At the end of 1999, the average US public pension plan had a funded ratio >100%. Yes, just a couple of short decades ago the average public pension plan was overfunded thanks to great equity returns during most of the 1990s. Wow! During the 1990s asset allocation models reduced their allocations to bonds as interest rates kept going down so by 1999 they had the lowest allocation to bonds in modern history.  Why? Well, when the yield on bonds went below the ROA target (8.0%+) starting in 1989, it was perceived that any exposure to fixed income would jeopardize a plan’s ability to achieve the ROA. If only a plan’s liabilities, and not its ROA, were top of mind in 1999 we wouldn’t have the pension issues that we do for many state and municipal plans.

According to several actuarial firms that track the funded status for public DB plans, the average funded ratio for a public fund is now in the low 70% range, when applying GASB accounting rules, which means that the discounting of liabilities uses the ROA rate instead of FASB that calls for a AA corporate bond rate to be used. The current yield on the 10-year US Treasury note is at 27% of the 5.65% (12/31/99 US Treasury note) yield that was deemed too low to be meaningful. Had plans focused on the liabilities by driving asset allocation through a liability lens, plans would have defeased their Retired Lives liabilities through cash flow matching when they were fully funded thereby securing benefits and low contribution costs. That exposure should have been used to defease the Retired Lives Liability. This action would have stabilized the plan’s funded status and contribution expenses, while also buying time for the alpha assets to work through some very challenging times, such as the Dot-Com bubble burst and the Great Financial Crisis.

As we discussed in a recent blog post, US public pension plans do have exposure to fixed income, primarily to provide the cash necessary to fund benefits and expenses. However, in a rising rate environment, traditional fixed income programs will see the value of their assets decline, producing a likely negative return for the plan. It is far better to cash flow match bonds with the plan’s liabilities ensuring that the cash necessary to meet the promised benefits will be kept. Furthermore, future values of promised benefits are not interest rate sensitive.

Instead of driving asset allocation decisions through a ROA lens, let’s adopt a return to traditional pension management that views the plan’s liabilities as the most important variable in the asset allocation decision tree. It makes no sense that a plan that is funded at 60% should have the same asset allocation as one funded at 90%, but this happens all the time, as these plans are focused on achieving the same 7.25% ROA. Given the improved funding that we’ve witnessed, it is time to focus on securing the promised benefits at low cost and with prudent risk. 

Remember when Alan Greenspan uttered this famous phrase? He spoke these two words at an American Enterprise Institute event in the 1990s. It was a reference to the stock market’s valuation during the Dot-Com go-go era. It was interpreted as a warning to investors that things had gotten too overheated. He was ultimately proven correct!

We think that pension plan sponsors, as well as any other type of investor, should heed this warning once again, as Irrational Exuberance seems to be everywhere today.

Stock market – Historically high multiples based on any fundamental analysis.

Bond market – 39-year bull market dating to July 1982

Single family homes – The median cost for a single-family detached house last month was $391,250, compared with $307,220 a year before (+27.4%)

Cryptocurrencies – What is it? It isn’t a currency. So, let’s pay $42,866.40 for one bitcoin that has no underlying value.

Also, let us not forget meme stocks, which are stocks that have seen an increase in volume NOT because of the company’s performance, but rather because of hype on social media. Now there’s an investment strategy for you!

Any one of these might give you pause, but all of them at the same time – oh, my! As we’ve stated on many occasions, after a successful run at a Vegas casino one should take some risk off the table. Pension plans would be wise to follow the same course of action. There is little from that list above that is suggesting to us that pension systems will be able to generate the types of returns that we’ve witnessed since the Great Financial Crisis and that they are banking on to reduce contribution expenses.

Now is the time to cash in those gains while simultaneously protecting the improved funded status/funded ratios. Defease your plan’s Retired Lives Liability as far out as possible providing your plan the opportunity to wade through potentially troubling markets in the foreseeable future. It would be a shame to see this funding progress wasted through complacency, or worse, neglect.

The US Federal Reserve has just released a report stating that inflation is running “hotter” than expected. That probably won’t come as a surprise to anyone buying nearly anything today. So, what happens to your fixed-income portfolio should we get continuing inflation that ultimately leads to higher rates? Well, if your pension plan is invested in a traditional fixed income product managed to a generic index, your bond portfolio’s principal will decline in value by 1% for every one-year of duration and every 1% increase in yields. Invested in a 5-year duration strategy, your portfolio will decline by 5% should interest rates back up 1%. Given where interest rates are your fund’s total return isn’t going to be protected much through income. We’ve been in a protracted bull market environment for US bonds since roughly July 1982. Fixed income managers and their clients have benefited tremendously from this tailwind. Is the bond party nearing its conclusion?

Plan sponsors of pension plans need fixed income if for no other reason than to have the cash necessary to meet monthly benefit and expense needs. Is there an alternative to sitting in a portfolio that will likely suffer principal and total return losses? There sure is! A portfolio of investment-grade corporate fixed income cash flow matched to your plan’s liabilities and expenses will provide significant protection from interest rate risk, as both the assets and liabilities will move in lock-step with one another. Actuarial projected benefits and expenses are future values which are not interest rate sensitive. By cash flow matching liabilities with bonds, you have eliminated interest rate risk which is by far the dominant risk in bonds.The Ryan ALM cash flow matching model (Liability Beta Portfolio™) is a corporate bond portfolio skewed to A/BBB+ securities. This LBP will outyield liabilities when discounted using ASC 715 rates of AA corporate bonds. This will produce some Alpha by the difference in yield (+/- 50 bps).

Furthermore, the cash flow matching portfolio (CDI) provides additional benefits. Importantly, because your cash flow needs are now taken care of for some period of time – we recommend 10-years – the non-bond assets (alpha assets) can now grow unencumbered, as they are no longer a source of liquidity. Studies have shown that the reinvestment of dividends is a major contributor to the S&P 500’s return over time. In fact, some studies that I’ve seen allocate 50% to 60% of the return coming from dividend reinvestment over periods greater than 20 years. In addition, both the funded status and contribution expenses should be more stable given this approach.

A pension plan’s asset allocation should be dynamic. It should be driven by the plan’s funded status and projected liabilities and not the return on asset assumption (ROA). There has been terrific progress made by many pension systems as a result of out-sized performance during the period since the Great Financial Crisis. It would be truly devastating to have those wonderful gains lost because we remained complacent thinking that yesterday’s great results were likely to happen once again. Now is the time to convert your fixed-income exposure from an allocation that will work against your fund should rates rise to one that insulates your portfolio against this great risk. Oh, and as rates rise, the CDI investment strategy gets to reinvest excess income at higher interest rates. That’s another benefit to adopting this approach. Call us. We’ve written the book or at least the chapter on CDI (Frank Fabozzi’s latest book).

It is common in our pension industry to fit every product/strategy into an asset class box. I understand the thought process, but it doesn’t work for ALM strategies, especially when discussing products that are designed to meet a client’s specific pension liabilities. As a reminder, no two liability cash flows are the same given different labor forces, salaries, mortality, and plan assumptions. This requires that every ALM mandate be tailored to meet the specific requirements of that fund. Thus, these unique ALM fixed income solutions can’t and shouldn’t be compared to a generic fixed income index. Such generic benchmarks are inappropriate objectives and are not a good fit.

In order to assist the asset consulting community and their clients, we at Ryan ALM created a Custom Liability Index ((CLI) trademarked in 1991) to provide the appropriate index for cash flow matching assignments (CDI) and any LDI strategy. When asked to provide CDI, we are usually asked to defease roughly 10-years of the Retired Lives Liabilities, but in several cases our mandates are for periods both shorter and longer. How would comparing these assignments inform anyone of our skill relative to say the long corporate index? Clearly, it wouldn’t. However, the Ryan ALM CLI produces the information absolutely necessary to determine if our fixed income skills were in place to match and fund each benefit and expense during the period that we are asked to cover. All that matters in these mandates is that we have secured and fully funded benefits at low cost, and with prudent risk.

If a pension plan were to hire a small cap core manager with the goal to beat the R2000 then placing that manager in a small cap box might make sense because they aren’t providing a unique solution since the objective is the same for 100s of managers. But asking a fixed income manager to create a cash flow matching strategy designed to fully fund a plan’s specific liabilities is as unique a solution as there is. Don’t try to put CDI or any custom LDI in an asset class box. The true value added and acid test of any CDI asset manager is the cost savings to defease the liabilities that have been targeted. It doesn’t matter how they perform versus the long corporate index or any other generic fixed income comparison. To help consultants and plan sponsors with return performance, Ryan ALM provides a CLI that calculates the growth rate (return) of liabilities and a Performance Attribution Report (PAR) that calculates 14 different risk/reward measurements of assets versus liabilities.

We’ve reported previously on the results of the Natixis Global Retirement Study. 2021’s results are out and the United States has fallen one spot to #17. Not much to be proud about given that ranking. Sure, we are one place ahead of the United Kingdom, but we trail the likes of Slovenia and the Czech Republic. We have 100,000s of well-intentioned individuals feverishly working on behalf of current and future retirees, but that effort isn’t creating the outcomes that our workers and retirees obviously need and want.

According to the study, the index “incorporates 18 performance indicators, grouped into four thematic sub-indices, which have been calculated on the basis of reliable data from a range of international organizations and academic sources. It takes into account the particular characteristics of the older demographic retiree group in order to assess and compare the level of retirement security in different countries around the world.” Those thematic sub-indices are Health, Quality of Life, Material Well-being, and Finances in Retirement. Regrettably, the U.S. doesn’t score in the top 10 in any of these categories. Shockingly, it scores in 34th place for life expectancy, which craters the overall Health ranking despite scoring well in 2 of the 3 main sections.

Importantly:

80% of individuals (including 77% of business owners in our survey) believe companies should be responsible for helping them achieve a secure retirement. In addition, 80% of individuals say they would be more inclined to work for a company that offered matching contributions to their retirement savings plan. That’s fine and dandy, but we’ve seen companies quickly eliminate or slash matches in DC plans when economic times get challenging.

If our goal is to provide a dignified retirement to our participants, then we as an industry need to do a much better job. Retirees need a monthly annuity that they can count on. Asking untrained individuals to fund, manage, and then disburse a “retirement” benefit with little skill to do this is a ridiculous exercise. Trying to manage a retirement portfolio in this low-interest rate environment is incredibly challenging and forces participants to chase more aggressive/risky strategies. I’m a huge fan of traditional defined benefit plans, but the private sector has abandoned them, and individual workers are less interested in working for one company anymore. I just read this morning that the average worker will have 12 employers during their career.

Lastly, too many American workers aren’t earning nearly enough to provide for their needs today let alone allocate a percentage of their incomes to a retirement benefit years away. Sure, I’ve read many an article about how people had wished they’d saved more for retirement, but you can’t get blood from a stone.

I suspect that most of us have no idea that today, September 10, 2021, is National 401(k) Day. This day is recognized every year on the Friday following Labor Day. The day is supposed to be an opportunity for retirement saving education and for companies to inform their employees about their ability to invest in company sponsored 401(k)s. Did you get your update today?

401(k) plans are defined contribution plans (DC). This plan type was created in the late 1970s as a “supplemental” benefit. Corporate America liked the idea of a DC offering because it helped them recruit middle and senior management types who wouldn’t accrue enough time in the company’s traditional pension plan. Again, the benefit was supplemental to the traditional monthly pension payment and not in lieu of it!

I think that defined contribution plans are fine as long as they remain supplemental to a DB plan. Asking untrained individuals to fund, manage, and then disburse a retirement benefit is a ridiculous exercise. Why do we think that 99.9% of Americans have this ability? Unfortunately, we have a significant percentage of our population living within 200% of the poverty line. Do you think that they have any discretionary income that would permit them to fund a retirement benefit when housing, health insurance, food, education, and transportation costs eat up most of an individual’s take home pay? Remember, these plans are predicated on what is contributed. Sure, there may be a company match of some kind, but we witnessed what can happen during difficult economic times. That employer contribution suddenly vanishes.

Defined benefit plans are the gold standard of retirement vehicles. They once covered more than 40% of the private sector workforce, most union employees, and roughly 85% of public sector workers. What happened? Did we lose focus on the primary objective in managing a DB plan which is to SECURE the promised benefits in a cost effective manner with prudent risk? Did our industry’s focus on the return on asset assumption (ROA) create an untenable environment? Yes, we got more volatility, but did we get the commensurate return? It was this volatility that impacted the financial statements and led to the decision to freeze and terminate a significant percentage of private DB plans. It is a tragic outcome.

What we have today is a growing economic divide among the haves and haves-not. This schism continues to grow, and the lack of retirement security is only making matters worse. DB plans can be managed effectively where excess volatility is not tolerated, where the focus is on the promised benefit and not some made up ROA and where decisions that are made relative to investment structure and asset allocation are predicated on the financial health of the plan and the funded status. We need DB plans more than ever and ONLY a return to pension basics will help us in this quest. Forget about all the new-fangled investment products being sold. Replacing one strategy for another is no better than shifting deck chairs on the Titanic. We need improved governance and a renewed focus on why pensions were provided in the first place.

We’ve been discussing pension obligation bonds (POBs) for the last couple of years and it seems as if folks are listening! According to a WSJ article that was published during the weekend, there have been 72 POBs issued in 2021 compared to the annual average of 25. In addition, more POB money has been raised this year than in any year during the last 15 years. We think that a POB can dramatically improve a plan’s economics provided that the proceeds are not used within the plan’s current asset allocation.

According to the WSJ article, the average interest rate for a municipal POB is 3%, while the average pension plan is striving for a 7% ROA. If the potential arbitrage is the driving factor in the decision to issue these bonds – good luck! Certainly, the historically low-interest rates help but remember that we are at historic levels for equities and the fundamental support is eroding. A dramatic decline in the equity markets would undercut the benefits of this issuance. We’ve seen this story unfold numerous times and it is what led the Center for Retirement Research at Boston College to issue their initial POB study in 2009. Their conclusions were not very supportive of using POBs to support DB plans.

There are potentially huge savings by issuing POBs in this environment, but plans need to be smart. Defease your pension liabilities chronologically as far out as possible using the POB proceeds. This allows your current assets and future contributions to be used for alpha-generating purposes, as they can now grow unencumbered as they are no longer a source of liquidity to meet benefits and expenses. Our work in this space has shown that plans can dramatically improve their plan’s funded status, stabilize contribution expenses, and in most cases reduce the target return on asset assumption (ROA). We’d be happy to produce a Custom Liability Index (CLI) highlighting the impact of your proposed POB on your plan’s future economics. Don’t hesitate to reach out for some help.

We, at Ryan ALM, are big supporters of Pension Obligation Bonds (POB) provided that the proceeds are used to defease the pension system’s liabilities chronologically for as far out as the POB allocation will permit. We are also encouraging the use of this funding strategy because of the historically low interest rate environment (reason #1). But there are other reasons, too. We remain very concerned about the underlying fundamentals of the US equity market and the extended blow-out performance for the last 10 years that would suggest (regression to the mean). As we wrote yesterday, the dividend yield on the S&P 500 (1.28% as of 9/1) has only been lower in 1999 (1.17%) and 2000 (1.22%).

For the 10-years ending 12/31/2009, the S&P 500’s total return (including dividends) was -0.95%! We aren’t suggesting that we are on the verge of a similar result, but given the 11 basis points difference in yield, we are intimating that US equity returns are not going to be close to historic averages for the next 10-years. Here are some #s to chew on:

S&P 500 (total returns through 7/31/21)

1-year   35.5%

3-years 18.2

5-years 17.4

7-years 14.7

10-years 15.4

20-years 8.8

Since 1871 to present: 9.1%

Reversion to the mean suggests that the 8.8% 20-year S&P 500 return generated through the period ending 7/31/31, would only produce a 2.6% return for the next 10-years given that it achieved a 15.4% return during the first 10-years of that period. Furthermore, I do believe that 8.8% is a reasonable target to shoot for over 20-year periods given the 9.1% annualized return since 1871. If you believe that a 10% annualized 20-year return is more appropriate because something has changed in the markets to support this higher target, a 10% annualized return for 20-years ending 7/31/31 would mean that the next 10-years produces a 4.85% annualized gain. Still no where near “average” long-term results or what is forecast for many DB plan asset allocations.

Why a POB? If plan sponsors are to receive considerably less from their alpha assets during the next 10-years, they will likely need to contribute much more than they have been to date. This greater contribution negatively impacts the sponsoring entity’s ability to support other important programs or initiatives. By issuing a POB at this time and using the proceeds to defease plan liabilities through a cash flow matching process, you are dramatically changing the plan’s economics, while securing the promised benefits for 10-years or more. In addition, you are providing those alpha assets with time to weather potentially rocky markets, as they are no longer a source of liquidity to meet benefits and expenses.

As stated previously, there is regression to the mean tendencies within our markets. You don’t get the types of returns that we’ve enjoyed recently without impacting (stealing from) future returns. There are strategies that can be utilized to help reduce the impact of weak markets on pension plan funding. Taking advantage of historically low interest rates to issue a POB and using those proceeds to pre-fund your plan makes sense to us. Defeasing the plan’s liabilities with those proceeds makes even greater sense. DB plans have benefited from historic returns recently. It is time to rethink your asset allocation for the next 10-years and beyond. We can’t afford as a nation to have more DB pension systems shuttered and plan sponsors can’t afford to see contribution expenses continue to rise. It is time to act.

There once was a time when investors demanded more from corporate America than just the opportunity to invest in companies with the hope of a return on that investment. They demanded and were given significant dividends. It was not unusual for the dividend yield on the S&P 500 to be greater than the yield on corporate bonds because of the risk that the equity investor was taking. In fact, it wasn’t until 1958 that the US 10-year Treasury Note had a yield that eclipsed the S&P 500’s dividend yield. Why the change?

In 1871, the dividend yield on the S&P 500 was 5.49%. It would remain robust for many years to come peaking at >10% in 1917 and 9.72% in 1931. It wasn’t until 1961 that we first had the S&P dividend yield fall below 3% (2.98%). It wasn’t until 1997 that we had the first dividend yield on the S&P 500 fall below 2%. The yield would subsequently bottom at 1.17% in 1999.

The dividend yield briefly rose to above 3% in 2008, but it has since plummeted to today’s level at 1.28% (9/1/21). Dividends have always played a significant role in the total return of the S&P 500 throughout its history. Furthermore, the level of the dividend yield has been a great predictor of future returns. We all know how the decade of the 2000s performed following the S&P’s lowest dividend yield. What does that suggest for today’s level and the next 10-years?

According to the folks at Advisor Perspectives, for an average holding period of 1 year, dividends accounted for 27% of total returns for the S&P 500 since 1940. Over a 10-year period the contribution of dividends to the total return rises to 48% and with a 20-year holding period dividends account for roughly 60% of total returns. Incredible! Worse than just the decline in the overall dividend yield is the fact that dividends are no longer as sacrosanct as they once were. We witnessed this quite dramatically during the second quarter of 2020 when many companies cut or eliminated their dividends in their response to Covid-19 related events. In fact, only 76% of S&P 500 companies paid a dividend in 2020 compared to 95% in 1980. Given how important dividends are to the total return of the S&P 500 over time, why would you ever elect to invest solely on the potential of an investment and not the certainty of receiving a significant down-payment each and every quarter?