As anyone knows who regularly follows this blog, Ryan ALM and I are huge fans of defined benefit pension plans (DB), and we work tirelessly trying to preserve and protect them. This doesn’t mean that we don’t appreciate defined contribution plans (DC) – we do – but supplemental (to DB plans) as savings vehicles. We also understand the motivation on the part of sponsors to migrate from DB plans (they don’t want to own the liability), but we still feel that it is an unfortunate trend. All that said, 2021 was a terrific year for sponsors of DB plans whether they were public, multiemployer, or private pensions. Capital markets and legislative initiatives combined to create an extremely favorable environment for Pension America. A year in which the average funded status improved, and in some cases, to levels not seen since the end of 1999. There are so many possible highlights to focus on, but I want to keep this post relatively short, so I’ll focus on the American Rescue Plan Act (ARPA), pension obligation bonds (POBs), equity markets, and US interest rates.
Legislation: It was extremely disappointing that the Butch Lewis Act (BLA) was never taken up by the US Senate in 2019, but we did get “Son of BLA” in the form of the American Rescue Pension Act (ARPA). This legislation was passed and signed into law in March. The Pension Benefit Guaranty Corporation (PBGC) was tasked with implementing this legislation. We are pleased to see following months of review, the “First Tier” applications are finally being approved (two so far). The Special Financial Assistance (SFA) will begin to flow to these plans soon. As a reminder, these grants are being given to multiemployer plans that are in Critical and Declining status and either currently insolvent or on the verge of insolvency. Importantly, benefits to participants that were cut under MPRA are to be reinstated if their pension plan receives an SFA grant.
Pension Obligation Bonds (POBs): Municipalities and states are aggressively using POBs to improve the economics of their pension systems. The historically low US interest-rate environment is providing a unique arbitrage opportunity. POBs have been around since the mid-’80s, but the pace at which they are being offered has established a new record. Only 2003 saw more $s committed to POBs than in 2021. Several entities, including the Center for Retirement Research at Boston College and the League of Municipalities, continue to be opposed to their use. We, at Ryan ALM, are supportive of POBs provided that the proceeds from these bond offerings are used to defease the plan’s Retired Lives Liability and NOT injected into the plan’s existing asset allocation, especially given current market fundamentals and valuations for both bonds and equities. Ryan ALM believes that POB proceeds should mirror the same asset allocation and objective of ARPA – secure the benefits! Plan Sponsors should invest POB proceeds in investment-grade fixed-income securities to defease projected benefits chronologically.
Equity Markets: The US stock market, as measured by the S&P 500 is up more than 27% YTD. This is the second-best annual return since 2013’s +32% result. Despite the wonderful performance result, all is not rosy. The Federal Reserve’s historic stimulus has potentially created an asset bubble rarely seen before. Equities have benefited tremendously since the Great Financial Crisis through this abundant liquidity (QE1, QE2, QE forever). Despite the stimulus, GDP growth has been modest at 2.3% per year since 2010. Wage growth, until recently has been weak with real annual increases of only 0.26% compared to 0.7% during the ’90s, and the labor market, as measured by the Labor Participation Rate, has shrunk to levels not seen since 1976 (<62%). Furthermore, roughly 85% of active equity managers have failed to beat the S&P 500 this year. A major contributor to this relative underperformance is the concentration within the S&P 500 to mega Technology stocks that continue to lead markets higher. This concentration in leadership tends to favor passive investment vehicles and 2021 is no exception. We should all be asking what the next 10-years will bring for equities.
US Interest Rates: The onset of Covid-19 brought the US economy to its knees in early 2020. As a result, US interest rates fell to levels not seen before (1.02% for the 30-year and 0.50% for the 10-year). As we began 2021 expectations were firmly established that rates would have to rise, and that expectation was quickly realized, as the US 30-year Treasury Bond saw its rate rise from 1.66% on the first trading day to 2.46% by early March. With inflation picking up to levels not seen since the early 1980s, most market participants felt that rates would continue to rise throughout the year and into 2022. Well, that didn’t happen, and as of today’s writing, the yield on the US 30-year Treasury sits below 2%. Will it remain there? Unlikely, as the Federal Reserve is expected to raise short rates at least 3 times next year. For pension America, any rise in rates helps reduce the present value of a plan’s liabilities, but it can be nasty for the plan’s fixed-income exposure if the allocation is focused on total return and long maturities.
So, in conclusion, 2021 was a terrific year for pensions. Now what? Given the improved funding and general expectations for more challenging environments for both equity and bond markets, plan sponsors should seriously consider reducing risk. It would be a travesty to waste all this good news by letting asset allocations remain static and subject to the whims of the markets. Use this unique time to reconfigure your fixed-income exposure to better manage assets versus plan liabilities. This reconfiguration will dramatically improve the plan’s liquidity while eliminating interest rate risk for the portion of the portfolio that will now focus on defeasing liabilities. This action will also buy time for the plan’s alpha assets (non-fixed income) to grow unencumbered, as they are no longer a source of liquidity to meet benefits and expenses. Furthermore, the buying of extra time allows markets to recover should we witness another major market correction. As we conclude 2021 we celebrate the great success enjoyed by Pension America. But, now is not the time to sit on one’s laurels.