Anyone who knows Ryan ALM and who has followed our blog posts for years knows that we are big supporters of DB plans as the primary retirement vehicle for the masses. We’ve discussed our rationale for this stance numerous times. That said, recent market action and economic activity have put public pension systems once again in the spotlight. The battle to control the outbreak of Covid-19 has impacted many state budgets from both a revenue (income and sales taxes, lotteries, fees, etc.) and expenses standpoint (Covid-19 emergency responders, PPE, etc.), and the likelihood of escalating contributions into state pension systems may be too much for some states to handle. What can be done?

Unfortunately, there aren’t an infinite number of actions that will improve plan funding, and in the cases of states like NJ, IL, and others, dramatically improve their systems’ funded status. In fact, there are really only five actions that would lead to improved pension funding, including; 1) assets outperform the ROA target, 2) the present value of future liabilities fall, 3) both actions 1 and 2 occur, 4) borrow additional resources (POB), and 5) renege on a portion of the promised benefits.

With regard to action 1, plans have been relying on asset performance for years to make up for contribution shortfalls. In most cases this goal has been met with enhanced volatility, but little reward. As we pointed out in a previous blog, the Bloomberg Barclays Aggregate Index bested the S&P 500 for the 20-years ending March 31, 2020, despite a greater than 10-year bull market for equities, little improvement in funded status occurred.

We have been in a protracted bull market for bonds since I entered the industry in 1981. The impact on pension systems from falling interest rates (action 2) has been devastating (I will have more on this issue in a subsequent blog post). How likely are rates to rise from here? Most participants in our industry have felt that rates would “normalize” for years, only to see one event after another drive rates further lower. Action by the US Federal Reserve has damaged (permanently?) pensions and retirees, who need income to sustain quality retirements. The movement of rates lower has correlated with plans and pensioners taking on more risk to try to create additional income. It has also proven to be a disaster.

Ideally, we would enter a protracted period of asset appreciation and rising interest rates that would lead to a fairly quick recovery in pension funding. For instance, at such low market interest rates, a 30 bps increase in rates would create negative liability growth for the plan. Given that dynamic, a Funded Ratio of 60% could improve significantly to 89.4% if in the next 5 years average asset growth was just 4% and average liability growth was -4%. The improvement is even more dramatic if during the next 5 years assets grew by 5%. In this case, the funded ratio would improve to 94.0% if liability growth proved to be negative 4% during this period. But given that our economy is just opening up now, how much economic growth, inflation, and rising rates can we expect in the near-term?

Action 5, the trimming of promised benefits, (yes, I jumped over my fourth “opportunity”) is a last resort action, and in many cases individual state laws prohibit such an action. Since the Great Financial Crisis (GFC), a majority of public pension systems have altered benefit formulas directed at new employees, but that does little to tackle the current under-funding. Furthermore, these plan participants have invested both years of time and their own contributions into a system with the expectation that they would receive the promised benefits. Anything less is truly an affront.

With regard to action 4 and the borrowing of funds, I believe that for states such as NJ, IL, KY, CT, etc. the issuance of a pension obligation bond (POB) is the only way for these systems to climb out from the huge hole that was dug by years of habitually under-funding their plans. POBs have been tried many times before and with mixed results, but I believe that the investment of the bond proceeds was implemented inappropriately, which ultimately lead to the failure of the action.

Historically, a pension plan would take the proceeds from the bond and invest those assets in a traditional asset allocation. As a result, the proceeds are subjected to the whims of the markets. In many cases these assets have been injected at an inappropriate (market peaks) time leading to losses. The plan is then on the hook for the original interest payment on the POB and the loss suffered on the “investment”. To mitigate this risk, any proceeds from the POB MUST be used to defease the plan’s retired lives liability. The current assets in the plan and any future annual contributions would then be used to meet future liabilities. Given the magnitude of the funding crisis, HOPING that assets will dramatically outperform, while interest rates rapidly rise is a lot to ask for. Cutting benefits is a non-starter. Issuing a POB and injecting significant assets into the system to SECURE pension promises seems to me to be the most viable alternative.

Let us know what you think.

Representatives from the Federal Reserve Bank in St. Louis recently discussed on a defined contribution webinar the implications for the retirement industry as a result of the Covid-19 crisis. The key action items discussed were all significant issues prior to the virus’s impact on our economy and markets, but the magnitude of the issues has certainly been exacerbated. Many of the following items have been highlighted in this blog before.

There is an urgent need to address these issues, which include: 1) Americans’ lack of emergency savings, 2) racial and economic inequality in retirement savings, 3) lack of access to workplace retirement plans, and 4) the Millennial cohort. As you can see, there is a host of critical issues just involving retirement savings, let alone all the other issues that are dominating our political and cultural landscape today.

Most of these issues have to do with the fact that a majority of Americans just don’t have wages that provide them with more than enough to just meet their basic needs. As a result, they don’t have funds to meet emergency expenditures. We’ve been reading about this for years how the average American can’t meet a $400 medical or auto expenditure without having to borrow. Even if these American workers had access to a retirement plan, and only about 50% do, they don’t have the disposable income to put money aside.

With regard to inequality, two-thirds of white families have 401(k) plans, while only about 1/3 of nonwhite families are participating in a DC-like plan. For those that are participating in a DC retirement plan, white families have saved on average $155,000, while non-white families have about $60,000, and those figures are from before the recent market sell-off. Trends in the American labor force (on-call arrangements) and the impact of that trend on wages and benefits are constraining one’s ability to save. Nonwhite Americans suffer as a result of the lack of wealth transfers from one generation to the next.

Lastly, as the father of five children (4 millennials), I am particularly concerned about the continuing impact of one crisis after another on this generation. The children of the ’80s and early ’90s have been stung by the burden of excessive student loan debt and the Great Financial crisis, just as they were entering the workforce, which had a profound impact on their starting salaries. At the point where some of this cohort may have just been recovering, they are hit with the Covid-19 crisis. This generation is clearly losing the “birth lottery”. According to recent studies, this generation’s wealth is 34% below where one would expect it to be at this age. Clearly, the implications for the long-term are devastating.

With so many Americans living within 200% of the poverty line, we need to address income inequality, but that might not be enough to help close the retirement gap. We need to rethink the inappropriateness of DC plans as one’s primary retirement vehicle, and once again consider them nothing more than supplemental income funds. If an American has a job, they should be receiving credit towards a defined benefit system. If this needs to be done outside of their employer/employee relationship – so be it! Asking untrained and underpaid employees to fund, manage, and disburse a retirement benefit is a failing policy that is leading to a disastrous outcome.

We, at Ryan ALM, are proud to share with you Ron Ryan’s chapter on Cash Flow Matching, also known as cash flow driven investing (CDI), that will appear in Dr. Frank Fabozzi’s latest edition of the “Handbook of Fixed Income Securities“. This is quite an honor and recognizes Ron, and the Ryan ALM team, as one of the true experts on this subject. Fabozzi’s Handbook is usually required reading for the CFA degree, university Finance courses, as well as a valuable reference for many fixed income practitioners.

Importantly, this work highlights the differences between cash flow matching and duration matching, which has been the preferred pension de-risking strategy in the U.S., while CDI is the preferred method among plan sponsors in Europe. We would encourage you to take a look. One of my favorite sections is the “seven flaws of duration” in the CDI versus LDI section. I think that you’ll find Ron’s thought on this subject to be incredibly insightful.

As we’ve recently witnessed, once again, stock and bond market performance can dramatically impair even the best funded pension systems when the unexpected presents itself. Adopting a cash flow driven approach helps Pension America protect critically important plans in the short- to near-term, while the growth (alpha) assets enjoy an extended investing horizon to overcome recent weakness without becoming a source of liquidity. We would certainly welcome an opportunity to respond to any questions that you have regarding this subject.

I read with both interest and fascination an article in the WSJ today that mentioned that the last surviving Civil War pension recipient had just passed away. Irene Triplett was born in 1930. Her dad, Mose Triplett, was 83 when she was born. His wife at the time was nearly 50 years his junior. As a result of his military service, his daughter, who was 90 when she recently passed away, received a $73.13 monthly benefit from the Department of Veteran Affairs. The pension liability lasted 156 years! I’m not sure that is a record, but it has to be close.

One of the issues impacting pension America is the fact that pensioners, on average, are living longer, and as a result liability tables are being rewritten to account for this extended aging. That said, I doubt that anyone expected a pension liability earned in 1864 to extend to 2020.

When we at Ryan ALM ask for liability data – estimated benefits and contributions – we ask for a minimum of 20 years so that we can produce our Custom Liability Index (CLI). I guess that we will now need to rethink our request. Do we really need to get the actuary to forecast the next 150 years?

Yesterday’s blog post highlighted once again why asking untrained individuals to fund, manage, and disburse a retirement benefit (DC offering) is incredibly challenging. We highlighted the fact that fund flows for the month of April showed a significant bias toward fixed income and away from equities. Not surprisingly, U.S. equities massively outperformed during April 2020. Unfortunately, May’s performance results once again reveal a similar outcome, although not quite as dramatic.

For May, the S&P 500 was up 4.8%, while the Bloomberg Barclays Aggregate index advanced only 0.5%. Although bonds have produced two consecutive positive months (2.3%) the opportunity cost associated with moving out of equities in April has resulted in a roughly 16% “loss” for those plan participants that migrated away from equities.

Human nature being what it is, it isn’t surprising to see many investors move away from exposure to equities in April when they’d been tanking day in and day out for more than one month. When a 401(k) balance may represent your only savings, it is troubling to the individual to see one’s hard earned money losing value on a consistent basis, especially for those nearing or recently retired. This is exactly why a defined benefit plan is superior to a DC offering, as pooling of risk and a monthly benefit payout can mitigate this fear-factor.

The equity market reaction to the Covid-19 lock-down was destabilizing! Many professionals were torn on what to do in the face of this unprecedented event. Why would we believe that less-trained 401(k) “investors” would behave in a manner different than how they have reacted during most, if not all, market corrections? Regrettably, they didn’t.

Data from Alight Solutions 401(k) index show that in April bond funds received 31% of all retirement fund flows, while money market funds received 18% of the flows. Somewhat surprising was the fact that 19% of the money went to self-directed brokerage accounts. Which funds were the big losers? Target-date-funds accounted for 44% of the outflows, while company stock (24%) and large cap equity (16%) also saw meaningful withdrawals.

It is really disappointing to see the flows from the TDFs, since they are professionally managed asset allocation pools designed to be long-term holdings for individual investors geared to projected retirement dates. What is equally troubling is that equity markets rallied tremendously in April, as the S&P 500 advanced by 12.8%, while the Barclays Bloomberg Aggregate Index was up only 1.8%. Interest rates continue to rise slowly, which will further erode the principal in bonds.

Defined contribution participants have once again shown that they often time their allocation decisions at the most inappropriate time. Selling equities and buying bonds in April locks in substantial losses. If our economy opens up in any meaningful way it is likely that bond yields will continue to rise putting pressure on bond prices. For many 401(k) investors, this activity is damaging to their ability to build a meaningful retirement fund that will provide them with the opportunity to retire with dignity, if they can retire at all.

For those individuals fortunate enough to be in a professionally managed defined benefit plan, you were not asked to make an asset allocation or funding decision during this volatile time. You may have been wondering how your fund was holding up, but as we reported last week, most DB plans have the financial wherewithal to meet benefit payments long into the future. The anxiety and uncertainty experienced by defined contribution participants are palpable. Recent government legislation permitting early withdrawals from DC plans is only compounding the long-term implications!