By: Russ Kamp, Managing Director, Ryan ALM, Inc.
There seems to be a school of thought evolving within SFA eligible multiemployer plans on how to invest the grant’s proceeds. We are hearing that plan sponsors and their advisors will invest the SFA assets in investment-grade fixed-income as instructed by the PBGC’s Interim, Final Rules. However, we are led to believe that they are investing with the goal of generating a total return and not for the bonds’ cash flows which can be used to secure the promised benefits. Their goal is to pay benefits as quickly as possible from this segregated bucket given the low return expectation from fixed income while hoping that the legacy assets generate outsized returns to compensate for the SFA bucket’s lower expected returns. This is the wrong approach, especially given that we are living in a likely persistently rising rate environment in which interest rate risk is the single greatest driver of negative returns. Plan sponsors should be trying to manage these assets within the spirit of the legislation.
Here is our roadmap on how we believe that these critically important assets should be invested.
To fund and secure the promised benefits chronologically.
Section 9704 of ARPA provides Special Financial Assistance (SFA) to pension plans who are in critical funding status as follows:
“The amount of financial assistance… shall be such amount required for the plan
to pay all benefits due during the period beginning on the date of payment of the
special financial assistance payment under this section and ending on the last day
of the plan year ending in 2051, with no reduction in a participant’s or beneficiary’s
Note: Based on how the SFA is calculated, plans will not come close to securing 30-years of benefits, but they should strive to defease and secure as many years as possible.
What we know:
- The SFA assets must be segregated from the fund’s legacy assets
- Based on the Interim, Final Rules, only Investment-grade bonds can be used for investment purposes
Funding and Securing the promised benefits:
The only way to secure the promised benefits for as long as possible is to use a cash flow matching strategy (CDI) that matches and funds liability cash flows with asset cash flows (income, principal, and re-invested income) chronologically.
Ryan ALM, Inc using the actuarial output from the SFA candidate’s actuarial firm we will create a Custom Liability Index (CLI) that becomes the plan’s roadmap for their pension liabilities… the portfolio’s index benchmark!
We then produce a cost-optimized cash flow matching portfolio (Liability Beta Portfolio™ or LBP) that will maximize the SFA assets while securing the promised benefits at the lowest cost to the plan.
Note: Importantly, bond math drives the cost optimization model. The longer the maturity and the higher the yield… the lower the cost. The longest maturity in the LBP will not exceed the longest benefit payment that is cash flow matched.
Based on the CLI data, Ryan ALM will build an LBP or CDI portfolio by overweighting longer maturity, higher yielding investment-grade bonds (skewed to A/BBB+) within the constraints of the cash flow limitations. For instance, if the SFA can secure 8-years of benefits based on the output from the CLI, the longest maturity in our portfolio will be 8-years. If we can go out 11-years, then we cap the longest maturity bond at 11 years.
The LBP will be carefully crafted to match the fund’s cash flow needs chronologically from the next benefit payments as far out as the SFA allocation will support. The portfolio will be 100% corporate investment-grade bonds with a heavy emphasis on A/BBB+ rated bonds (higher yields produce cost savings).
Once the LBP has been constructed, the plan’s assets and liabilities will move in lockstep. It does not matter the direction of interest rates as the cash flows are matching future values which are not interest-rate sensitive. This is the significant advantage of using a CDI approach instead of a total return-oriented bond product.
Why one shouldn’t use a total return-oriented bond program:
Bonds are interest-rate sensitive. The longer the maturity the greater the interest rate risk. Bond prices fall when interest rates rise. After a 39-year bull market for bonds and historically low-interest rates, it is highly likely that US interest rates rise from current levels especially given current inflation trends and Fed monetary policy. If the SFA assets are managed against a generic bond index and rates continue to rise, there is a serious mismatch of asset cash flows versus the liability cash flows. It is likely that some of the portfolio’s holdings will have to be liquidated each month to meet cash flow needs causing losses on the bonds and subjecting the portfolio to liquidity risk. Moreover, the popular bond index benchmarks (i.e. the Aggregate) are heavily skewed to low-yielding Treasury/Agency/AAA bonds with a high percentage in long maturity bonds. A total return focus certainly doesn’t fund and secure benefit payments in a cost-efficient manner.
Proper Fixed Income Strategy
Adopt a CDI approach that will secure the promised benefits chronologically in a cost-efficient manner. Avoid a total return focus of bonds managed to a generic bond index which will mismatch asset cash flows versus liability cash flows. Avoid taking losses for immediate liquidity needs. Using bonds here for SFA can eliminate the need for a bond allocation in the legacy assets that can now grow unencumbered to meet liabilities past the horizon that the SFA funds.