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)
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.