What are you hedging?

Since the Great Financial Crisis (GFC) many pension plans have shifted assets into either Treasury Inflation-Protected Securities (TIPS) or real assets (commodities) or both. The question that I’d ask is what are they trying to hedge? Is it asset inflation or pension inflation? If it is pension inflation then they are likely not hedging their exposures appropriately since pension inflation is very different from that of asset inflation.

Pension inflation is what a plan sponsor agrees to as a benefit increase as a cost of living adjustment (COLAs) for Retired Lives and a salary increase factor for Active Lives. Usually, these COLAs are based on the Consumer Price Index (CPI) with a floor and a cap or even a % of the CPI while salary increases tend to be quite static at a 3% annual increase. As a result, pension inflation tends to be less volatile than the CPI. The plan sponsor actuary includes pension inflation (COLAs and salary increases) in their projected benefit payment schedule for both retired and active lives. In sharp contrast, the CPI is a volatile measurement of consumer inflation.

In a quick screen of the Money Market Directory, it appears that roughly 730 DB plans have some exposure to real assets and another 120 use TIPS. I’m guessing that the plans are trying to hedge asset inflation, but that is purely a guess, fearing that the U.S. government’s multiple quantitative easing programs would create massive inflationary pressures. Well, that has obviously not happened. Inflation has been muted in the last decade with no calendar year since 2011 experiencing a CPI reading greater than 3%.

At Ryan ALM we are researching the subject of pension inflation versus asset inflation, and how that distinction impacts asset allocation. Please don’t hesitate to reach out to us if you’d like to get our thoughts.

What You Should Ask During Your Search

Asset consultants continue to play a vital role in the management of defined benefit plans. Occasionally, a plan has to conduct a search for a new one based on several reasons. An industry colleague recently asked me what questions they should ask during their search process for a new asset consultant. I appreciated getting asked that question and I took some time to think about the questions that I’d ask if given the opportunity.

I believe that consultants will tell you that their primary functions are related to asset allocation and manager selection. I know that they do much more than just that, but I think that these areas are where they feel that they add the most value. Given these areas of focus, here are the questions that I would pose:

  • What is the true objective of a DB plan?
  • How is that reflected in the asset allocation?
  • How do you calculate the ROA?
  • Is asset allocation based on the funded status or the ROA?
  • Should a plan with a 60% funded status have a different asset allocation than a plan with a 90% funded status even if they have the same ROA objective?
  • What is the role of bonds within a DB plan?
  • How do you de-risk a pension plan within your asset allocation strategy?
  • How do you fund benefit payments?
  • What are you doing differently today than 5 to 10-years ago? 
  • What did you do differently after the GFC?
  • How do you define risk in asset allocation?
  • If risk is defined as the uncertainty of funding benefits. What is the strategy that you employ to meet this objective?
  • What benchmark do you use for asset/liability management? 
  • What is highlighted on the first page of your quarterly performance report? If it isn’t assets versus liabilities what it it?
  • How do contributions play a role in asset allocation?
  • What are your definitions of alpha and beta within a DB pension plan?
  • When do you change an asset allocation?
  • Do you have an inflation hedge strategy? If so, what are you hedging – asset inflation or pension inflation?
  • How does your shortlist of managers do 3 years after a search is completed relative to the broad universe of managers? Do you monitor this and how often?

As you see, my questions are much more focused on asset allocation and importantly through a liability lens, which is often missing in a traditional asset consultant relationship. Unfortunately, our industry has the tendency to do the same old, same old. Clearly, defined benefit plans have come under great stress in recent decades. Doing the same old, same old has failed.  Isn’t it about time that we try something new? But, in actuality, paying greater attention to plan liabilities would bring us back to the early days of managing DB pension plans when a plan’s liabilities were the main focus and those obligations were defeased.

Why did we get away from securing the promised benefits by focusing more attention to the return on asset assumption (ROA)? By doing so, we have added greater uncertainty and more risk.  DB plans need to be secured, but for them to be successful, we need to significantly reduce funding volatility. Are you comfortable that the average DB plan has greater equity exposure at this time than they had before the Great Financial Crisis?  I’m not.

Baby Steps

With the bipartisan effort recently put forward by the U.S. Senate to support funding for the nearly collapsed United Mine Workers pension system, Congress is finally showing an interest in supporting the American worker that was promised a benefit, but who have been left high and dry in many recent cases. Given Congress’s heightened focus on the impeachment hearings, I wasn’t sure that much, if anything, was going to get done during the remainder of the year. Glad that I might be wrong!

The proposed American Miners Act of 2019 would transfer funds from the Interior Department’s Abandoned Mine Land fund to help meet the benefit obligations (including some healthcare expenditures) for those workers in the 1974 Pension Plan, which is a plan with roughly $3.1 billion in assets, while saddled with an estimated $3 billion in unfunded obligations. The legislation was introduced by West Virginia Senators Shelly Moore Capito (R) and Joe Manchin (D) along with Senate Majority Leader Mitch McConnell, (R-KY). The legislation is also co-sponsored by a number of Senators from mining states, such as Ohio, Pensylvania, and Virginia, as well as others.

This is a good first step, but much more needs to be done to sure up the failing pension systems for roughly 120 other multiemployer plans. Hopefully, with McConnell’s support of this effort, he will be more inclined to bring to the floor for a vote the Butch Lewis Act that passed through the House in July. Time is wasting, and with each passing day, more pressure is applied to these cash-starved plans. A major market correction prior to receiving critical support would likely be a death knell event.

 

Here we Go Again?

My wife and I are blessed with four grandchildren, and with that gift comes many opportunities to “sing” nursery rhymes to our little ones.  One of my favorites is the “Wheels On The Bus”, which as you know go round and round and round and round and… Well, I can’t help think that the song is relevant to decision making within the U.S. pension industry. We continuously live through multiple cycles running concurrently as if they are just wheels on the bus going round.

I recently presented to attendees at the IFEBP conference in San Diego. My topic was “Modern Asset Allocation”, and my thesis was that doing the same old, same old, was just NOT going to cut it anymore! We need to finally stop that bus. (Please reach out to me if you are interested in getting my presentation and notes). Managing to the return on asset assumption (for public and multiemployer plans) has led to the habitual underfunding of the pension plans through lower contributions, while also leading to more aggressive risk profiles than necessary as asset allocations are stretched to achieve more aggressive return targets. You would think that having suffered through two significant market declines in the last 18 years that consultants and plan sponsors would want to get off the asset allocation rollercoaster.

Well, according to database provider Wilshire Trust Universe Comparison Survey (TUCS), few have learned their lesson, as public pension systems continue to either increase equity exposure or they’re letting their gains just ride. According to Wilshire, equity and equity-like alternative weights are now at pre-2007 levels as median exposures for domestic equities sit at 47.3%, while private equity averages roughly 5.6%. In addition, traditional fixed income, the only asset class that correlates to a pension’s liabilities, has been significantly reduced and the composition of the bond portfolio has changed dramatically with the additions of high yield and private debt, potentially injecting more risk into the equation.

I certainly don’t know when the next recession might occur, but it will. Do we really want to have these plans sitting with their highest equity exposure when it hits the fan? Shouldn’t we be looking for ways to reduce risk after a long cycle of outperformance? Contribution expense as a percentage of salary has been growing leaps and bounds. In a recent article in Cal Matters, pension costs were highlighted. Specifically, the Stanislaus Consolidated Fire Protection District was highlighted. It seems that pension costs are about to bankrupt this entity because CalPERS has levied an additional annual required contribution to cover the UAL.

Even with the extra CalPERS charge in 2015-16, Stanislaus Consolidated’s retirement costs were not overwhelming, about 32% of wages and salaries for the district’s employees. But the UAL squeeze was about to get tighter. It jumped to $397,981 the next year and $517,834 in 2017-18. The agency’s 2019-20 budget sets aside $842,404 for UAL, contributing to a financial freefall. This rapid increase has caused layoffs of staff and the closing of a firehouse. Residents are obviously not pleased to see their taxes go up at the same time that services are diminishing.

But, let’s just keep swinging for the fences, and maybe, just maybe, we’ll get lucky this time. I don’t know about you, but I wouldn’t want to have to rely on luck to make sure that the promised benefits would be paid. It may not be time to get off the bus, but let’s encourage the driver to take a different route this time.

Could It Happen Here?

The Chilean pension system, adopted in the early 1980s, was once heralded as a “model of privatization” and imitated by other countries, but has recently been derided for failing to provide the promised benefits. The pension plan is a defined contribution system that depends on employees having access as well as making contributions in order to receive the benefit. Sound familiar?

More than 1 million Chileans have marched through the streets of the capital city, Santiago, protesting all sorts of social issues, including the country’s pension system. Workers are asked to pay 10% of their wages each month to for-profit funds called AFPs. Regrettably, many workers are not able to contribute enough to their plans to provide for an adequate retirement benefit. Compounding the issue are the roughly 1/3 of Chileans who have a less formal working arrangement, the unemployed, and women leaving the workforce to raise their children.

The prior pension system was a pay-as-you-go defined benefit plan. Many Chileans switched to the new plan on the promise that they would be able to retire on a full pension for life. Instead, it has basically left millions struggling in their golden years. The supporters of the system say that the real issues are low wages, a weak job market, an aging population, and long retirement periods relative to the worker’s career. Again, I ask, does this sound familiar?

The U.S. has witnessed the collapse of the defined benefit pension system in the private sector and public fund and multiemployer plans that are struggling under low funding status and escalating contribution expenses. The private sector has shifted a significant percentage of the workforce into DC plans, but a large percentage of workers don’t have access to an employer-sponsored plan. They, too, are struggling with decades of weak wage growth, a changing workforce, longer longevity, and the burden, and it is a burden, of our retirees having to manage the disbursement of retirement assets through an uncertain retirement life cycle.

We are reminded nearly daily of the wealth gap that has been created in our country, as the bottom 50% of Baby Boomers only have 1% of the wealth among the members of this cohort. We are also told that the Millennial generation is fairing no better. At what point do we see millions of Americans marching through our capital cities? Think that can’t happen? Please don’t kid yourself. DC plans were once used as supplemental benefits for middle-level executives that wouldn’t spend enough time at their new employer to make the DB plan an attractive retention tool. Oh, how times have changed. Asking untrained individuals to fund, manage, and then disburse the proceeds from a DC plan is a math problem too hard for most of our citizens. The outcome is not going to be positive!

Why It Makes No Sense

One of the ideas bandied about within the Joint Select Committee on Solvency of Multiemployer Pension Plans was the idea that discount rates (for plan liabilities) should be adjusted for all multiemployer pension systems to reflect a more realistic valuation, such as a risk-free Treasury rate. The idea was that discounting plan liabilities at the return on asset assumption (ROA) had habitually underfunded these plans and forced asset allocations into more risky investments. That may be true, but to force plans to adopt this accounting of liabilities at this time for these mature plans makes no sense.

Employers and employees are already feeling the pinch of higher contribution expense. Dramatically reducing the discount rate would be an incredible burden and would likely lead to the eventual termination of the DB system. Just how profound would this impact be on the current universe of multiemployer systems? According to Ben Ablin, pension actuary for Horizon Actuarial Services and someone with whom I’ve shared the podium a couple of times at IFEBP events, produced a wonderful analysis that determined that all but 6% of the plans using FAS 715 rates would fall below 80% funded, while only 2% of plans would remain above 80% funded using a 30-year Treasury discount rate. More than 50% of multiemployer plans are >80% when using the plan’s ROA to discount liabilities.

As mentioned above, the impact on contributions would be crippling. In Ben’s analysis, he estimated that contribution expense would grow by 1.7 to 2.4Xs when using corporate discount rates and 2 to 3X when using the 30-year Treasury discount rate. If the goal is to drive these plans into the outstretched arms of the PBGC, you would likely accomplish your objective. Since that is not what most of us want to see, forcing plans to adopt a substantially lower discount rate in this environment is just not prudent.

This doesn’t mean that plans shouldn’t become more liability focused. They should look for opportunities to defease Retired Lives liabilities using their current fixed income exposure while managing the balance of the assets relative to future liability growth. This approach will help to stabilize the funded status and contribution expense as it relates to the piece that is being defeased. You have now bought time for the growth assets (non-defeased assets) to outperform your plan’s future liabilities. The bonds are now providing the cash flow, net of contributions, to meet the Retired Lives liabilities and are no longer considered performance assets, nor should they be, given the low-interest-rate environment.

 

Moving In The Right Direction?

A Washington Post article is suggesting that negotiations for the Butch Lewis Act may be moving in the right direction after a suggestion to tack on the BLA to the USMCA (the former NAFTA trade deal). Conversations between Representative Richard Neal (D, MA) and Treasury Secretary Steven Mnuchin have taken place and may suggest that final “intense deal-making” has begun.

According to the article, “the pension overhaul legislation could act as a powerful sweetener for organized labor and wavering Democrats who are skeptical about agreeing to a rewrite of the North American Free Trade Agreement that is being pushed by President Trump.” It is suggested that Mnuchin had a “courteous” response to Neal’s suggestion about tacking the BLA onto the trade deal. Let’s hope!

We will share more as more is known.