When do you rebalance?

Here is another interesting and insightful article from the folks at Spring Valley Asset Management. They ask the question: When should one rebalance their portfolio? It is a question that allocators rarely ask prospective investment managers. However, when one rebalances a portfolio can have an incredible impact on the realized and future performance of their underlying strategies. This Study demonstrates how two managers running identical investment strategies but rebalancing on different dates can achieve substantially different performance.

They attribute this result to path dependency, or as they call it “rebalancing luck.” It does not represent any additional investment skill of one manager over another. They show that differences in performance over 1-year horizons can eclipse an astounding 20%. In addition, over their whole 17-year sample, the difference between the best and worst performing rebalance date resulted in a total return differential of 250%! They go on to provide a novel approach called partitioning to reduce path dependency and realize much more consistent results. The approach also allows them to produce much more accurate return expectations, which should be a critical input into an asset allocation process. The implications of this paper cannot be overstated, and I encourage you to have a read yourselves!



H.R. 397 Is Now Ready For A Floor Vote

House Ways and Means Chairman Richard Neal, D-Mass., confirmed that pension bill H.R. 397 (Butch Lewis Act) is ready for a floor vote. Some are estimating that the cost of the legislation could be roughly $65 billion, although the proposed loan program could actually be revenue neutral if each of the recipients of the loans pays back the principal in year 30.

If the legislation passes through the House of Representatives, the U.S. Senate must agree to take up the legislation.  During the review of the legislation by the Ways and Means and Education and Labor Committees, Democrats had rejected 12 amendments along party-line votes. There are roughly 13 additional amendments that were withdrawn with an eye toward bringing them forward for consideration in a final Bill.

As we’ve highlighted many times, inaction at this time is unacceptable. Failure to support these critically important pension systems jeopardizes the economic future for more than 1.3 million American workers and retirees. A pay-as-you-go approach is far more expensive than one that has a 30-year lifeline to meet future obligations.

How Is The Promise Paid?

In order to understand the basics of actuarial methods of valuing pension liabilities, one must consider the fundamental equation of pension plan funding, which is:


Where (C) Contributions + (I) Income = (B) Benefits + (E) Expenses

First, actuaries will calculate the future benefits to be paid.  With this information actuaries are able to calculate contribution rates based on a Return on Assets (ROA) forecast for investment income (returns). However, if investment income or contributions fail to meet expectations, the stability of the plan may be affected and benefits may have to be adjusted. Please note that the actuary has no input for asset growth to exceed liability growth since they both have the same ROA forecast (error). Given the same forecasted growth rate (ROA) any deficit would also grow at the ROA causing higher projected contributions (not acceptable).

Prefunded defined benefit plans allow for assets to be built up funding future benefits. The more “income” earned the less the need for contributions. In order to determine future benefits an actuarial valuation is calculated. There are many factors in an actuarial calculation, but the most important is likely the discount rate. Actuaries, guided by plan sponsors and investment professionals/consultants, use a discount rate to value future benefits. In public pension funds, actuaries generally use the forecasted return on investments (GASB), whereas corporate plans using guidelines from FASB value future benefits at market rates using a discount rate yield curve of Corporate AA zero-coupon bonds.

When discussing multiemployer defined benefit plans, their funding is not as straightforward.  The benefits in DB plans subject to ERISA are required to be prefunded, which means that in the current year the plan sponsor sets aside adequate funds, taking into account expected future investment returns, for pension benefits earned in that year.

Plan sponsors may also be required to make additional contributions for investment losses that occurred in previous years and increases in the present value of future plan obligations (actuarial losses). Plan participants receive their monthly benefit in retirement from these funds that have been set aside. The required contributions for employers in multiemployer DB pension plans are negotiated and tend to fixed for several years as established in collective bargaining agreements. Given that contributions are negotiated, “make up” contributions are not always available should investment returns fall short of expectations.

Two significant market declines during the last 19 years have been one of the major factors in creating a funding shortfall among multiemployer pension plans in Critical and Declining status. The focus on earning the ROA as the target asset return as a means to control contribution expense has lead many plans to strive for outsized return expectations. This more aggressive return profile increases the volatility associated with the plan’s asset allocation and subjects the plan to greater downside risk.

Within H.R. 397, the proposed legislation calls for the loan proceeds to be used to defease the plan’s Retired Lives and Terminated Vested Liabilities through one of three possible implementations: 1) annuities, 2) duration matching, or 3) cash flow matching. Ryan ALM and KCS have for years written about the benefits of cash flow matching to meet near-term liabilities chronologically. This strategy enables the plan to extend the investing horizon for those assets not deployed to meet liabilities, reduce interest rate sensitivity from traditional bonds, and improve liquidity to meet the promised benefits. If implemented successfully, a cash flow matching strategy should defease Retired Lives, help to stabilize both the plan’s funded status and contribution expense, while setting the plan on a de-risking path toward full funding. There are only two ways to truly defease liabilities, which are insurance buyout annuities (IBA) and cash flow matching. Since IBA is expensive, cash flow matching is the only practical way to defease Retired Lives.


And Another Hurdle is Cleared

As you may have heard or read, the House of Representatives’ Ways and Means Committee has passed H.R. 397 (July 10th) joining the Education and Labor Committee that voted to support this proposed legislation in June. A third committee, Appropriations, will soon begin their review prior to a vote. As a reminder, H.R. 397 is basically the Butch Lewis Act that was first introduced in November 2017, but not approved.

Unfortunately, the votes have followed party lines with Democrats supporting the proposal to provide low-interest rate loans to multiemployer plans deemed to be in Critical and Declining status, while Republicans continue to treat the legislation as nothing more than a bailout. If the legislation passes through the Appropriations Committee it will then be brought to the House for a full vote.

It has been assumed by most that the House, under Democrat control, would pass this legislation. The significant challenge/hurdle will be getting the Senate to follow suit. At present there are no competing bills to help struggling multiemployer plans survive, but rumors persist that the Republicans are preparing a bill that will strengthen the PBGC with greater oversight and finances. Of course, time will tell, but we don’t currently have the luxury of time! Something needs to be done in this Congressional session or we will begin to see the significant damage that delay has inflicted.


Can We Get An Amen?

“Public pension accounting methodologies devised by the Governmental Accounting Standards Board (GASB) produce flawed results and are in urgent need of improvement, according to an independent study released by the National Conference on Public Employee Retirement Systems, wrote Hank Kim, Executive Director for NCPERS. Amen, we say to that!

For more than eight years, we have crisscrossed the U.S. highlighting the fact that public pensions are being negatively impacted because of GASB accounting standards. “When things go awry for some pension plans, it is often not because the accounting rules are ignored but because they are followed,” the study’s author, Brown University researcher Tom Sgouros, wrote in “The Case for New Pension Accounting Standards.” Sgouros also stated, “GASB rules can mislead decision-makers’ views as to the health of a pension system, prompting poor decisions, the study found. The study recommended developing different rules that will address some of these shortcomings.”

Ron Ryan, Ryan ALM, highlighted several years ago the negative impact of accounting rules on pensions in his outstanding book, titled “The U.S. Pension Crisis”. One of his points was the fact that future contributions should be treated as an asset of the plan when calculating the funded status. Sgouros highlights the same issue in his study. “One of the many quirks of today’s pension accounting rules is that they value the promise of future contributions at zero, which is unlike any other government obligation, from revenue bonds to purchase orders,” Sgouros said. “As a result, the strength of the economy behind the pension plan counts for nothing from an accounting perspective. That is clearly a disservice to pension plan participants.”

Managing a pension plan is difficult under the best of circumstances. Let’s eliminate the many impediments that are created through accounting standards that mask the truth. We stand ready to share our insights on where other opportunities for improvement exist. Are you?



Setting the Record Straight

Gene Kalwarski, CEO, Cheiron, a leading pension actuarial firm has penned a response to Olivia Mitchell’s article regarding the multiemployer pensions crisis and the legislation that is currently before the House (H.R. 397). Gene, Peter Hardcastle and the team at Cheiron did the heavy lifting in completing the analysis to determine future solvency on each of the 114 Critical and Declining plans that existed in 2017 when the Butch Lewis Act was first presented to both the House and Senate. Gene’s response is excellent, and the complete article follows.

Just days ahead of the House Ways and Means Committee’s planned markup of legislation that would offer government loans for struggling multiemployer pension plans, conservative academics have launched an all-out attack on the bill.

The legislation, The Rehabilitation for Multiemployer Pensions Act, is a rebranding of the Butch Lewis Act introduced in November 2017 by Rep. Richard Neal (D-Mass.) and Sen. Sherrod Brown (D-Ohio).

In a June 27 commentary in the Hill, Olivia Mitchell, an economist who teaches at the Wharton School, called the legislation “A step in the wrong direction.” Far from it.

Well before Neal and Brown introduced the bill, they asked the company where I am CEO, Cheiron Inc., to prepare actuarial projections to determine how effective the legislation would be in stemming insolvencies of struggling multiemployer pension plans.

Our projections – which have been reviewed by congressional staff, pension experts on Wall Street and other actuaries – show that the legislation would protect 1.3 million plan participants from insolvency, eliminate the need for as much as $65 billion in financial help from the Pension Benefit Guaranty Corp. and prevent insolvencies for at least 30 years.

Conservative economists maintain that the multiemployer pension crisis is more than 10 times larger than the $54 billion estimate, and that Congress would be wasting taxpayer money by lending money to struggling pension plans.

But even if all the troubled multiemployer pension plans were to become insolvent, their underfunding would be less than half that amount, according to their 2017 annual filings with regulators. That’s based on even more conservative assumptions than single-employer plans.

Conservative economists blame labor unions and employers for the financial troubles of multiemployer pension and for not contributing enough to multiemployer pension plans.

But during the 1980s and 1990s, it was the IRS tax code that limited employers’ tax-deductible contributions to multiemployer pension plans. Because the plans were constrained from contributing more to the plans while earning double-digit returns and generating large surpluses, they were forced to increase pension benefits or stop making contributions.

Conservative academics say that multiemployer pension plans pay far too low premiums to the PBGC compared with single-employer pension plans. But this ignores that the top PBGC guarantee for participants in single-employer plans is $67,295.40 a year or about five times as much as the $12,870 a year that full-career participants in multiemployer plans would receive. 

Critics assert that while corporate plans that go out of business are required to cover pension promises out of company assets, bankrupt employers in multiemployer pension get a pass. But federal pension law lets corporate pension sponsors use Chapter 11 of the Bankruptcy Code to offload pension obligations on the PBGC, as hundreds of companies have done. Multiemployer plans don’t have this option under pension law. When an employer contributing to a multiemployer goes bankrupt the remaining employers and, ultimately, the participants are saddled with its unfunded liabilities.

Conservative critics argue that the Butch Lewis Act would make the multiemployer pension crisis worse by allowing struggling plans to make new pension promises and leave taxpayers on the hook if they can’t repay the federal loans.”

Great job, Gene.

The Importance of a Longer Time Horizon

As discussed in our previous blog post, many, if not most, public fund and multiemployer plans have injected greater risk into their investment processes by allocating significantly more assets to equities and alternatives in an attempt to best the return on asset assumption (ROA). On the surface, that decision is fine depending on the plan’s investing time horizon.  However, given that many of these plans have significant negative cash flow situations (paying out more in benefits than they are receiving in contributions) the greater use of these asset classes brings about less liquidity while forcing the plan to have a shorter time horizon.

When it comes to evaluating market risk, one’s time horizon is a key factor to consider. As a general rule, shorter time horizons require more caution than do longer ones. Yet, plan sponsors have adopted an entirely different approach. The dilemma: how does a plan meet its liabilities in the short-term while creating a potential return that can beat both the ROA and liability growth longer-term.

Investing for the long-term eliminates the “noise” of short-term market moves and the longer-term averages get one closer to an expected return that is more realistic. In the current construct for most DB plans, a single asset allocation is used to create a return that will exceed the ROA, but performance results are looked at quarterly, making long-term investing difficult to achieve.

Ryan ALM produces performance results quarterly for a generic asset allocation of 60% domestic equities, 5% MSCI EAFE, 30% Bloomberg Barclay Aggregate, and 5% cash.  When looking at annualized monthly returns since 12/99 (222 12-month periods), the average return is 6.02% and the standard deviation of those returns is +/- 10.8. Wouldn’t it be great to have an asset allocation that can successfully achieve both desired outcomes of meeting near-term liquidity needs while producing fairly consistent longer-term results?  If successful, both the funded status and contribution expense would be more stable.

I am pleased to write that there is a way to achieve these two important objectives in managing a pension system.  First, asset allocation should be bifurcated. There should be two buckets for the assets, which will have very different objectives. In order to meet near-term liquidity needs a cash flow matching strategy should be built through investment grade (and in some cases high yield) corporate bonds to meet monthly benefit payments in chronological order from nearest payment as far out as possible. Second, the remainder of the assets should be invested in instruments that are lowly correlated to traditional bonds, as liabilities are bond-like in nature.

As mentioned above, the one-year return for that generic asset allocation had a 10.8% standard deviation meaning that 68% of the time that annual return since 12/99 could have been as good as 16.8% or as poor as -4.8%.  Furthermore, extending to 2 standard deviations (95% of the observations) would produce a range of results that has one seeing equal chance of a 27.6% return to one at – 15.6% or more than 43% from top to bottom. Tough to manage a pension plan with that type of volatility, yet that is precisely where we are today.

If one had the resources to dedicate enough assets to the cash flow matching portfolio the standard deviation of returns falls precipitously from 10.8% to less than 1/2 at 5 years (5.05) and to nearly 1/3 of the risk at 10 years (3.6), increasing the odds that the expected return will be achieved, the required benefits paid, and a glide path established toward full-funding.

Does this sound to good to be true? Hardly, as cash flow matching strategies have been used for more than 7 decades to achieve the desired goals stated above. Furthermore, it is one of only three strategies (along with annuities and duration-matching) to be considered as part of the Butch Lewis Act (H.R. 397) regarding how the loan proceeds can be invested. Many alternative investments are designed to provide good long-term results, but they need time to capture the liquidity premium that exists. Only through an extended investing horizon will this be accomplished.