P&I reported that CalSTRS generated a 6.8% return for their fiscal year ending June 30, 2019, which exceeded their benchmark’s 6.5% return. Unfortunately, this is no cause for celebration, as CalSTRS funded ratio was only 65.5% as of June 30, 2018. Given the funding deficit, a small level of outperformance will not chip away at the significant underfunding.

CalSTRS has a plan in place that will provide them with a 70% chance of getting to full-funding in 2046, but a significant market dislocation (or two or three) during that timeframe will obviously adversely impact their ability to achieve this objective, as approximately 2/3rds of their benefit payments come from investment returns. Unfortunately, CalSTRS portfolio will have to generate outsized returns or contribute significantly more to the fund to whittle away at the deficit. There is already considerable risk being assumed with a 7% investment target. Contributing more may be an even more difficult hurdle as the state currently contributes more than 9% of total teacher payroll into the fund.

Senator Sherrod Brown (D-OH) and 26 other Democrat Senators, including some of the former members of the now defunct Joint Select Committee on the Solvency of Multiemployer Pensions, have reintroduced pension legislation to tackle the evolving pension crisis. The legislation was filed on Wednesday, which was the same day that the House passed H.R. 397.

The passage of H.R. 397 in the House was expected given the Democrat majority, but the 29 Republicans that joined in support provides a glimmer of hope that Senator Brown’s and the other co-sponsors’ efforts will not be futile, although likely difficult.

As we’ve reported on numerous occasions kickers of the proverbial pension can down the road have finally run out of terrain.  Although Republican Senators will be striving for a more bipartisan compromise, important elements must be maintained in order for this legislation to be successful. Importantly, no action should be taken to potentially harm currently healthy plans by increasing their costs, such as PBGC premiums or mandating mark-to-market discount rates.

In addition, troubled plans should be given an opportunity to borrow low-cost funds provided through the proposed Pension Rehabilitation Administration (PRA) at the current proposed rate of 25 basis points above the prevailing 30-year U.S. Treasury yield. Any meaningful change in the proposed yield, such as that which was proposed by Congressman Roe (R-TN), will adversely impact the plan’s ability to repay the loan principal in 30 years. Failure to do so increases the odds that these pension systems will collapse forcing them (and the beneficiaries) onto the PBGC, which has a benefit threshold that would severely reduce the average pension benefit.

The House passed the H.R. 397 legislation Wednesday in a 264-169 vote aimed a helping stabilize multiemployer pension plans in hopes of mitigating the looming pension crisis.

Importantly, twenty-nine Republicans — nine of whom co-sponsored the legislation — joined Democrats in voting for the measure.

Getting this legislation through the Republican-controlled Senate will be the next and most challenging hurdle. Stay tuned.

I want to provide a quick update for you regarding H.R. 397. I just heard from Congressman Gottheimer’s Legislative Assistant, Zach Eckstein that the “Butch Lewis Act” will be up for a vote on the floor before 8 pm this evening.  A last minute “Hail Mary” amendment by Congressman Roe (R – TN) will be taken up before the vote on 397.

The amendment by Congressman Roe sets the loan interest rates at 5% per annum for the first 5 years and 9% per annum thereafter. This is another game by some in Congress to kill this important bill. Currently, language in the Bill calls for the interest rate to be 25 bps above the prevailing 30-year Treasury (2.58% as of today).

We will update you later this evening on today’s vote.

As mentioned yesterday, I am participating at the Opal Public Fund Summit in Newport. The conference is well attended and the panels/presenters have been very good.  Yesterday’s sessions provided a heavy dose of product related conversation, including equities, fixed income, real estate, real assets, private equity, and private debt.

As I sat through each session I began to think about the types of questions that I’d want to ask if I were a plan sponsor for one of these large public fund entities. It is great that plan sponsors are in attendance, as they are tasked with a very important job in allocating plan assets with the goal to cobble together a combination that will achieve the return on asset assumption over some longer time frame. However, as I sat there I didn’t hear any of the points being made or questions being asked that would provide me with the information necessary to confidently remain in an asset class or allocate to a new one.

So as I thought about this some more, here are the questions that I’d want addressed:

1. What are the long-term expectations for return, risk, and correlation for your asset class? Have those numbers deviated recently and why?
2. Where are we in the investing cycle?
3. How have flows been within your asset class? Are there any capacity issues to be concerned about?
4. Anything new and exciting to report?
5. What keeps you awake at night?
6. What should plan sponsors be asking that they haven’t been?
7. How would a recession likely impact your asset class?
8. Have you begun thinking about the 2020 presidential election and how it might impact your asset class?
9. Are there investment opportunities outside the U.S. in your asset class? Do they have similar return, risk, and correlation expectations?
10. Does the median manager outperform their benchmark after fees in your asset class? If not, shouldn’t a low-cost index fund be considered as an option?

I’m sure that I’m missing some important and relevant questions, but before making any asset allocation changes I’d want to be comfortable that I wasn’t buying yesterday’s news.

Ron Ryan and I are presently spending a few days in Newport, RI at the Opal Public Funds Summit East. The sessions on day one were outstanding, and the audience was very engaged. One theme, in particular, continues to echo through the conference facility related to the inclusion of traditional fixed income in their pension plan’s asset allocation.

The question to ask at this time given this low-interest-rate environment is whether fixed income is a performance asset, an anchor to windward (given the extended bull market for U.S. stocks), a source of cash flow, or none of the above? We would posit that the primary role for fixed income is as a source of cash flow to meet net benefit payments (after contributions) through a cash flow matching strategy.

Through this approach, a portion of your portfolio will be transitioned (most likely your existing fixed income) to a “beta” portfolio where the objective is to match each benefit payment, net of any contributions, in chronological order from nearest out as far as the asset allocation will permit. By using this approach a plan would benefit by having no interest rate risk in the beta portfolio since we are funding future values, better liquidity to meet those future benefit payments, and an extended investing horizon allowing for the greater use of alternatives in the alpha portfolio, which will now have time to capture the liquidity premium that exists. As a reminder, the “alpha” portfolio should look similar to a traditional asset allocation minus investment grade fixed income that is highly correlated to the plan’s liabilities.

The performance objective of the plan’s asset allocation will now become that plan’s specific liabilities and no longer the return on asset assumption (ROA). As the plan’s alpha portfolio outperforms liability growth, “excess” assets should be ported to the beta bucket extending the cash flow matching of benefits and further de-risking the plan toward full funding. We would be happy to discuss this asset allocation technique in further detail.

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!

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.

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:

C+I=B+E

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.

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.