It’s The Opposite of Market Timing

No one’s crystal ball is any clearer than the next person’s. Sure, there are investors who are more disciplined, experienced, perhaps brighter, and luckier, but no one has a true knowledge of what awaits. Given this reality, market pros often, and correctly so, warn about trying to market time major moves within asset classes. Each of those decisions needs two right calls – the getting out and just as important, the getting back in – in order to capitalize. This ability is rare, and it can be expensive, as moving assets in the cash markets can have a high opportunity cost.

For years, we at Ryan ALM have encouraged plans to adopt an alpha/beta approach to managing pension assets for the reason that market timing is challenging, to say the least. Sure, we’ve been encouraging plan sponsors and their asset consultants a little more aggressively at this time to adopt our strategy but not because we have any greater clarity on the future direction of markets, but because we know from history that what goes up eventually goes back down. Pension plans are enjoying an improved funding position. As we’ve said, it would be sinful to see the great work/improvement wasted.

In proposing a new approach to asset allocation we are admitting that we have no idea about the future behavior of markets – bonds or equities. Using our Cash Flow Matching (CDI) approach creates an improved liquidity profile that will insulate the portfolio from having to liquidate alpha assets (non-bonds) during periods of turbulence. Furthermore, the alpha assets now have time to grow unencumbered while they potentially wade through rocky markets, such as the one we are in right now. Earlier this week we wrote about the 39-year bull market in bonds (began in 1982). Are we at the end of this extraordinary period of time? Who knows, but I like the bet that we are much more likely to see rates rise than fall further from these levels.

In a rising rate environment, total return-oriented bond products will likely suffer principal losses sufficient to produce a negative annual return. Given this possibility, use bonds for their cash flows and specifically to match asset cash flows with liability cash flows (benefit payments). In this case, assets and liabilities will be carefully matched (future values) producing a relationship that eliminates interest rate risk, which could be substantial during the next bear market.

Cash Flow Matching is a tried and true portfolio strategy that currently supports both lottery systems and insurance companies. It was once how pension plans were managed in the U.S. This “sleep well at night” strategy should be used at all times, as using bonds for liquidity purposes makes far greater sense than sweeping dividends from equity portfolios that could potentially reinvest those dividends at higher projected growth rates. You also don’t want to be searching for liquidity in an environment when everything correlates to 1 and liquidity disappears, such as that which we experienced in 2008. Don’t try to time the market. Adopt an all-weather strategy that will make your pension plan much more efficient to manage. Remember, the primary objective in managing a DB pension plan is to SECURE the promised benefits at both reasonable cost and with prudent risk.

Just over $1 billion

To date, the PBGC has approved the Special Financial Assistance (SFA) for 4 plans totaling just over $1 billion in grant money. The largest of these allocations was to Local 707 (1/19/22) which will receive $812.3 million. It remains the case that only Local 138 has received their payment. I guess that isn’t too problematic since we still haven’t been informed by the PBGC regarding their Final, Final Rules pertaining to the legislation’s implementation. As you may recall, we got the Interim Final Rules last July just before plans in Group 1 were permitted to file an application for the SFA.

Presently, any SFA grant money received must remain segregated from the plan’s legacy assets and they must be invested in investment-grade (IG) bonds. The intent of the legislation was to provide funds to SECURE the promised benefits (and expenses). Many industry practitioners have been prodding the PBGC to expand the investible universe to include other assets (and asset classes). We have cautioned that any movement away from a defeased portfolio using bond cash flows to match and fund pension liabilities opens the plan to greater volatility and potentially less security. Based on the current rules, most plans aren’t going to be able to secure more than 8-10 years of benefits. Why risk shortening this timeframe even more.

One need only look at the beginning of 2022 to be reminded that risk assets don’t only rise in value. The S&P 500 is off -9.2% YTD, while the R2000 is down -14%, while NASDAQ has fallen nearly -15%. The sequencing of returns is a critical element in a plan’s ability to meet its future obligations. It would have been a travesty had any one of these plans received their SFA only to have it decline by >-10% out of the gate after investing in assets other than IG bonds. Furthermore, who is to say that equity markets can’t correct more from these levels. We’ve certainly witnessed far greater declines in the past.

Oh, and by the way, I may be discussing the implementation of the SFA proceeds, but the same can be said about POB proceeds. This recent market action following the issuance of more POB $ since 2003 is why there are critics of POBs. We believe that both SFA and POB assets should be used to defease a plan’s liabilities chronologically as far out as the allocation will permit. No games! Secure the promises that have been made to your plan participants. Allow yourself and them to sleep well at night.

A New Day For Most!

I entered the pension/investment industry in October 1981. In fact, it was October 13, 1981, and the US 10-year Treasury was trading at a yield of 14.7% at that time. US interest rates have fallen steadily since then to the nearly historic levels at which they trade today. As the chart below reflects, rates trended higher for the 30-years prior to the 1981 peak and it has been mostly downhill since then. What a ride!

That said, you’d have to be in your early 60’s and at least a 40-year veteran to have experienced a bear market in bonds within the US. Sure, there have been brief periods when one’s mettle may have been tested, but the anguish and confusion brought on by a sustained bear market correction has been avoided by all but a few of us long-timers. It will be interesting to see how most market participants react.

For sponsors of pension plans, especially those in the public and multiemployer arenas, it will be challenging to see how they reconfigure the asset allocation to account for the likelihood of total return-oriented bond portfolios generating negative returns as rates rise. Achieving that ROA may become even more challenging. I specifically didn’t mention corporate plan sponsors because of two reasons: 1) they are exiting the pension game, and 2) they have their focus squarely on the plan’s liabilities to a far greater extent than those not swimming in the corporate pool – thanks to FASB. By adopting a greater focus on asset/liability management, corporate sponsors appreciate the fact that a cash flow matching bond portfolio’s interest-rate sensitivity is mitigated because assets and liabilities will move in lock-step with one another.

How much would rates have to back up to generate a negative total return? NOT MUCH! As the information below highlights, rates only have to back up by 25 bps, which could happen in a week, for bond programs as short as a 5-year duration strategy to have a negative annual return.

Price Return is determined by the duration of the bond

                                                                        Interest Rate move

                   Duration      YTM        +25 bps   +50 bps

5-yr Treasury      4.8 years       1.19%      -1.20%      -2.40%

A Corporate       4.1 years       1.63%      -1.03%      -2.05%

10-yr Treasury     9.2 years       1.40%      -2.30%     -4.60%

A Corporate       8.3 years       2.26%      -2.08%     -4.15%

30-yr Treasury    22.8 years     1.81%       -5.70%      -11.40%

A Corporate       19.9 years      2.87%      -4.98%     -9.95%

Historically, US real interest rates have provided at least 1%-2% premium versus inflation. In today’s 7% inflation environment, real rates are trading at a negative 5% real return (30-year is at 2.12%). For how long will bond investors tolerate this situation? Given the lack of experience in managing through a bond bear market, it will be interesting to see the strategies that are adopted. One proven approach is to manage assets versus liabilities through a cash flow matching (CDI) strategy. Because asset cash flows are matched against liability cash flows, which are future values, interest rate risk has been eliminated. There is no more important risk to manage in bond land than interest rate risk. We’d be happy to share our insights with you. We’ve all enjoyed this incredible bull market, but after 39 great years, I believe that the party is over. The hangover that we experience may need more than a couple of Advil to cure!

The Ryan ALM Q4’21 Newsletter

We are pleased to share with you the Ryan ALM Q4’21 Newsletter. This newsletter highlights the relationship of pension assets to liabilities, which we believe is the most important metric. As you will read, calendar year 2021 was a strong year for Pension America as assets dramatically outperformed liability growth. Now what? Will you rethink the traditional approach to asset allocation or will the whims of the markets impact your plan’s funded status and contribution expenses. Will pension plans respond to their improved funded status and de-risk some of the assets? We believe that the primary objective in managing a pension plan is to secure the promised benefits at a reasonable cost and with prudent risk. Are your promised benefits secure? We’d welcome the opportunity to share our thoughts and expertise with you.

Should You Buy Downside Protection?

At the time of writing, equity markets seemed to have stabilized a bit today following a rough start to 2022. It isn’t surprising that markets have been soft to start the year given current market valuations following a nearly unprecedented run-up in stock prices. That said, are we looking at a brief pause in the upward trajectory of stocks or perhaps something more sinister that was witnessed twice during the ’00s and many times before? A reasonable question for investors is whether they should “insure” against downside risk in equity markets. However, current option prices suggest that such insurance strategies are quite expensive, especially relative to history. Why? One of the factors influencing the pricing of insurance is the plethora of macro events such as interest rates, economic growth, Covid-19, geopolitical risk (Russia/China), etc.

If buying traditional equity market insurance is too expensive, there is another way to protect your flank that might just minimize risk on a couple of fronts – liquidity and interest rates – if not the equity markets themselves. I am referring to the use of a cash flow matching strategy (CDI) that would be used in lieu of a traditional fixed income total return approach. If US rates continue to rise, not only will they likely destabilize equity markets, but total return-oriented fixed income portfolios will likely produce negative returns for the foreseeable future. We’d suggest using bonds for their cash flows carefully matched against the plan’s specific liabilities that will eliminate interest rate risk, as we will be matching future values that are not interest-rate sensitive, while dramatically improving the plan’s liquidity profile.

So where does the downside risk for stocks come in? Well, if we deconstruct the current approach to asset allocation that uses all the assets focused on a return on asset assumption (ROA) to one that uses a bifurcated approach separating liquidity (beta) and growth (alpha) assets we can provide a unique form of downside protection at a minimal cost. The beta assets are the cash flow matching bonds carefully allocated to maximize the cash flows (principal, income, and reinvested income) to meet benefits and expenses, while the alpha assets are the plan’s growth assets that will eventually meet future liabilities. In this construct, the alpha assets can grow unencumbered as they are no longer a source of liquidity. We’ve now bought time for these assets to recover should markets get hit. Furthermore, the reinvestment of dividend income is critical to the long-term growth of equities. One study, in particular, suggests that 48% of the return of the S&P 500 over rolling 10-year periods is attributable to the reinvestment of dividends. Extending that analysis to rolling 20-year periods finds an incredible 60% of the total return comes from dividends reinvested.

With the Ryan ALM approach, plan sponsors won’t need or be tempted to take dividend income to use for benefit payments. It isn’t necessary now that the CDI portfolio is responsible for funding the promised benefits and expenses. Traditional downside risk protection can be complicated and expensive. Adopting our approach is just common sense.

The Ryan ALM Pension Monitor

We are pleased to share with you the Q4’21 Ryan ALM Pension Monitor, which is a look at how pension assets and liabilities performed during 2021. As you will note, there are significant differences in the relationship of assets to liabilities based on the type of plan. Corporate pension plans use a FAS (ASC 715) AA corporate discount rate to value pension liabilities. Using this approach produces a -4.6% return for pension liabilities in 2021 for a pension plan with a 12-year duration. Despite lower returns among the average corporate plan due to their much greater fixed income exposure (P&I’s asset allocation survey of the top 1,000 plans), corporate plan assets outperformed plan liabilities by 12.5%.

Public and multiemployer plans that use the return on asset assumption (ROA) for their liability discount rate don’t benefit from the rising US interest rate environment, as liability growth is a static or plugged number. We are using 7.25% as the average discount rate among these plan types. Given the 7.3% return on liabilities in 2021 for plans using this ROA discounting methodology, assets only outperformed liabilities by 6.5% for public plans and 6.3% for multiemployer plans. As a reminder, liabilities are bond-like in nature and move daily with changes in the interest rate environment. The 39-year bull market for bonds crushed pension funding, as US interest rates plummeted causing the PV of liabilities to grow significantly. We may very well be entering a period of time that will prove beneficial to Pension America as liability growth could be muted as rates rise. But will public and multiemployer plans even notice?

Lastly, the primary objective for any pension plan should be to SECURE the promised benefits in a cost-efficient manner and with prudent risk. The only way that this can be achieved is through cash flow matching of assets versus the plan’s liability cash flows. Not focusing on or masking the true value of a plan’s liabilities makes this process nearly impossible.

Amazing Contradiction!

US interest rates have been rising after touching historic lows at the onset of Covid-19. For the calendar year 2021, both short-term and long-term interest rates backed up. For corporate America’s pension systems this meant that plan liabilities sank -4.6% based on a 12-year duration. Viewed in combination with the average asset growth of +7.9% based on the P&I Asset allocation for the top 1,000 plans, pension assets outperformed plan liabilities by 12.5%. Wonderful! However, despite significantly stronger average returns for both public +13.8% and multiemployer plans +13.6% (given greater equity exposure) outperformance for the assets of these plans to plan liabilities was much more muted at 6.5% and 6.3%, respectively. Why the significant difference? Regrettably, the accounting rules permit both public and multiemployer plans to use the return on asset assumption (ROA) to value plan liabilities with the average plan using a 7.3% ROA.

If you are a public or multiemployer plan, you’ve skated through the last four decades thinking that a plan’s liabilities grew at a consistent rate – whatever the ROA was at the time. This masking of reality has been harmful, especially for many municipalities and states that have seen contribution expenses ratchet higher and higher. In a year like 2021 when assets growth was wonderful, while liability growth was negative, neither public nor multiemployer plans truly benefited to the extent that they should have because of these antiquated accounting rules. A rising interest rate environment may provide negative headwinds for plan assets, but the impact on plan liabilities should be even worse. But the truth may not be revealed!

The 39-year bull market for the US bonds crushed Pension America as the present value of future liabilities grew disproportionately when compared with plan assets. The dramatic increase in “cost” pushed many corporate sponsors to de-risk with the goal to freeze, terminate, and ultimately transfer plan liabilities. A small subset of corporate DB plans exists today compared to the early 1980s when more than 40% of the private labor force was covered by a traditional pension plan. The good news about rising interest rates is the impact on the present value of pension liabilities which shrink as rates rise improving a plan’s funded status all else being equal.

We’ve communicated often about these accounting irregularities. In fact, Ron Ryan wrote an award-winning book on the subject. Ultimately, we should have one accounting standard in the US to value pension liabilities. The rest of the world uses the accounting rules under IASB, which require a market valuation of assets and liabilities. Perhaps we don’t need to adopt the IASB standards, but it makes no sense to have two different accounting standards (FASB and GASB) in the US based on whether it is a public plan or a corporation. It is beyond time to take the blinders off. Let’s value a plan’s liabilities using a true market rate. It is only when we know the truth can we begin to formulate an appropriate response. We’ve closed our eyes during the longest bond bull market in history. We may just be opening our eyes in time to see what happens to plan liabilities when US rates rise as a secular trend. Forecasted weaker asset growth for the foreseeable future may not be the death knell that has been predicted when you might just have significantly negative liability growth at the same time.

Not This Week

I had been hearing rumors, as I’m sure that many of you were too, that the PBGC was going to present their “Final, Final Rules” as it relates to the ARPA implementation this week. We have been waiting roughly six months since they informed us of their “Interim, Final Rules” last July. Well, it is Friday, and it doesn’t look like we are going to get any update today, especially since the Office of Management and Budget (OMB) has not been provided with an update for their review. According to someone who I absolutely trust, an OMB review is a standard part of the rulemaking process. The updated guidance will not be released to the public until the OMB has reviewed those changes if any.

As we know, the Special Financial Assistance (SFA) grant has been approved for two plans to date. Another two dozen or so are in the queue, with many plans having had to submit revised applications. Most pension plans that used MPRA legislation to previously cut benefits have not filed an application for the SFA as of yet despite being eligible to do so since January 1st. Perhaps they are just waiting for these “final” rules to be published. Let’s hope that is the case.

Anyway, I’m not expecting a major update to this legislation. There may be some tinkering with the eligible list of investments for the SFA segregated assets, but that won’t dramatically improve this legislation. It will do more to destabilize the grant money’s original goal to “secure” benefits for as far out as possible. It is unlikely that the current discount rate will be reworked, as a change there could result in a substantial increase in the cost of the legislation, which is currently estimated at roughly $90-$95 billion. I do know that the legislation called for as simple a process as possible to file and receive grant money. Six months into this process and I think that it is safe to say that goal hasn’t been accomplished.

Are We Witnessing A Sea Change?

I’m writing this post from 35,000 feet as I return from a terrific Opal conference in Scottsdale, AZ. The conference was focused on public pension funds. It was great to be back among industry peers and friends who I have known for years. I was impressed with the panels and the questions from the audience. However, what struck me were the several comments expressed by leading plan sponsors that identified the “securing of the promised benefits” as THEIR primary focus. They couldn’t be more right! For years, we at Ryan ALM have claimed that the primary objective in managing defined benefit plans was to SECURE benefits at both reasonable costs and with prudent risk.

However, for most of my 40-years in the pension/investment industry, achieving the return on asset (ROA) objective has been the dominant pursuit by sponsors, consultants, actuaries, etc. This objective has led to a significant migration within asset classes from a more balanced fixed income/equity mix to one that is today dominated by equity and equity-like risk products. The volatility associated with this asset mix migration has ramped up as well. Furthermore, liquidity to meet benefit payments and expenses has become more challenging.

Yet, for two days I heard several public fund sponsors tell the audience that securing benefit payments was their most important objective. I nearly jumped out of my seat on those occasions. You see, it was just roughly 5-7 years ago that I could attend an Opal conference or any other sponsor’s conference and not hear the word LIABILITY once. Now you hear the mention of pension liabilities throughout the sessions. But what really has changed? Have plan sponsors, their consultants, and actuaries really changed the focus from one that is return centric to one that has liabilities squarely in the scope? Private pension plans certainly have, but they in many cases are trying to de-risk their plans with the goal of freezing, terminating, and eventually transferring their pension liability to an insurance company.

Public pension sponsors desperately want to preserve their DB pension systems and rightly so. These plans were designed to reward their participants for a job well done. The benefits paid help participants to achieve a dignified retirement. Failure to secure the funds necessary to meet these obligations would be disastrous. Yet, the change in asset allocation witnessed during the last 2+ decades creates an environment in which huge swings in funded status can be realized leading to significant increases in contribution expenses by the sponsoring entity. These increases have gotten the attention of taxpayers, many of whom don’t have a defined benefit plan to help them retire.

Today, we have seen significant improvement in funded ratios and funded status for many public pension plans. If securing the promised benefits is truly their new focus, it is time to take some risk off the table. The prospect of rising US interest rates will lead to challenging times for total return-oriented fixed income programs. But the total return is NOT the value in fixed income. Their value is the certainty of their cash flows! Use fixed income assets currently allocated to these programs to secure the promised benefits through a cash flow matching program that will move assets in lockstep with a plan’s specific liabilities while creating the liquidity necessary to meet the monthly payments. The current fixed income allocation might just secure the next 10 years or so of benefits after contributions, which helps create a bridge of security for your risk assets that can now grow unencumbered, as they are no longer a source of liquidity.

Don’t risk your improved funding. Secure those promised benefits for the participants who have represented your system with the utmost professionalism. They deserve to be able to sleep well at night knowing that no matter what happens within the volatile segments of our capital markets that their benefits have been protected for the foreseeable future.