By: Russ Kamp, Managing Director, Ryan ALM, Inc.
We tried. Oh, we tried so hard! We begged, cajoled, reasoned, and pleaded with the plan sponsor community to take full advantage of the historically low US interest rates witnessed following the onset of Covid-19 by issuing a pension obligation bond (POB). We spoke at conferences, conducted webinars, wrote research and blog posts, and met individually with sponsors and their consultants, but we weren’t able to convince a significant majority that they had a wonderful opportunity to dramatically improve the long-term economics of their plan. What a waste!
Despite our frustration and lack of success, we do know that some public plans did issue POBs. In fact, more than 2Xs the $ amount of POBs had been issued by August 2021 ($6 B) than had been issued in 2020 for the full year ($3 B). We were very pleased to see that. However, our enthusiasm was quickly diminished by the fact that the POB proceeds were being invested in the plan’s asset allocation and not used to defease the plan’s liabilities. Once again, we attempted to educate those willing to listen that investing the proceeds into a traditional asset allocation came with a lot of risks, especially given equity valuations at that time.
One of the greatest concerns articulated by critics of POBs was the investing of the bonds’ proceeds into a “normal” asset allocation. Many rating agencies had voiced concerns about this practice. In fact, POBs often negatively impacted the sponsoring agency’s credit rating. We were on record trying to get plans to defease through a cash flow matching strategy as much of the plan’s retired lives liability as possible. Most importantly, this strategy wasn’t dependent on the timing of the investments. We suspect that most of the plans decided to stay the course and invest some of the money in equities, some in bonds, perhaps a little PE, and/or something else.
That is really too bad, as 2022 has been a complete disaster from an asset performance standpoint and it isn’t likely to get better soon as the Fed continues to raise rates. Both equities and fixed income are taking it on the chin. As of August 31, 2022, the S&P 500 was down -16.1%, small cap equities had fallen -17.2%, international stocks (MSCI) were down >-19%, and bonds, yes BONDS, were down more than -12%! If only! If only plan sponsors and their advisors had used the proceeds to defease pension liabilities, those assets would have SECURED the promised benefits, improved liquidity, and eliminated interest rate risk for that portion of the account that was defeased, while buying time for the alpha assets to grow unencumbered. What a wasted opportunity! Now the pension plan’s portfolio has to work extra hard to try and make up for the substantial principal losses experienced so far while simultaneously paying the ongoing interest on the bond. When will we learn?
Hi Russ: Is this the case for all the funds that have SFA funds? And to defeased pension liabilities do you mean funds should be in a safe liquidated account that can’t receive losses? Thank You
Good morning, Joe. Thanks for the question. Yes, I believe that the SFA assets should be treated as a sinking fund to meet the promised benefits for as long as possible. Putting together a cash flow matching strategy that matches asset flows (interest and principal) to meet those liability cash flows (benefit payments) is the best (only) strategy to accomplish that objective. Just look at what is happening to the markets in 2022. The sequencing of returns is critically important. Start the SFA investing at the end of 2021 and you now have only 80%-85% of the assets left to meet benefits.
Thanks Russ: 15-20% less assets is alot in that short of time!
Good morning, Joe. It is! Approaching the management of this pool of assets (SFA) similarly to the way that you would manage the legacy assets is foolish. As I’ve stated, the SFA bucket is a sinking fund with the expressed purpose to secure the promised benefits for as long as possible. Playing the markets is gambling when the investment horizon is short-term.