It is common in our pension industry to fit every product/strategy into an asset class box. I understand the thought process, but it doesn’t work for ALM strategies, especially when discussing products that are designed to meet a client’s specific pension liabilities. As a reminder, no two liability cash flows are the same given different labor forces, salaries, mortality, and plan assumptions. This requires that every ALM mandate be tailored to meet the specific requirements of that fund. Thus, these unique ALM fixed income solutions can’t and shouldn’t be compared to a generic fixed income index. Such generic benchmarks are inappropriate objectives and are not a good fit.
In order to assist the asset consulting community and their clients, we at Ryan ALM created a Custom Liability Index ((CLI) trademarked in 1991) to provide the appropriate index for cash flow matching assignments (CDI) and any LDI strategy. When asked to provide CDI, we are usually asked to defease roughly 10-years of the Retired Lives Liabilities, but in several cases our mandates are for periods both shorter and longer. How would comparing these assignments inform anyone of our skill relative to say the long corporate index? Clearly, it wouldn’t. However, the Ryan ALM CLI produces the information absolutely necessary to determine if our fixed income skills were in place to match and fund each benefit and expense during the period that we are asked to cover. All that matters in these mandates is that we have secured and fully funded benefits at low cost, and with prudent risk.
If a pension plan were to hire a small cap core manager with the goal to beat the R2000 then placing that manager in a small cap box might make sense because they aren’t providing a unique solution since the objective is the same for 100s of managers. But asking a fixed income manager to create a cash flow matching strategy designed to fully fund a plan’s specific liabilities is as unique a solution as there is. Don’t try to put CDI or any custom LDI in an asset class box. The true value added and acid test of any CDI asset manager is the cost savings to defease the liabilities that have been targeted. It doesn’t matter how they perform versus the long corporate index or any other generic fixed income comparison. To help consultants and plan sponsors with return performance, Ryan ALM provides a CLI that calculates the growth rate (return) of liabilities and a Performance Attribution Report (PAR) that calculates 14 different risk/reward measurements of assets versus liabilities.
We’ve reported previously on the results of the Natixis Global Retirement Study. 2021’s results are out and the United States has fallen one spot to #17. Not much to be proud about given that ranking. Sure, we are one place ahead of the United Kingdom, but we trail the likes of Slovenia and the Czech Republic. We have 100,000s of well-intentioned individuals feverishly working on behalf of current and future retirees, but that effort isn’t creating the outcomes that our workers and retirees obviously need and want.
According to the study, the index “incorporates 18 performance indicators, grouped into four thematic sub-indices, which have been calculated on the basis of reliable data from a range of international organizations and academic sources. It takes into account the particular characteristics of the older demographic retiree group in order to assess and compare the level of retirement security in different countries around the world.” Those thematic sub-indices are Health, Quality of Life, Material Well-being, and Finances in Retirement. Regrettably, the U.S. doesn’t score in the top 10 in any of these categories. Shockingly, it scores in 34th place for life expectancy, which craters the overall Health ranking despite scoring well in 2 of the 3 main sections.
80% of individuals (including 77% of business owners in our survey) believe companies should be responsible for helping them achieve a secure retirement. In addition, 80% of individuals say they would be more inclined to work for a company that offered matching contributions to their retirement savings plan. That’s fine and dandy, but we’ve seen companies quickly eliminate or slash matches in DC plans when economic times get challenging.
If our goal is to provide a dignified retirement to our participants, then we as an industry need to do a much better job. Retirees need a monthly annuity that they can count on. Asking untrained individuals to fund, manage, and then disburse a “retirement” benefit with little skill to do this is a ridiculous exercise. Trying to manage a retirement portfolio in this low-interest rate environment is incredibly challenging and forces participants to chase more aggressive/risky strategies. I’m a huge fan of traditional defined benefit plans, but the private sector has abandoned them, and individual workers are less interested in working for one company anymore. I just read this morning that the average worker will have 12 employers during their career.
Lastly, too many American workers aren’t earning nearly enough to provide for their needs today let alone allocate a percentage of their incomes to a retirement benefit years away. Sure, I’ve read many an article about how people had wished they’d saved more for retirement, but you can’t get blood from a stone.
I suspect that most of us have no idea that today, September 10, 2021, is National 401(k) Day. This day is recognized every year on the Friday following Labor Day. The day is supposed to be an opportunity for retirement saving education and for companies to inform their employees about their ability to invest in company sponsored 401(k)s. Did you get your update today?
401(k) plans are defined contribution plans (DC). This plan type was created in the late 1970s as a “supplemental” benefit. Corporate America liked the idea of a DC offering because it helped them recruit middle and senior management types who wouldn’t accrue enough time in the company’s traditional pension plan. Again, the benefit was supplemental to the traditional monthly pension payment and not in lieu of it!
I think that defined contribution plans are fine as long as they remain supplemental to a DB plan. Asking untrained individuals to fund, manage, and then disburse a retirement benefit is a ridiculous exercise. Why do we think that 99.9% of Americans have this ability? Unfortunately, we have a significant percentage of our population living within 200% of the poverty line. Do you think that they have any discretionary income that would permit them to fund a retirement benefit when housing, health insurance, food, education, and transportation costs eat up most of an individual’s take home pay? Remember, these plans are predicated on what is contributed. Sure, there may be a company match of some kind, but we witnessed what can happen during difficult economic times. That employer contribution suddenly vanishes.
Defined benefit plans are the gold standard of retirement vehicles. They once covered more than 40% of the private sector workforce, most union employees, and roughly 85% of public sector workers. What happened? Did we lose focus on the primary objective in managing a DB plan which is to SECURE the promised benefits in a cost effective manner with prudent risk? Did our industry’s focus on the return on asset assumption (ROA) create an untenable environment? Yes, we got more volatility, but did we get the commensurate return? It was this volatility that impacted the financial statements and led to the decision to freeze and terminate a significant percentage of private DB plans. It is a tragic outcome.
What we have today is a growing economic divide among the haves and haves-not. This schism continues to grow, and the lack of retirement security is only making matters worse. DB plans can be managed effectively where excess volatility is not tolerated, where the focus is on the promised benefit and not some made up ROA and where decisions that are made relative to investment structure and asset allocation are predicated on the financial health of the plan and the funded status. We need DB plans more than ever and ONLY a return to pension basics will help us in this quest. Forget about all the new-fangled investment products being sold. Replacing one strategy for another is no better than shifting deck chairs on the Titanic. We need improved governance and a renewed focus on why pensions were provided in the first place.
We’ve been discussing pension obligation bonds (POBs) for the last couple of years and it seems as if folks are listening! According to a WSJ article that was published during the weekend, there have been 72 POBs issued in 2021 compared to the annual average of 25. In addition, more POB money has been raised this year than in any year during the last 15 years. We think that a POB can dramatically improve a plan’s economics provided that the proceeds are not used within the plan’s current asset allocation.
According to the WSJ article, the average interest rate for a municipal POB is 3%, while the average pension plan is striving for a 7% ROA. If the potential arbitrage is the driving factor in the decision to issue these bonds – good luck! Certainly, the historically low-interest rates help but remember that we are at historic levels for equities and the fundamental support is eroding. A dramatic decline in the equity markets would undercut the benefits of this issuance. We’ve seen this story unfold numerous times and it is what led the Center for Retirement Research at Boston College to issue their initial POB study in 2009. Their conclusions were not very supportive of using POBs to support DB plans.
There are potentially huge savings by issuing POBs in this environment, but plans need to be smart. Defease your pension liabilities chronologically as far out as possible using the POB proceeds. This allows your current assets and future contributions to be used for alpha-generating purposes, as they can now grow unencumbered as they are no longer a source of liquidity to meet benefits and expenses. Our work in this space has shown that plans can dramatically improve their plan’s funded status, stabilize contribution expenses, and in most cases reduce the target return on asset assumption (ROA). We’d be happy to produce a Custom Liability Index (CLI) highlighting the impact of your proposed POB on your plan’s future economics. Don’t hesitate to reach out for some help.
We, at Ryan ALM, are big supporters of Pension Obligation Bonds (POB) provided that the proceeds are used to defease the pension system’s liabilities chronologically for as far out as the POB allocation will permit. We are also encouraging the use of this funding strategy because of the historically low interest rate environment (reason #1). But there are other reasons, too. We remain very concerned about the underlying fundamentals of the US equity market and the extended blow-out performance for the last 10 years that would suggest (regression to the mean). As we wrote yesterday, the dividend yield on the S&P 500 (1.28% as of 9/1) has only been lower in 1999 (1.17%) and 2000 (1.22%).
For the 10-years ending 12/31/2009, the S&P 500’s total return (including dividends) was -0.95%! We aren’t suggesting that we are on the verge of a similar result, but given the 11 basis points difference in yield, we are intimating that US equity returns are not going to be close to historic averages for the next 10-years. Here are some #s to chew on:
S&P 500 (total returns through 7/31/21)
Since 1871 to present: 9.1%
Reversion to the mean suggests that the 8.8% 20-year S&P 500 return generated through the period ending 7/31/31, would only produce a 2.6% return for the next 10-years given that it achieved a 15.4% return during the first 10-years of that period. Furthermore, I do believe that 8.8% is a reasonable target to shoot for over 20-year periods given the 9.1% annualized return since 1871. If you believe that a 10% annualized 20-year return is more appropriate because something has changed in the markets to support this higher target, a 10% annualized return for 20-years ending 7/31/31 would mean that the next 10-years produces a 4.85% annualized gain. Still no where near “average” long-term results or what is forecast for many DB plan asset allocations.
Why a POB? If plan sponsors are to receive considerably less from their alpha assets during the next 10-years, they will likely need to contribute much more than they have been to date. This greater contribution negatively impacts the sponsoring entity’s ability to support other important programs or initiatives. By issuing a POB at this time and using the proceeds to defease plan liabilities through a cash flow matching process, you are dramatically changing the plan’s economics, while securing the promised benefits for 10-years or more. In addition, you are providing those alpha assets with time to weather potentially rocky markets, as they are no longer a source of liquidity to meet benefits and expenses.
As stated previously, there is regression to the mean tendencies within our markets. You don’t get the types of returns that we’ve enjoyed recently without impacting (stealing from) future returns. There are strategies that can be utilized to help reduce the impact of weak markets on pension plan funding. Taking advantage of historically low interest rates to issue a POB and using those proceeds to pre-fund your plan makes sense to us. Defeasing the plan’s liabilities with those proceeds makes even greater sense. DB plans have benefited from historic returns recently. It is time to rethink your asset allocation for the next 10-years and beyond. We can’t afford as a nation to have more DB pension systems shuttered and plan sponsors can’t afford to see contribution expenses continue to rise. It is time to act.
There once was a time when investors demanded more from corporate America than just the opportunity to invest in companies with the hope of a return on that investment. They demanded and were given significant dividends. It was not unusual for the dividend yield on the S&P 500 to be greater than the yield on corporate bonds because of the risk that the equity investor was taking. In fact, it wasn’t until 1958 that the US 10-year Treasury Note had a yield that eclipsed the S&P 500’s dividend yield. Why the change?
In 1871, the dividend yield on the S&P 500 was 5.49%. It would remain robust for many years to come peaking at >10% in 1917 and 9.72% in 1931. It wasn’t until 1961 that we first had the S&P dividend yield fall below 3% (2.98%). It wasn’t until 1997 that we had the first dividend yield on the S&P 500 fall below 2%. The yield would subsequently bottom at 1.17% in 1999.
The dividend yield briefly rose to above 3% in 2008, but it has since plummeted to today’s level at 1.28% (9/1/21). Dividends have always played a significant role in the total return of the S&P 500 throughout its history. Furthermore, the level of the dividend yield has been a great predictor of future returns. We all know how the decade of the 2000s performed following the S&P’s lowest dividend yield. What does that suggest for today’s level and the next 10-years?
According to the folks at Advisor Perspectives, for an average holding period of 1 year, dividends accounted for 27% of totalreturns for the S&P 500 since 1940. Over a 10-year period the contribution of dividends to the total return rises to 48% and with a 20-year holding period dividends account for roughly 60% of total returns. Incredible! Worse than just the decline in the overall dividend yield is the fact that dividends are no longer as sacrosanct as they once were. We witnessed this quite dramatically during the second quarter of 2020 when many companies cut or eliminated their dividends in their response to Covid-19 related events. In fact, only 76% of S&P 500 companies paid a dividend in 2020 compared to 95% in 1980. Given how important dividends are to the total return of the S&P 500 over time, why would you ever elect to invest solely on the potential of an investment and not the certainty of receiving a significant down-payment each and every quarter?
In our recent post, “Right Idea, Wrong Implementation” we discussed the fact that using STRIPS in lieu of coupon bonds would neither reduce the cost of de-risking nor work more effectively than a cash flow matching portfolio. We believe that the true pension objective is all about cash flows…asset cash flows versus liability cash flows. The use of US Treasury STRIPS in lieu of coupon bonds is a very expensive implementation. Just how expensive?
We produced two Custom Liability Indexes (CLI) as of June 30, 2021 – one using STRIPS and the other coupon bonds. We have a representative defined benefit liability stream that is $1 billion in future value liabilities and has payments going out to 2102. When using U.S. Treasury STRIPS to implement a de-risking strategy the present value cost to defease that liability is $695.2 million. The yield on that portfolio is 1.77% and the modified duration is 16.3 years. When implementing a defeasance strategy using our Liability Beta Portfolio (LBP) invested in U.S. investment grade corporate bonds, we see a cost savings versus the STRIPS implementation of $142.2 million! The yield on our portfolio is 3.6% and the modified duration is 13.3 years. The cost to defease $1 billion in pension liabilities using our cash flow matching approach saves the “client” $446 million (44.6%).
As a reminder, the funding cost savings are realized immediately upon implementation allowing the client (and their consultant) to use those savings within the alpha or performance portfolio to hopefully improve the probability of achieving the return on asset (ROA) objective. Oh, and by the way, a cash flow matching portfolio, which uses interest, principal, and reinvested income to meet the future benefits is the most efficient implementation. For example, a $10 million per year projected benefit schedule would require a $500 million bond portfolio at a 2% yield to fund benefits through income. Our LBP cash flow matching could fund these same projected benefits for only $84 million.
I’m happy to share with you today a wonderfully written article by Eleanor Laise, Reporter, Barron’s Group, who effectively captures the human toll inflicted by MPRA legislation that saw 18 multiemployer pension plans slash promised benefits to their participants. Highlighting the conversation in Eleanor’s article is Carol Smallen, who I had the pleasure of first speaking with in August 2018 and whose story I shared on several occasions within this blog. Carol’s story is heart-wrenching, but regrettably, not unique! Importantly, Eleanor also introduces us to several other individuals who have been severely impacted by developments within a subset of the multiemployer pension plan universe.
When we, as an industry, discuss issues related to DB pension plans it is easy to get lost in the debate surrounding various investment theory/strategies, and often neglect the true reason why it is so important that these issues are addressed – the plan participants, who are our relatives, friends, and neighbors. These hard-working Americans went to their jobs each and every day with the expectation and understanding that they were entitled to a pension upon retirement that was going to be based on years of service and other elements. Why was it okay that the promise that they were given was not kept? We need to keep fighting for these individuals and for all American workers, who should have access to a defined benefit plan. Defined contribution plans were intended to be supplemental to DB plans, and not Social Security.
There recently appeared an article in FundFire that suggested that plan sponsors, particularly corporate sponsors, were using their allocation to fixed income inefficiently. We absolutely agree! However, we find that the suggested implementation cited in that article to be just wrong. The article stated that corporate pension plans had roughly 40% in fixed income, which a consultant from a leading firm said was too much. Again, we agree. This consultant went on to say that plans should use US Treasury STRIPS in lieu of coupon bonds, which would allow them to put far fewer $s to work. This is incorrect math and needs to be tested. The pension objective is all about cash flows… asset cash flows versus liability cash flows.
US Treasury STRIPS are highly volatile and expensive. They performed well during the bond market’s lengthy bull market (since 1982), because they have longer durations than coupon bonds. Since we are near historic lows in interest rates now a trend toward higher interest rates (which most economists predict) would produce an opposite effect. Moreover, STRIPS do not secure benefit payments, as they have been stripped of their income component and they certainly are not low risk.
Does it really make sense to use STRIPS now? We would also suggest that the true pension plan objective is too “secure” the promised benefits in a cost efficient manner with prudent risk. This is best accomplished through cash flow matching liabilities with coupon bonds. The difference in cost versus STRIPS could be close to 1% per year of liabilities (a 25-year benefit payment schedule = 25% cost savings). The higher the funded ratio the more the plan sponsor should allocate to defeasance through fixed income securities. We recommend that Retired Lives should be defeased as much as possible since they are the most certain, imminent, and important liabilities.
Do you want to improve the efficiency of your asset allocation? Would you like to put fewer assets into fixed income in this low-interest-rate environment? Adopting a cash flow driven investing (CDI) approach will accomplish your objectives. As the example below reflects, traditional bond management (TBM) requires an allocation of $500 million to fund $10 million in annual benefit payments in this 2% interest rate environment. This is very inefficient. By adopting a CDI approach, the fund can accomplish the objective of funding $10 million in benefit payments with ONLY $84 million. The additional $416 million can now be used in other asset classes to support alpha generation.
The allocation to fixed income is now 83.2% less than using a traditional bond manager. In a CDI implementation the $10 million in benefits is achieved through the use of principal, income, and reinvested income. In addition, bond math suggests that the longer the maturity and the higher the yield the lower the cost. Our cash flow matching process is a cost optimization model that will take advantage of both of these mathematical principles by biasing our portfolio to longer maturities. Thereby we can partially fund the next nine years of benefit payments with the income from a 10-year maturity at 3% yield versus a 1-year Bill providing the investor with 7 basis points and lower yields for the 1-9 year benefit payments.
A CDI strategy is the most cost efficient implementation in accomplishing the primary objective of securing the pension system’s promised benefits. Only an insurance company annuity can provide the same certainty of securing benefits, but at a much higher cost (@ 4% premium). We agree that pension plans should get smarter about the asset allocation that they adopt. It needs to be driven by the funded status and not the return on assets assumption. If plans were to start doing this, I don’t believe that there would be any debate as to how plans would approach their fixed income allocation.
I was extremely pleased to be asked to participate in a Barron’s Live interview today. Eleanor Laise and I discussed ARPA and other matters related to DB plans. With regard to ARPA we discussed the SFA calculation and discount rate issues. Despite some concerns about both, we at Ryan ALM have determined that the SFA working in conjunction with the legacy assets and future contributions can accomplish the primary objective set by Congress to pay benefits and expenses for the next 30-years, while still maintaining a surplus to meet future liabilities.
In addition, we talked about the state of public DB plans, including the use of Pension Obligation Bonds. Please don’t hesitate to reach out to me if you have any questions or comments related to what was discussed today.