By: Russ Kamp, Managing Director, Ryan ALM, Inc.
I’ve recently seen questions raised about the recent interest rate increase in the Fed Fund’s Rate and the potential impact that has on the pension rescue through ARPA. I’m happy to address this issue since the discount rate chosen was a source of concern for me and others. Interest rate increases, such as we’ve witnessed so far in 2022, have the potential to impact both the pension plan’s liabilities and assets.
First, and as it pertains to the legislation’s impact, the recent increase in the Fed Fund’s rate of 75 basis points will have little to no impact on the discount rate used to calculate the potential SFA. As a reminder, legislators chose to use the 3rd segment (under PPA) plus 200 bps as the discount rate in helping to determine the size of the Special Financial Assistance (SFA). The three rates under PPA reflect different maturity buckets. It was surprising that the third segment was used given that it reflects benefits that would be paid for periods greater than 20 years. Obviously, pension systems eligible for SFA payouts will be paying benefits for the next 20 years. At the very least all three segments under PPA should have been used in the discount rate calculation. In addition, this rate uses a 24-month smoothing in its calculation. So, Fed Fund Rate increases have little impact on the 3rd segment rate given these are short-term rates that are being increased. Fortunately, that works to the plan sponsor’s advantage given that a higher discount rate would lessen the amount of the potential SFA allocation.
With regard to increased interest rates on assets, there are both benefits and drawbacks. First the drawbacks. US interest rates are rising as a result of decades high inflation. The Federal Reserve is aggressively pursuing a tighter monetary policy in an attempt to thwart the onerous impact of this inflation spiral. Increased interest rates are negatively impacting most asset classes that pensions invest in, especially stocks and bonds. These asset classes have experienced double-digit losses so far in 2022. This reduces the current value of the legacy assets. This result doesn’t help those plans that have already filed the application and received SFA payment, but it reduces the existing asset value for SFA calculations for those plans that have yet to file which will increase the potential SFA. The impact will be very much dependent on the size of the legacy portfolio, expected return on investment, forecasted contributions, etc.
Plans that have received the SFA are currently mandated to invest those proceeds in investment-grade fixed-income only (bonds). This mandate may change based on the Final, Final Rules that we’ve all been waiting to get since the Interim Final Rules were shared last July. Any investment in a total return-seeking fixed income strategy will have suffered losses as a result of the rising rate environment. The size of the loss is very much dependent on the timing of the investment implementation. As mentioned previously, the Fed has promised to be diligent in its fight to moderate inflation. This suggests to me that we have not seen the end of rising US rates. Further increases in US interest rates will continue to weigh heavily on fixed income returns within the SFA bucket and those of other asset classes in the legacy asset pool.
We’ve been encouraging recipients of SFA payouts to cash flow match their future benefits and expenses chronologically. By matching asset cash flows of principal and income with liability cash flows (benefits and expenses) the impact of rising rates is mitigated since we are dealing with future values (cash flows) that are not interest-rate sensitive. Even the present values are not an issue as those values will rise and fall in lock-step with each other. It is unfortunate that many plans that have received SFA payouts have not initiated a cash flow matching program. The legislation specifically had as its goal to SECURE the promised benefits for 30 years. You can only secure benefits through either an insurance annuity or cash flow matching. Plans that haven’t pursued a cashflow-driven investment (CDI) program are jeopardizing the security of those assets.
For plans that haven’t yet received the SFA, the rising rate environment is a blessing, as the cost to secure benefits and expenses is falling rapidly across the yield curve, including short-term interest rates most affected by the Fed’s action. As an example, we recently produced a cash flow matching portfolio for an SFA-eligible multiemployer plan that would have those benefits secured for the next 17 years. The yield-to-maturity (YTM) on that portfolio was a robust 5.34% and it was accomplished using a conservative universe of potential bond investments restricted to BBB+ credit ratings or better. Furthermore, this portfolio saved the client nearly $93 million in future payouts equaling about a 34% savings. Further increases in rates will continue to lower the cost of securing those benefits.
It really makes no sense given the current rate environment to engage in an active total return-focused bond program. Use the rising rate environment to secure the promised benefits as sought by the ARPA legislation. Everyone will sleep better knowing that the promised benefits have been secured for some extended timeframe!