Is Your Head Spinning yet?

The market action over the last week or so has been so crazy that many participants are likely suffering from seasickness. It has given me the feeling that I’ve been on a monstrous roller coaster of just ups and downs with no extended straightaways. How about you? There are so many inputs that need to be factored into the decision to buy or sell the US equity market, but have things really changed that significantly since Thanksgiving let alone every day? Sure, we have the new Covid-19 strain called Omicron, but as of today we really don’t know how much we will be impacted by it. Yet, with each piece of “information”, the markets rapidly adjust (overreact). Is it rational behavior? Given underlying valuations for US stocks… are holders of equities just looking for a reason to sell or are we seeing long-term investors using every opportunity to buy dips? I guess that only time will tell.

However, if your head is spinning and you aren’t sure about the near-term direction of your equity exposure I would encourage you to look to your Investment Policy Statement (IPS) for guidance. Take advantage of the tremendous gains created during the last 18 months to rebalance your pension asset allocation back to policy normal targets. It is never a bad time to take profits! Furthermore, if you believe, as we do, that US interest rates need to eventually reflect the current economic environment, you may also want to change the composition of your fixed-income allocation.

A rising US interest rate environment will create significant headwinds for your total return-oriented manager. It doesn’t take much of an interest rate move upward to create a negative annual return for your manager. In fact, at these low-interest rates, only a 30 basis point move up in rates would have a 7-year duration portfolio producing a negative annual return for your bond manager. That can happen in a week or less! Consider adopting a cash flow matching fixed income (CDI) implementation that matches asset cash flows from bonds (interest and principal) with liability cash flows. A CDI strategy will ensure that your plan’s liquidity is enhanced, interest rate risk on that portion of the portfolio is mitigated, and importantly, the investing horizon for your growth assets is extended allowing for those assets to grow unencumbered.

Adopting this approach will likely reduce the seasickness that you may be experiencing at this time. Securing the plan’s liabilities (the promise to participants) should be the primary objective, which can be accomplished at a reasonable cost and with prudent risk. Save the ups and downs for your next visit to Six Flags.

Remember… trends don’t wait for the end of the year to happen!

Disappointing, but not Shocking

According to the U.S. Census Bureau, 59% of Americans have access to a 401(k) plan through their employer, but only 32% actually invest in one. Some people would find that shocking, but I don’t. We have a significant percentage of Americans living within 200% of the poverty line in an era of escalating costs for housing, insurance, education, food, etc. Funding a retirement account, although important, isn’t the first order of business for the average American when it comes to allocating their very finite disposable income.

What is worse to me is the fact that only 16% of the private sector workforce (26% if you include public employees) has exposure to a defined benefit pension plan. For many of these participants, their plans have unfortunately become frozen meaning that they are no longer accruing benefits. There is a reason why the US labor force is witnessing tremendous growth in the number of workers 65-years-old or older continuing to work and it’s not because they all aspire to want to be greeters at Walmart. For a majority of this cohort they just can’t afford not to work. Where other age segments of the U.S. labor force have remained stable or declined, this cohort is witnessing annual growth rates in excess of 5%.

The loss of a true retirement vehicle (DB Pensions) in favor of defined contribution (DC) plans is further exacerbating this trend. The uncertainty for individuals in DC plans related to when to retire, what asset allocation to use, and how much to disburse annually from one’s retirement account are incredibly difficult problems to “solve”. DC plans would be great if they were truly supplemental to a DB plan, which was their original intended use. The “great resignation” which we are experiencing today might not have been as robust had DB plans been maintained. The fact that DC participants can jump around from one job to another (provided that they offer a DC plan) is likely one very big unintended consequence brought about by the demise of DB plans. Let’s hope that as DC participants jump around that they don’t actually take premature withdrawals from their previous employer’s offering.

It’s Okay To Peek!

Private pension plans operate under different accounting standards than those in the public sector (FASB versus GASB). As a consequence, private plans are “forced” to use market discount rates (ASC 715 = AA corporate yield curve), as opposed to a static discount rate (the ROA) permitted under GASB. Why is this important? Well, for one, using a static (non-market rate) masks the plan’s true liability. Unfortunately, in this environment of near-historically low-interest rates, that means that the plan’s liabilities are likely severely understated and the funded ratio overstated. as opposed to a static discount rate (the ROA) permitted under GASB. Why is this important? Well, for one, using a static (non-market rate) masks the plan’s true liability. Unfortunately, in this environment of near-historically low-interest rates, that means that the plan’s liabilities are likely severely understated and the funded ratio overstated.

I entered the pension industry in 1981, and interest rates have basically been falling ever since. This has created a huge headwind for defined benefit pension plans, as lower rates not only make it difficult for plans to achieve their return objectives, but it makes it much more expensive to try and defease pension liabilities. As the following chart depicts, it would have cost a plan sponsor only $14.37 to defease a $1,000 30-year liability in September 1981. Today, that same liability costs a plan more than $622! Oh, my!

Oh, how we wish for the days of double-digit interest rates (at least if you are a retiree or a pension plan sponsor) where winning the retirement game would consist of nothing more than understanding your liability and managing to it (i.e. defeasance or dedication)! So simple. But, again, when forced to operate under accounting rules that provide for static measurement of a plan’s liabilities (GASB), changes in interest rates are not understood to have any impact on pension liabilities. Yet, they do, and it can be significant. Despite the decades of falling rates, there is some good news to share. U.S. interest rates have moved steadily higher since touching all-time lows last year. This provides some relief for pension funds that have been crushed by falling rates. Given the current inflationary environment (transitory or not?) one should expect that US interest rates will move higher. As a reminder, the US bond market has provided a “real return” from bonds that is >2% longer-term but currently provides investors a negative return when adjusting for inflation. This situation is not sustainable.

Unfortunately, investing in a traditional return-oriented bond program will likely generate negative returns for the foreseeable future, as the 39-year bull market in bonds likely comes to a close. How high US rates go is anyone’s guess, but it would only take about a 30 basis point move upward in rates to create a negative annual return for a portfolio with a 7-year duration. A move of that magnitude could happen in a blink of an eye. Instead of using a core fixed income manager as a performance generator, use bonds for the certainty of their cash flows to match assets versus liability cash flows. You’ll be happy that you did!

Lastly, get a more frequent view of your plan’s liabilities. We, at Ryan ALM, produce a Custom Liability Index (CLI) that uses your plan’s unique actuarially projected benefits, expenses, and contributions that are produced by your actuary to monitor monthly your plan’s liabilities using multiple discount rates. Managing pension assets to pension liabilities ensures that asset allocation decisions are being done with all of the information necessary to be successful. Not only is it okay to peek at the promises (liabilities) that have been made to your participants… it is absolutely imperative!

 

Not a Correlation of 1, But Certainly Strongly Positive

We recently produced a post on the investment into Bitcoin and Ethereum by a large public pension system. One of the points stressed by this plan’s CIO was the fact that “this is another tool to manage my risk,” that “has a positive expected return… and a low correlation to every other asset class.” Having observed the pattern of performance during the last couple of years, it doesn’t appear to me that Bitcoin has a low correlation to equities. In fact, the Bloomberg chart below that was published by the Daily Shot appears to highlight a meaningful correlation to US equities.

Given current valuations for the US equity market… is Bitcoin or any other cryptocurrency truly a hedge against a significant market decline? As we discussed in the previous post published on October 29th, Bitcoin has only been around for about 11 years. It is much too short of a timeframe to make any real determination as to whether or not it will be a good hedge against inflation and/or a risk diversifying “investment” during periods of market dislocation when everything seems to correlate towards 1 with the exception of long-term US Treasuries, which have exhibited true diversifying tendencies.

If you want an appropriate investment that will protect your plan during significant down markets, convert your fixed-income core portfolio to a defeased bond portfolio that matches bond cashflows versus plan benefits and expenses (i.e. liability cash flows). Whether interest rates rise or fall, the value of your bonds will move in lockstep with the plan’s liabilities. This will provide the plan with the necessary liquidity to meet all of your short-term needs while extending the investing horizon for your growth (alpha) assets to rebound from the negative impact of any market correction. This is a tried and true investment approach used for many, many decades. Who needs another new-fangled product that might not produce the desired outcome?

Happy Thanksgiving!

I want to wish you and yours a Happy Thanksgiving holiday from my family and me (sorry, Calvin Russell Kamp, our youngest grandchild who didn’t make it into this picture). May the beginning of this holiday season be truly memorable! I wish that I could thank each person individually who has played such an important and meaningful role in who I am today, but there are just so many. THANK YOU! Your support and encouragement have been amazing.

As a nation, we are blessed in so many ways, but there are many among us who are in need of assistance at this time. During this holiday season, let us ALL strive to do just a little more to help our family members, friends, neighbors, and perfect strangers overcome their unique challenges.

In 1863, President Abraham Lincoln proclaimed that a day should be set aside to reflect on all our blessings. Lincoln saw the reason for thanks despite trying times (the country was in the grip of the Civil War). Given the challenging times that many in our country have faced this year (pandemic, fires, floods, hurricanes, poverty, etc.), a day such as Thanksgiving is critically important for all of us. Let us collectively make tomorrow better for all and as good as possible!

This is No Time to be Greedy

The WSJ’s Heather Gillers has published an article today highlighting the potential risk of a liquidity crunch due to asset allocation decisions that have significantly reduced both fixed income and cash, as more aggressive exposure to alternatives – private equity and debt, real estate, infrastructure, etc. – are pursued. We’ve seen this scenario play out before, and it wasn’t pretty, as E&Fs were forced to liquidate less liquid investments in alternatives to fund their spending needs during the 2007-2009 Great Financial Crisis (GFC). That activity exacerbated the selling pressure and lead to the development of secondary markets for many of the alternative investment categories. Are we nearing a similar liquidity cliff?

According to Heather and several sources including both Boston College and Boston Consulting Group, fixed income allocations have fallen on average from 33% to 24% within the public fund universe, while average cash reserves are <1% today. The thought that fixed-income assets could be a source of liquidity when equity investments were under pressure was a very reasonable assumption during the last 39 years of a bull market for bonds. However, the next equity market crash may be driven by inflationary pressures forcing US interest rates higher. In that case, all bets are off as to the ease by which bonds can be sold and cash raised!

The WSJ article quotes Ash Williams, the recently retired and renowned (rightly so) pension officer for Florida’s Retirement system, who stated “finding a strategy that can accomplish what bonds once did, providing yield in good times and accessible cash in bad, is “not a problem with an easy solution.”” We agree that using fixed income as a total return vehicle is the wrong use for bonds in today’s environment. However, we disagree that there isn’t an easy solution – sorry, Ash. Bonds should be used for their value… the certainty of their cash flow – period! A cash flow matching investment (CDI) would allow for plan sponsors to use less fixed income, while dramatically improving the liquidity to fund benefits and expenses while buying time for non-CDI assets to grow unencumbered.

Bifurcating the plan’s assets into beta (liquidity) and alpha (growth) assets ensures that the liquidity necessary to meet monthly benefit payments is readily available without having to force liquidity during turbulent market environments. The CDI implementation will use roughly 80% fewer assets to meet the projected benefits than a traditional bond portfolio, as the funding of benefits and expenses comes from yield, principal, and unused reinvested income. This is a much more efficient asset allocation implementation than the current practice of sweeping cash from wherever it can be found. It allows all of those alternative investments to grow unencumbered as they are no longer a source of liquidity. An additional benefit includes the elimination of interest rate risk on the portion of the portfolio that is being defeased through CDI, as cash flows are funding future benefits which aren’t interest-rate sensitive.

The primary objective in managing a defined benefit plan is to SECURE the promised benefits in a cost-efficient manner and with prudent risk. Putting all of your eggs in an alternative bucket and hoping to find liquidity when it is needed doesn’t seem to fit this definition. Equity markets are expensive through the lens of any traditional valuation. Searching for liquidity during difficult markets may prove more challenging this time and it may be necessary sooner than one thinks.

Leverage – A Double-edged Sword

There have been many investment strategies over the years that have incorporated some aspect of leverage, but it is rare to see a public pension system decide to use leverage as an overlay on its plan’s asset allocation. The CalPERS Board of Directors recently adopted a new policy in a 7-4 vote permitting the use of leverage at 5% of the plan’s total assets. This strategy certainly comes with risk and it is the risk that needs to be evaluated relative to the potential gains.

I find it interesting that CalPERS has only recently reduced the long-term (20-years) expected return on assets (ROA) to 6.8% from 7% earlier in the year. In a WSJ article written by Heather Gillers, the writer refers to a CalPERS presentation that highlighted the fact that the current asset mix would only provide a 6.2% return going forward, which is clearly short of the new return objective. She also states that the use of leverage “reflects the dimming prospects for safe publicly traded investments by households and institutions alike and sets a tone for increased risk-taking by pension funds around the country”. But does it? Are more plans going to use leverage to create greater exposure to certain asset classes given the “dimming prospects”? We would certainly hope not, especially given the current investing landscape in terms of valuations and fundamentals.

As a reminder, the S&P 500 declined by nearly 50% during two major market drawdowns to start this century. As a result, the funded status for pension America collapsed, while contribution expenses skyrocketed! Using leverage at 5% of CalPERS’ current asset level means that potentially $25 billion in greater exposure will be created synthetically. Can you imagine what will happen to contribution expenses should this implementation results in greater losses WHEN the market corrects? In addition to approving the use of leverage, the Board also increased exposure to both private equity and private debt, but there are no guarantees that these strategies will achieve their forecasted returns.

The primary objective in managing a defined benefit plan is to SECURE the benefits at low cost and with prudent risk. Do the additions of leverage and greater exposure to both private equity and debt accomplish this objective? I think not!

Funded Status Improvement – Now What?

PlanSponsor magazine is reporting on the improved funded status of DB plans following strong asset growth that offset a more modest rise in plan liabilities during October. Several organizations, including Ryan ALM, have “pension monitors” that are all reflecting similar improvements. In fact, each of the studies is estimating a funded status for corporate America in the neighborhood of 94% to 95% funded. In most cases, the reduction in the funded ratio during September’s market sell-off in equities was mostly reversed during the last month.

Now what? We believe that asset allocation strategies need to be dynamic or responsive and that decisions should be based on the plan’s funded status, with better-funded plans taking risk off the table, while those less-well funded maintain more risky implementations. Importantly, being responsive does not mean tactical. Trying to “time” market moves has proven incredibly difficult for nearly all market participants. Plan sponsors and their advisors should take full advantage of the improved funding to lock in the gains. We espouse using a cash flow matching (CDI) implementation to SECURE the promised benefits and plan expenses chronologically for as far out as the allocation will allow. This enables the plan to maintain exposure to more risky assets, as they now can grow unencumbered, but they are no longer a source of liquidity.

As the plan’s funded status/ratio improves port additional “profits” (portable alpha) from the alpha or risk assets to the CDI portfolio extending the period of Retired Lives liabilities that are being defeased. This process secures more of the promised benefits and reduces the volatility in the funded status that we’ve witnessed on multiple occasions during the last couple of decades.

Pension Stabilization – What is it?

We recently read an article (actually a paid commercial) from a large asset management organization that declared that traditional LDI was dead and that “pension stabilization” was to become LDI 3.0. For those interested, LDI 1.0 was the investment by corporate America in long corporate credit. An LDI 2.0 strategy consisted of “customized hedging strategies” including adding derivatives, SWAPs, completion funds, etc. LDI 3.0 is according to this firm a means to re-introduce alpha-seeking assets in lieu of “low returning and increasingly inefficient LDI programs”. They refer to it as a more balanced approach. A careful blending of modest excess return and low volatility.

We, at Ryan ALM, are flattered by this pronouncement, since we have been espousing a strategy very similar to LDI 3.0 for decades. We have recommended separating liquidity or Beta assets from growth or Alpha assets forever.  The Beta assets’ job is to fund benefits chronologically while buying time for the Alpha assets to grow unencumbered. Given the improved funding for pension plans, particularly private plans, we believe that sponsors should de-risk even more than before by adding to the Beta assets to de-risk liabilities chronologically. We absolutely agree with this asset management organization when they recommend that continuing to hold long-corporate credit is not a wise solution at the current level of US interest rates. Given the 39-year bull market in US bonds, we certainly don’t see much upside in holding long bonds that don’t necessarily provide the best hedge possible for DB plans. We remind everyone that the value in bonds is the certainty of their cash flows. The best way to apply this value is to cash flow match liability cash flows chronologically.

As a reminder, we believe that the primary pension objective should be to SECURE benefits at low cost and with prudent risk. Duration strategies don’t secure the promised benefits. They actually don’t even do a great job of matching liability durations with asset durations because durations change continuously and individual bonds are not impacted the same with changes in rates. The ONLY way to secure the promised benefits is either through a pension risk transfer (PRT) or through a cash flow matching (CDI) implementation. The CDI approach matches liability cash flows with asset cash flow in chronological fashion so that each month’s benefits (and expenses) are secured for as many months out as the allocation to the strategy will permit.

By implementing a CDI program (Beta assets) the pension system has improved liquidity to meet those monthly obligations, mitigated interest rate risk for the assets in the CDI program, reduced funding costs, and extended the investing horizon (bought time) for the alpha bucket to perform up to expectation. Furthermore, the CDI program (usually 1-10 years of benefit payments) will be far less sensitive to rising interest rates than the long-duration corporate credit used in LDI 1.0 helping to reduce the potential impact on the portfolio. We love the idea of creating a “sleep well at night strategy” that affords the plan sponsor and their advisors the comfort of knowing that liquidity is available when needed without having to force it during periods of market dislocation.

DB pension plans are critically important to the plan participant. Access to one is often the difference between possibly retiring or retiring with dignity. Great strides have been made to improve pension funding in all plan sponsor types since the Great Financial Crisis. It would be sinful to see this improved funding wasted by not reconfiguring the plan’s asset allocation to reflect the current market environment of excessive valuations for many asset classes. Keep your bond allocation short to intermediate given the current inflationary environment, secure your plan’s benefits, while buying time for the alpha assets to grow unencumbered. If this is pension stabilization – great! As indicated earlier, we’ve been doing this for decades. If you want to learn more we are always available to discuss. Good luck!

Is it Time to Go Back to the Future?

I haven’t had the opportunity to speak with Michael J. Fox, but I believe that he’d agree with John Lowell. According to the latest JOLTS release, there are approximately 10.4 million job openings in the US at the end of August 2021. US companies are clearly having a challenging time hiring and retaining their employees. Wage growth, which had been stagnant for decades, is finally providing some real growth, but wages alone don’t seem to be accomplishing the objective of “securing” new employees.

I referenced John Lowell above. John is an Atlanta-based actuary and partner with October Three Consulting LLC. He has more than 35 years of experience consulting on corporate retirement plans. His recent article in Benefits Pro is spot on! John has put his finger on three key areas of focus for corporate HR professionals, including:

  1. Recruiting and retention
  2. Diversity, Equity, and Inclusion (DEI)
  3. Guaranteed lifetime income for employees who fear outliving their savings

He further states that the most important of these from an employee’s standpoint may just be #3, as a retirement industry providing access to only DC plans is fraught with danger and disappointment. John understands that corporate America has pretty much put defined benefits in their rearview mirrors, but does that decision make sense in today’s environment? Both John and I think not! Anyone who reads this blog on a regular basis knows that I am a staunch supporter of DB plans, as asking untrained individuals to fund, manage, and then disburse a “retirement benefit” through a DC plan is an exercise in futility for many.

I hope that you’ll take the time (3-4 minutes) to read John’s article. His years of experience are shining through his words, which HR departments and corporate leaders would be wise to heed. Thanks, John!