly as robust. Managing a DB pension without knowledge of how the opponent is doing (plan liabilities) is like trying to play a sport when you only know your score. It is impossible to adjust your strategy confidently without greater transparency on how your liabilities are performing.

With the explosion of data and vast computing capabilities, machine learning and artificial intelligence are all the buzz these days. However, a serious consequence of this is the ease of producing a wonderful looking backtest that fails to deliver when put into practice. In statistical parlance, this is called overfitting, or a situation where researchers have merely captured noise in data. This is believed to be largely responsible for the claim that “most claimed research findings in financial economics are likely false.”

An outstanding paper written by Spring Valley Asset Management gives context to this claim by demonstrating that seemingly inconsequential changes to an investment model can introduce substantial risks when put into practice. It then explores a novel approach to mitigate these risks. Whether you design, or allocate to, systematic investment strategies, the concepts described in this paper are of immense importance. I hope that you’ll find this paper as educational as I did.

An acquaintance of mine recently shared with me an article from The Hill, titled, “Multiemployer Pension Bailout Plan Is Fatally Flawed”. Renowned economist, Olivia Mitchell, Economics professor at the Wharton School of the University of Pennsylvania, wrote the article. Much of what she highlights as issues pertain to the broader multiemployer pension space and are not relevant to the argument as to whether or not H.R. 397 should or shouldn’t be supported. Unfortunately, we are not working with a clean slate at this time and as a result, we cannot wipe away years of actions and decisions that have contributed to today’s pension crisis. If we could, I would agree with many of her suggested actions.

H.R. 397 (aka the Butch Lewis Act) would provide a lifeline to more than 120 Critical and Declining (C&D) multiemployer plans that provide (or will) benefits to more than 1 million Americans. A collapse of these plans and their subsequent move to the Pension Benefit Guaranty Corporation (PBGC) would provide pennies on the dollars to these pensioners. Fortifying these plans through the proposed loan program would keep taxpayers from having to support a very expensive pay as you go social safety net. Furthermore, Ms. Mitchell complains that some of these plans may not be able to pay back the loan in 30 years or may have to renegotiate the terms. Are you kidding me? Countries, corporations, and individuals renegotiate terms of their loans all the time. Why should this be a basis for sabotaging this legislation?

In addition to her concern about a potential default 30 years from now, she also raises several other concerns. Ms. Mitchell claims that the legislation doesn’t prohibit benefit enhancements. She is wrong. Section 4, Loan program for multiemployer defined benefit plans, subsection B Loan terms, paragraph 3A as a condition of the loan, the plan sponsor stipulates that— (A) except as provided in subparagraph (B), the plan will not increase benefits, allow any employer participating in the plan to reduce its contributions, or accept any collective bargaining agreement which provides for reduced contribution rates, during the 30-year period. Furthermore, paragraph B has to do with reinstating benefit cuts in plans that have filed for relief under MPRA.

The legislation contemplates a new course for the plans and their sponsors. Any plan taking a loan must defease the retired lives and the terminated vested liabilities. This reduces risk in the process. Furthermore, the determination of the loan amount is predicated on a true mark-to-market of those liabilities. U.S. Treasury STRIPS will be used to determine the true liability. The defeasance strategies that will be considered use in two of the 3 cases Corporate bonds which significantly out-yield Treasury STRIPS providing for additional assets that can be used to meet future liabilities (Active Lives).

Importantly, the defeasance of retired and terminated vested liabilities addresses the near-term liabilities and as such, extends the investing horizon for the balance of the Active Lives. This extended time horizon is an important investing tenet. The predictability of returns over a 15-year or longer time horizon will allow the remaining assets to capture the liquidity premium that exists in equities and alternative assets.

Again, if we had a clean slate and we were creating a multiemployer pension system starting from day one we would agree with her that all liabilities should be priced at a true mark-to-market rate, that PBGC premiums be greater, that benefits not be enhanced until the current promises are met, and that exiting companies pay their fair share of what is owed and not leave the liability to the surviving sponsors, but alas we are where we are and protesting that this legislation doesn’t address these issues is a non-starter.

We cannot kick this pension crisis down the road any longer. Furthermore, in an attempt to address this situation we must not enact legislation that harms currently “healthy” plans by increasing their costs either through a significant reduction in the discount rate currently used or a dramatic increase in PBGC premiums. We have an opportunity through the Federal Government to provide a lifeline of 30-years. Much can happen during that time period. Nothing good happens if we let these C&D plans collapse, causing bankruptcies and reduced pension benefits under the PBGC. If you are concerned about the taxpayers then doing nothing puts them on the hook to support the federal social safety net far sooner than if we try a loan program.