I had been hearing rumors, as I’m sure that many of you were too, that the PBGC was going to present their “Final, Final Rules” as it relates to the ARPA implementation this week. We have been waiting roughly six months since they informed us of their “Interim, Final Rules” last July. Well, it is Friday, and it doesn’t look like we are going to get any update today, especially since the Office of Management and Budget (OMB) has not been provided with an update for their review. According to someone who I absolutely trust, an OMB review is a standard part of the rulemaking process. The updated guidance will not be released to the public until the OMB has reviewed those changes if any.

As we know, the Special Financial Assistance (SFA) grant has been approved for two plans to date. Another two dozen or so are in the queue, with many plans having had to submit revised applications. Most pension plans that used MPRA legislation to previously cut benefits have not filed an application for the SFA as of yet despite being eligible to do so since January 1st. Perhaps they are just waiting for these “final” rules to be published. Let’s hope that is the case.

Anyway, I’m not expecting a major update to this legislation. There may be some tinkering with the eligible list of investments for the SFA segregated assets, but that won’t dramatically improve this legislation. It will do more to destabilize the grant money’s original goal to “secure” benefits for as far out as possible. It is unlikely that the current discount rate will be reworked, as a change there could result in a substantial increase in the cost of the legislation, which is currently estimated at roughly $90-$95 billion. I do know that the legislation called for as simple a process as possible to file and receive grant money. Six months into this process and I think that it is safe to say that goal hasn’t been accomplished.

I’m writing this post from 35,000 feet as I return from a terrific Opal conference in Scottsdale, AZ. The conference was focused on public pension funds. It was great to be back among industry peers and friends who I have known for years. I was impressed with the panels and the questions from the audience. However, what struck me were the several comments expressed by leading plan sponsors that identified the “securing of the promised benefits” as THEIR primary focus. They couldn’t be more right! For years, we at Ryan ALM have claimed that the primary objective in managing defined benefit plans was to SECURE benefits at both reasonable costs and with prudent risk.

However, for most of my 40-years in the pension/investment industry, achieving the return on asset (ROA) objective has been the dominant pursuit by sponsors, consultants, actuaries, etc. This objective has led to a significant migration within asset classes from a more balanced fixed income/equity mix to one that is today dominated by equity and equity-like risk products. The volatility associated with this asset mix migration has ramped up as well. Furthermore, liquidity to meet benefit payments and expenses has become more challenging.

Yet, for two days I heard several public fund sponsors tell the audience that securing benefit payments was their most important objective. I nearly jumped out of my seat on those occasions. You see, it was just roughly 5-7 years ago that I could attend an Opal conference or any other sponsor’s conference and not hear the word LIABILITY once. Now you hear the mention of pension liabilities throughout the sessions. But what really has changed? Have plan sponsors, their consultants, and actuaries really changed the focus from one that is return centric to one that has liabilities squarely in the scope? Private pension plans certainly have, but they in many cases are trying to de-risk their plans with the goal of freezing, terminating, and eventually transferring their pension liability to an insurance company.

Public pension sponsors desperately want to preserve their DB pension systems and rightly so. These plans were designed to reward their participants for a job well done. The benefits paid help participants to achieve a dignified retirement. Failure to secure the funds necessary to meet these obligations would be disastrous. Yet, the change in asset allocation witnessed during the last 2+ decades creates an environment in which huge swings in funded status can be realized leading to significant increases in contribution expenses by the sponsoring entity. These increases have gotten the attention of taxpayers, many of whom don’t have a defined benefit plan to help them retire.

Today, we have seen significant improvement in funded ratios and funded status for many public pension plans. If securing the promised benefits is truly their new focus, it is time to take some risk off the table. The prospect of rising US interest rates will lead to challenging times for total return-oriented fixed income programs. But the total return is NOT the value in fixed income. Their value is the certainty of their cash flows! Use fixed income assets currently allocated to these programs to secure the promised benefits through a cash flow matching program that will move assets in lockstep with a plan’s specific liabilities while creating the liquidity necessary to meet the monthly payments. The current fixed income allocation might just secure the next 10 years or so of benefits after contributions, which helps create a bridge of security for your risk assets that can now grow unencumbered, as they are no longer a source of liquidity.

Don’t risk your improved funding. Secure those promised benefits for the participants who have represented your system with the utmost professionalism. They deserve to be able to sleep well at night knowing that no matter what happens within the volatile segments of our capital markets that their benefits have been protected for the foreseeable future.

The 18 Pension plans that received approval under MPRA to file for benefit relief have been slow to file their application for Special Financial Assistance (SFA). These plans were part of Priority Group 2 under the PBGC’s pecking order that permitted filing to begin on 1/1/22. To date, only Local 805 Pension and Retirement Plan has filed its application. Given that nearly 6 months have elapsed since the PBGC announced their “Interim Final Rules” in July 2021, one would think that applications would have been filed immediately upon the designated date. That clearly hasn’t been the case.

There is some speculation that more than one of these plans may not file for the SFA given the issues related to the legislation’s implementation and the likelihood that any SFA received would not be nearly sufficient to cover the prescribed 30-year time (until 2051) frame for the securing of benefits and expenses. These plans, using MPRA, have restructured their payouts to current beneficiaries and future retirees hoping to extend that life of the plan. A “reworking” of the benefits for plans that receive the SFA may create greater headaches than those that exist today. The truly sad part of this legislative failure is the expectation that benefits were to be restored to those participants who saw in many cases draconian cuts. A decision to not file for the SFA will be devastating news to the tens of thousands of plan participants that were celebrating the passage of ARPA last March.

My hope would be that any plan that has cut benefits under MPRA should gladly accept this grant from the Federal government to restore benefits. The SFA grant won’t likely cover more than 8-10 years of benefits, but it certainly buys time for future legislative efforts to bring effective change that actually accomplishes the intended action of protecting and preserving benefit payments for the next 30-years. These poor participants have gone above and beyond in their effort to help get legislation passed. It would be a slap in their face if a decision were made to forgo the receipt of this government largesse.

There are supporters and critics of almost any action or decision, especially in today’s hyperactive social media environment. The movement to consolidate downstate fire and police pension systems in Illinois is no exception. There were 649 police and fire plans merged for investment purposes into two large funds with about $15 billion in total AUM at the time of the consolidation. The primary motivation was to gain access to more investment opportunities because of scale, while also capturing some economies of scale in terms of fees, as many (roughly 65%) of these plans were <$20 million. I’m sure that there were other factors, as well.

What concerns me about this recent action has to do with asset allocation decisions based on the funded status of the individual systems that have been rolled up into these larger entities. Every plan’s funded status, contribution history, and unique liabilities should be factored into an asset allocation framework. However, that is not the case here. Every plan gets the same asset allocation depending on the pool that they invest in. How does this make sense? Asset allocation decisions should reflect the funded status. A plan that has a 90% funded ratio should NEVER have the same asset allocation as a plan that is 40% funded. Yet, that is precisely what will happen in Illinois.

Plans that are well funded should be able to reduce the risk inherent in the asset allocation, while those plans that are challenged from a funding standpoint should be given the opportunity to inject more risk into their asset allocation framework. We’ve seen what can happen to a well-funded plan when markets get hit, and they will again. Most public pension systems were overfunded in the late ’90s. Instead of securing the promised benefits and winning the battle, plans reduced their fixed income exposure and ramped up equity and alternative allocations. This decision proved disastrous, as two major market corrections decimated the funded status of Pension America during the ’00s leading to an explosion in contribution expenses as a direct result of this action.

We are once again at a point where public pension funds (and those of corporate America and multiemployer plans) have seen improvement in their funded status. It would be fiduciarily imprudent to not take risk off the table at this time. With equity valuations teetering at very expensive levels and US interest rates forecast to rise, perhaps rapidly so, markets could destabilize fairly quickly. It’s not like we haven’t seen this story play out before our very eyes. I applaud Illinois for trying to do something to sure up their unfunded police and fire plans, but not providing each system with the opportunity to tailor their plan’s asset allocation is a huge mistake. I wouldn’t want to be the municipal finance officer who has to inform their citizens that the 90+% funded plan is now at 65%.

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.

 

Since peaking at $68,789 per Bitcoin on 11/10/21, the price has fallen by more than 35% to just over $44,000 as I write this note. So much for the inflation hedge expectation and uncorrelated nature of this entity to other “asset” classes. Furthermore, it continues to trade like a “meme” stock. Oops!

Thank you, Alanis Morrissette, for coming up with a song title that is just perfect for today’s blog. Many industry practitioners have been complaining loudly, including us at Ryan ALM, that the discount rate used in the ARPA legislation (the 3rd segment under PPA + 200 bps) is wrong! This discount rate understates the “true” level of a plan’s liabilities. Instead of the one that was in the legislation, we should be using all three segments under PPA without any additional basis points penalty. As a result, the Special Financial Assistance (SFA) is much smaller than these struggling pension plans should be getting to fortify their funded status and preserve the promised benefits to pensioners through 2051.

However, many of the same industry voices are arguing that it is absolutely appropriate to use the return on asset assumption (ROA) to value a plan’s liabilities on an ongoing basis. HUH? Public pension systems operate under GASB accounting rules that permit this inappropriate accounting methodology instead of the discount rate required under FASB, which is much more of a true market-based rate. Multiemployer plans operate under a FASB hybrid system, with many (most?) using the ROA to “value” their plan’s liabilities. As a result, most multiemployer pension plans have funded ratios that are overstated, as their plan’s liabilities are understated in this historically low-interest-rate environment.

This action causes many problems, including the belief that the “ONLY” objective for multiemployer plans is to achieve the ROA! That is so wrong! The primary objective in managing a pension plan is to SECURE the promised benefits at a reasonable cost and with prudent risk. The pension objective is absolutely not to achieve a ROA target that in many cases has been determined through a “Goldilocks” approach. Pension plans of all types have been hurt by the significant decline in US interest rates since the bond bull market began in July 1982. As a result of this incredible fall in rates, the present value of plan liabilities has grown disproportionately relative to the benefit that the assets would have gained from a similar fall in rates, given the difference in the duration of a plan’s liabilities and its average fixed income exposure.

However, the absence of a true focus on pension liabilities, especially among public and multiemployer plans, masks this development. It doesn’t mean that the problem isn’t real, it does mean that many decisions with regard to asset allocation and benefits have been based on the wrong set of valuations. Now is the time for a re-thinking as an industry no matter what the accounting rules might suggest. After 39-years of US rates falling to incredibly low levels, we may finally be on the verge of seeing rates rise given the current inflationary environment. If rates rise, the present value of your plan’s liabilities will fall. In this scenario, a plan “wins” if assets outperform plan liabilities whether the targeted ROA is achieved or not. A 3% absolute return on pension assets outperforms a -3% on liabilities growth rate. It won’t take much of a backup in rates for a plan’s liabilities to dramatically underperform. 

Most pension systems have an average duration of their liabilities between 10-15 years depending on the maturity of the plan. In an environment in which US rates move 100 bps higher, a plan with a 12-year duration would see the present value of those liabilities decline by 12%, and with a YTM of liabilities (@ 2%) the pension plan experiences a -10% liability growth rate. A plan’s assets achieving only a 3% return would look heroic relative to liabilities despite not achieving the ROA’s hurdle. During the truly remarkable decline in rates, pension liabilities dramatically outperformed assets, even for those plans that regularly achieved or exceeded their return target.

So, is the SFA understated because of the wrong discount rate being used, or is the average multiemployer pension system’s funded ratio/status wrong because we are hiding behind accounting rules that mask the true story? Unfortunately, it is both! As an industry, can we finally commit to a TRUE accounting of our liabilities? Not having the truth means that actions taken are likely based on the wrong set of data which will invariably lead to the wrong conclusions. Ron Ryan wrote an award-winning book several years ago titled, “The U.S. Pension Crisis”. He lays the blame for our current situation on the “inappropriate accounting rules”. I couldn’t agree more. Pension America’s DB plans need to be protected and preserved, but that won’t happen until we truly know the scope of the funding issues.