We have a tendency in our industry to get hyper focused on products and concepts that at the end of the day contribute little to the success of pension plans. As an example, one can’t pick up a pension-related magazine without reading about ESG or divestment, whether that is for firearms, fossil fuels, etc. These are just the current fads in our industry, as there are many examples of activities stretching far back into our past. I entered the business in 1981 shortly before pension systems were being asked to become South African free. A noble cause without question, but did it add value to the plan? Did it help secure the promised benefits? As Fiduciaries, that should be the only thing that matters.

Furthermore, we constantly read about minor asset allocation decisions, as if they are going to deliver amazing results. For instance, we may read how one pension system is shifting 2% from this asset class to that one, or another pension system has decided to add exposure to a new asset class at 3-5%, or another one is exiting an asset class that had a small allocation. At the end of the day these activities are nothing more than the shifting of deck chairs on the Titanic. They will add incrementally at best, and worse, take precious time from trustees, actuaries, and asset consultants whose time could have been used on more meaningful activities that would have actually had far greater impact on the overall success of their plans.

For years Ron Ryan and I have been running around the country encouraging plan sponsors and their consultants to develop a new approach to asset allocation that calls for the bifurcation of the assets to meet different pension objectives: 1) secure the benefits, and 2) maximize the efficiency of the asset allocation. We have recommended that plans convert their current fixed income with all of its interest rate risk into a cash flow driven approach that specifically meets that plan’s Retired Lives liabilities. Furthermore, we suggested that the remaining assets could be managed more aggressively in order to meet the remaining Retired Lives liability and all future active liabilities now that the near-term benefit payments have been defeased.

We’ve described this process as a “sleep-at-night” strategy for the plan sponsor who no longer has to worry about such annoying things such as liquidity, interest rate risk, next month’s benefit payments or for that matter the next 10-year’s benefit payments, and/or significant market declines, as the investing horizon will have been extended by 10 years, and we know that over most 10-year periods (>80%) of time equities outperform bonds. How nice would it be to inform your plan participants that no matter what is transpiring in the markets today or any day during the next 10-years, that your benefits are absolutely secured for the next 10 years? How comforting that must be.

Corporate America has engaged in de-risking activities for years, but they have been inspired to reduce risk for the expressed purpose, in many cases, to terminate their pension plans. They have also been incentivized because of more rigorous accounting standards imposed on them through FASB. Both public and multiemployer plans have been slow to adopt de-risking approaches as they continue to believe that managing a pension system is all about achieving the return on asset assumption (ROA). In fact, instead of de-risking many plans have injected more risk into their asset allocation as they’ve pursued more private and alternative investments that come with their own set of liquidity challenges. Need cash in the near-term because you don’t want to sell into this market correction? well, you aren’t getting it from the private/alternative program.

I admire pension trustees who spend endless hours in meetings around the country attending various conferences, such as IFEBP, FRA’s Made In America, Opal’s public fund forums, state specific programs such as FPPTA, TexPERS, IPPFA, and 100s of other well-intentioned gatherings. But, the information that is shared should become the basis for asking questions and challenging the status quo. Unfortunately, we as an industry have done the same things for years despite the fact that many pension plans have been shuttered during the last 40+ years. Isn’t it about time that real change was enacted so that our plan sponsors could actually approach their participants with the great news that all is well – your benefits are secure!

There appears an article on the CIO Magazine website, titled, “Multiemployer Pension Funding Reaches Pre-financial Crisis Levels” followed by “double-digit asset gains boost aggregate funded ratio to 85% in 2019.” Wow, if only that were the case! The article, written by Michael Katz uses information produced by actuarial and consulting firm Milliman, which claims that more plans are above 100% funding in the multiemployer space than there were prior to the GFC.

Regrettably, it is a false narrative, although technically correct, to suggest that pension funding dramatically improved in 2019 for multiemployer pension plans. To suggest that there was an 11% increase in funding is outrageously misleading. U.S. interest rates, especially long-term interest rates, plummeted in 2019 driving liability growth (marked-to-market) higher and leading liability growth to exceed asset growth despite a very strong year for equity (and bond) markets.

It is this fallacy that continues to harm the long-term viability of pension systems. America’s pensions (public and multiemployer) are not in good shape, and pretending that they are because of accounting rules that allow pension liabilities to be discounted at the return on asset assumption (ROA) is reckless! We need an honest evaluation of our pension system so that important changes can be made to help protect and preserve them before they collapse.

Pretending that everything is hunky-dory is dangerous and ineffective. I would encourage you to refer to either the Ryan ALM Pension Monitor in the latest edition of P&I (2/24/20) or the quarterly Ryan ALM Newsletters that can be found at RyanALM.com to see the latest truth on pension funding.

We are extremely pleased to announce that P&I has published the initial Ryan ALM Pension Monitor in the February 24th edition of Pensions & Investments (page 23). The Pension Monitor highlights assets versus liability performance for Corporate, Multiemployer, and Public pension plans, both on a calendar and cumulative basis.

Despite the good equity and bond markets, pension liabilities continue to outperform assets during the last five years, and that is before this awful week for Pension America. Our objective is to publish this monitor on a quarterly basis, but we can certainly provide updates on a monthly basis if you need that insight.

Pension plans should absolutely NOT be managed to a return on asset assumption (ROA), as the only objective that matters is if the plans have secured the benefits that were promised. Continuing to inject more risk into these plans in pursuit of the ROA is reckless.

Pension risk management

I just had the opportunity to speak at the Opal/LATEC conference in New Orleans on the topic of pension risk management. For many plan sponsors and their consultants, “risk management” is focused on the asset side of the equation, but managing a DB pension plan is much more than just assessing the risks associated with plan assets. We, at Ryan ALM, espouse a risk management approach that focuses first and foremost on the plan’s liabilities.  Liability-driven investing (LDI) is a refocusing of the management of the plan’s pension assets away from an “asset only” approach to an approach that considers both the assets and the pension plan’s specific liabilities. The objectives are two fold: 1) secure the promised benefits, and 2) maximize the cost efficiency of the plan’s asset allocation.

There is more than one way to de-risk a plan within the broad Liability-driven investing category:  pension risk transfers, duration matching, and cash flow matching are three of the most common approaches. At Ryan ALM we utilize cash flow driven investing (CDI) as the preferred implementation for we believe that it is the most precise and least expensive de-risking strategy.  However, many corporate plans, and some public funds and multiemployer plans, have used duration matching strategies to accomplish their goal of neutralizing interest rate risks (not necessarily securing the benefits) with a combination of target duration LDI, Treasury STRIPS, long government/credit, and in some cases derivatives to construct a portfolio suited to meet an individual plan sponsor’s liability hedging goals.

Plan sponsors that have used long credit maturities and longer duration STRIPS to duration match their plan’s liabilities may want to reassess the composition of their fixed income program at this time.  U.S. interest-rates continue to plummet, as both the 10-year (1.33%) and 30-year U.S. Treasury (1.82%) rates are at historic lows. By selling the long-term credits/STRIPS, plan sponsors can lock in significant gains from these assets and then use the proceeds to cash flow match near-term Retired Lives liabilities (1-10-years) chronologically in order to finally secure those promised benefits, while significantly reducing the interest-rate sensitivity of their holdings since CDI matches and funds future values (benefit payments) which are not interest rate sensitive.

Obviously, no one knows where U.S. rates are headed, but at these incredibly low levels the probability of seeing interest rates remain flat to rising is greater than rates continuing to fall much further from here. We encourage you to use this unique opportunity to restructure your LDI program away from duration matching and refocus on cash flow matching 1-10 year Retired Lives using shorter maturity bonds to truly secure the benefits that have been promised to your plan participants. We’d be pleased to help guide you in this process.

Last July, American workers in failing multiemployer pension plans, also know as Critical and Declining (C&D) plans, got bi-partisan support from the House of Representatives when they approved H.R. 397. The bill went to the Senate at that time where it continues to reside. Is it on life-support? Melanie Waddell reported for ThinkAdvisor on a recent interview with Congressman Richard Neal (D, MA) in which the Congressman states, “Improving Americans’ retirement security remains a top priority of mine in 2020.” Neal also stated, “Last year, the House passed my Rehabilitation for Multiemployer Pensions Act — also known as the Butch Lewis Act — and I intend to do all I can to make sure the Senate passes that critical bill during this Congress as well.”

Let’s hope that he can get this done and sooner rather than later. As we reported earlier this year, the folks at Cheiron have estimated that each monthly delay increases the cost to “fix” this problem by $750 million! The Grassley and Alexander counter proposal to the Butch Lewis Act (BLA) , which was floated in November 2019, is too draconian (in my humble opinion) to even be considered by organized labor. Regrettably, the BLA does not currently have support from Senate Republicans to move this critical legislation forward.

We would prefer to see a legislative proposal that keeps these critically important DB plans alive and not be left to fail only to then have the PBGC step in to “save” a percentage of the promised benefits after their collapse. One criticism of the BLA is that some of the C&D plans receiving low-interest loans from the proposed Pension Rehabilitation Administration (PRA) would not be able to pay back the loan in thirty years. Why is that a problem? By providing the loans to these troubled plans, participants would get another 30-years of the promised benefits that would further help local economies and produce tax revenue at the state and federal levels that dwarfs the estimated cost of the program. Furthermore, aren’t debts renegotiated all the time? Why should these borrowers be treated any differently?

Corporate America continues to use different discount rate methodologies to measure and fund their pension plan’s liabilities. According to Russell Investments, the use of smoothing techniques (90%/110% corridor and 25 years) would create a discount rate of roughly 5.5% today, while a true marked-to-market discount rate would be about 2.5%. Plans claiming to be “fully funded” using smoothing are likely much worse off. The folks at Russell estimated that a plan claiming to be fully funded when using smoothing, would actually be only about 76% if the plan had a duration of about 12 years. A plan at 90% funded with an average duration of liabilities at 16 years might be truly funded at only 64%. Wow!

This certainly has implications for future contributions, PBGC premiums, the ability to engage in risk transfers, and other pension matters. Oh, and by the way, according to Russell “barring future changes to pension law, sponsors ought to be mindful of the coming phase-out of funding relief. With the ongoing decline in the 25-year average determined by the IRS, and the 90%/110% corridor expanding from 2021, the effects of funding relief will increasingly wear away. Contribution requirements will increase for many plans, bringing marked-to-market liabilities into economic reality.”

I saw the above chart in a MarketWatch article and it really struck home. We are living during a period of nearly unprecedented gains for the U.S. stock market, yet many Americans are being left behind. According to MarketWatch, “the rate of credit card balances that are 30 days or more delinquent at the 4,500 or so commercial banks that are smaller than the top 100 banks spiked to 7.05% in the fourth quarter, the highest delinquency rate in the data going back to the 1980s.

The need to borrow for many American workers doesn’t come from the fact that they are being frivolous with their money. It has everything to do with the fact that basic needs for items such as healthcare, education, housing, food, etc. are outpacing the earnings potential and incomes for many workers. A significant percentage of Americans now live paycheck to paycheck. So while it is great for the “Haves” that equity markets and home prices are rising, for many of America’s “Havenots” that reality is nothing more than a fairytale.

Given this fact, does it really seem logical to ask them to fund a defined contribution retirement program? Do you really believe that they have the disposable income to adequately prepare for a dignified retirement? The answer is, of course not. This is another reason why DB plans are so necessary for a great swath of our workers.

Ryan ALM is a leading voice in the trying to rescue and preserve DB pension plans. We were established in June 2004 with the mission to try to preserve these incredibly important social and economic tools by focusing greater attention to the promise that was given to the plan’s employees. We believe that everyone should be entitled to a dignified retirement, but the demise of the DB plan and the greater, almost exclusive use of the DC plan (within the private sector), is undermining this important effort.

Regrettably, we’ve seen DB plans nearly wiped out in the private sector.  However, a significant majority of public employees (estimated at about 85%) still enjoy the benefits of a traditional pension plan.  But for how much longer will they?  As I mentioned at the Opal/LATEC conference in New Orleans just yesterday, there is a perception among public plan participants and sponsors that these plans are perpetual. However, since the Great financial crisis most, if not all, public plans have taken action to reduce the future liability by asking employees to contribute more, extend vesting periods, reduce benefits for new hires, eliminate COLAs, etc.

This doesn’t signal to us that everything is honky dory! In fact, employer contributions have rocketed higher in the last couple of decades.  There are many examples of annual contribution rates being 25% to more than 40% of salary. At what level of contribution do these “perpetual” plans become unsustainable?  For many states and municipalities, the pension contribution is but one element of a social safety net that must be funded.  As the contribution rate escalates for DB plans, it naturally squeezes out other necessary programs unless there is no restriction on the taxing authority’s ability to raise revenue.

Given the pension envy that exists among those taxpayers in the private sector that aren’t participants in a DB plan (most), it is doubtful that they would be supportive of any administration that attempts to substantially raise taxes in this economic environment to fund someone else’s retirement benefit.

DB plans can be saved, but plan sponsors and their consultants need to begin to think outside the box. Focusing on the return on asset assumption (ROA), as if it were the Holy Grail, has lead to greater volatility and little reward to show for it! DB plans need to focus on the promise that they have made, use their funded status to adjust asset allocation, and de-risk plans as they see improved funding.  We missed the boat to de-risk at the end of the 1990s.  Let’s not blow it again!

As much of Pension America struggles to meet the promised benefits, significant work has been done to address the benefits through various tiers and changes to benefit formulas. There has also been a concerted effort to address the investment side with a significant shift from traditional asset classes, such as bonds and equities, to much greater emphasis on private markets, but at what cost, and is this move actually going to help plan sponsors and their consultants achieve the desired results?

Actuaries are fond to remind us of the pension equation:

C + I = B + E

Where C is contributions, I is the investment return, B is benefits paid and E is expenses, a big part of which are investment fees paid to managers.

Andrew Vo, CFA, Founder and CEO, Aidos, has penned an excellent article titled, “Venture Capitalists Are Getting Rich Off The Management Fees”, in which he discusses the concept of asset gatherers versus performance generators. He specifically focuses on VCs for his series of articles, but the same case can be made for hedge fund managers, too. The mega funds generate so much in management fees (2% in many cases), that a $1 billion AUM fund would generate $20 million per year and $200 million during the life of the fund (assuming the fund has a 10-year life) before the investors earn $1.

As mentioned above, Pension America is struggling in many cases to meet the promised benefits, and the move to private markets may not be the right course of action if at the end of the day these funds with these extraordinary fees don’t produce net results that exceed traditional asset classes, such as equities (private equity) or bonds (hedge funds). At the same time that plan sponsors are asking their employees (average Americans) to fork over a greater percentage of their salaries to help fund their retirement benefit, these same plan sponsors are rewarding the general partners of these funds with greater compensation packages. According to Mr. Vo, “many of these average Americans are government employees who rely on, and indirectly self-fund, their public pension plan, the same public pension that often misallocates capital to Venture Capitalists who earn 85X the salary of the government employees who partly funded them.”

If asset consultants and their clients continue to believe that investing in private markets – both equity and fixed – makes sense for the long-term viability of Pension America then let’s align all of the interested parties. Let’s adopt a new framework in which management fees of this magnitude disappear for good and a greater percentage of the outperformance is provided to the GPs of these funds, such as 30%. What do you think?

We are pleased to share with you Ryan ALM’s latest research paper, “Pension De-risking, Cash Flow Matching versus Duration Matching”. You can view the full white paper here.

Many defined benefit systems, especially within the private sector, have been engaged in de-risking activities for some time now. The prevailing methodology has been to use duration matching, but is that really the most effective way to secure the promised benefits at the lowest cost and reasonable risk? We believe that Cash Flow Driven Investing (CDI) is the more effective process to ensure that the cash flows will be available to meet the benefits as they come due. This piece will explain why we’ve come to that conclusion.

We hope that you find our thoughts insightful, and we look forward to receiving your feedback whether in the form of questions, comments and/or concerns. Don’t hesitate.