Lotteries are a Cash Flow Matching Proof Statement

Let’s talk about the Mega Millions Lottery, which is now offered in 45 US states and 2 additional territories. I wish that I were ready to announce that I’d won the $632 million from last night’s drawing, but alas, I’m not that lucky! However, the 2 winners will soon have to decide whether they take their winnings in a lump sum or in 26 annual payments. Most winners take the lump sum believing that they’ll generate a return greater than the annual growth rate factored into the future payouts. But, if they were to take the annual payments, how does the lottery system ensure that the proceeds are there when needed?

Let’s assume in this case that the winning ticket pays $10 million in total. The owner of the winning ticket is now going to own a series of 26 yearly payments that add up to $10 million. The lucky gal would receive the first payment for 2.5 percent of the total, or $250,000 (some taxes would be withheld from each check), two weeks after submitting the winning ticket. One year later, they would receive a check for 2.7 percent, or $260,000. Each year, the amount of the check goes up by a tenth of a percent with the last payment at 5 percent, or $500,000. In order to guarantee that the funds for all of these payments are available, the Lottery sponsor buys U.S. Treasury Bonds called STRIPS. (Separate Trading of Registered Interest and Principal of Securities). These are also known as zero-coupon bonds.

A zero-coupon bond pays a certain amount of money when it matures (future value). The longer the amount of time before the bond matures, the less it will cost you today (present value) to fund that future liability. Have you heard of any lottery systems going broke or being significantly underfunded? I haven’t! This is a “sleep well at night” strategy that doesn’t inject unnecessary volatility into the process. The liability is known (future payout) and the funding is secured using fixed income instruments. This is how defined benefit pensions (DB) were managed decades ago. Liabilities were known, monitored, and managed using defeasance and immunization strategies. The sponsoring entity wasn’t trying to achieve a return as an asset objective hoping that a collection of assets actually provided the “forecasted” return. Why do we live with that risk today?

The volatility in return patterns witnessed within DB plans since 2000 plays havoc with the contributions necessary to make up for any shortfall. As a reminder, most pension plans were well overfunded in the late ’90s. Instead of securing the victory, we saw asset allocation strategies reduce fixed income exposure, the only asset that resembles a plan’s liabilities, and instead, they injected more equity risk into the equation. This “strategy” failed miserably when markets got crushed on two different occasions during the ’00s (2000-02 and 2008). As a result, contribution expenses skyrocketed, and funded ratios plummeted. Not good!

Today, funded ratios have improved, but contribution expenses are still significantly elevated from 2000, as deficits are being amortized. Why did Pension America move away from the goal of securing the promised benefits with little risk toward a funding strategy that was predicated on taking more risk? Lottery systems are thriving in the US and around the world. On the other hand, defined benefit pension systems are under great pressure because of the costs associated with providing the promised benefit. Shouldn’t Pension America rethink the current strategy? Wouldn’t we be much better off securing a portion (Retired Lives Liability) of the promised benefits today? We believe that plans should bifurcate the asset allocation to Beta (defeased portfolio) and Alpha (risk/growth assets) buckets that serve to secure near-term funding needs while allowing the risk assets to grow unencumbered to meet future liabilities. Why would you ever want to use dividends and income from growth assets to fund assets? Let the Beta assets be the liquidity necessary to provide proper funding in securing benefits while reducing contribution costs and volatility.

Most plans have an allocation to fixed income already within the asset allocation. That exposure is likely to come under great pressure as the 39-year bull market for bonds ends. Convert your traditional return-seeking bond allocation to a cash flow matching strategy that will secure benefits and expenses for some # of years determined by the size of the current fixed income allocation. The remaining risk/growth assets can now grow unencumbered as they are no longer a source of liquidity. If interest rates go up, cash flow matching will enjoy lower funding costs while return-seeking bonds will receive a negative return. DB pension plans need to be protected and secured but managing them with a return focus instead of a liability focus only increases the odds that problems will present themselves sooner than later… remember the 2000-02 and 2008 corrections. It is time to get off this rollercoaster.

 




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