It’s All About Contributions!

The most significant cause of the current pension crisis is the failure to contribute enough to these plans! As a result, too much emphasis has been placed on generating out-sized returns, which have failed to materialize. Oh, we’ve had brief moments of glory (decade of the ’90s), but far too often we’ve had these riskier portfolios subjected to significant market corrections (’00-’02, ’07-’09, Q4’18, 2/20-3/20). When will we finally choose another course?

Federal Reserve policy decisions that have lead to rapidly falling US rates have proven incredibly harmful to Pension America and savers in general. But, instead of ponying up more cash in the form of contributions, we tried to game the system by juicing up possible returns. We got the volatility, but not returns! The chart below tells an amazing story.

The chart above highlights the cost to secure a $1,000 benefit payment 30-years out, and at various points in time throughout my career. The green line is representative of the average ROA for the 50 US states. When we discuss the impact that the Federal Reserve policy decisions have had on Pension America, this is exactly to which we are referring.

In 1981, when I first entered this industry, you could secure a $1,000 pension benefit payment 30-years out with just $14.37. Incredible! The US 30-year Treasury bond yield was 14.8% at that time. The power of compounding (is it the eighth “wonder of the world”?) provided you with an amazing opportunity that we are likely never to see again in the US. Given this environment, one has to wonder why Pension America didn’t immunize and defease every pension system and secure the victory for decades to come?

Interestingly, pension systems that had an “average” ROA (they were higher in the early ’80s than what we are depicting) were paying more into the system than they needed to in 1981, as the discounting mechanism for liabilities was lower than the prevailing 30-year yield. In our example, plan sponsors were contributing $109.49 more than they needed to if they actually achieved the projected ROA. They continued to contribute more into their systems through the early 1990s, but as interest rates began to plummet, those contributions fell further and further behind.

In fact, today we have a situation in which that same $1,000 would cost you $622.61 in present value $s. Regrettably, because pension systems are using an inflated discounting mechanism of 7.21% (the ROA), they are under contributing to these systems by about 5X. Instead of funding that $1,000 at $623, they are only putting into their systems $123.86. Again, this forces pension systems to try to spike returns, and as a result, we get this constant roller-coaster effect to ruin. Remember what Hurricane Sandy did to the NJ shore communities.

Enough is enough. As we discussed in our most recent blog, most state and municipal pension systems are not going to invest their way to improved funding, as the hole that has been dug is just too deep. Plan sponsors need to find additional resources to enhance contributions. Without addressing the need for greater contributions plan assets will continue to be whipsawed by market action, and the sustainability of these systems will once again be called into question.

Saving Pension America – There Aren’t an Infinite Number of Possibilities!

Anyone who knows Ryan ALM and who has followed our blog posts for years knows that we are big supporters of DB plans as the primary retirement vehicle for the masses. We’ve discussed our rationale for this stance numerous times. That said, recent market action and economic activity have put public pension systems once again in the spotlight. The battle to control the outbreak of Covid-19 has impacted many state budgets from both a revenue (income and sales taxes, lotteries, fees, etc.) and expenses standpoint (Covid-19 emergency responders, PPE, etc.), and the likelihood of escalating contributions into state pension systems may be too much for some states to handle. What can be done?

Unfortunately, there aren’t an infinite number of actions that will improve plan funding, and in the cases of states like NJ, IL, and others, dramatically improve their systems’ funded status. In fact, there are really only five actions that would lead to improved pension funding, including; 1) assets outperform the ROA target, 2) the present value of future liabilities fall, 3) both actions 1 and 2 occur, 4) borrow additional resources (POB), and 5) renege on a portion of the promised benefits.

With regard to action 1, plans have been relying on asset performance for years to make up for contribution shortfalls. In most cases this goal has been met with enhanced volatility, but little reward. As we pointed out in a previous blog, the Bloomberg Barclays Aggregate Index bested the S&P 500 for the 20-years ending March 31, 2020, despite a greater than 10-year bull market for equities, little improvement in funded status occurred.

We have been in a protracted bull market for bonds since I entered the industry in 1981. The impact on pension systems from falling interest rates (action 2) has been devastating (I will have more on this issue in a subsequent blog post). How likely are rates to rise from here? Most participants in our industry have felt that rates would “normalize” for years, only to see one event after another drive rates further lower. Action by the US Federal Reserve has damaged (permanently?) pensions and retirees, who need income to sustain quality retirements. The movement of rates lower has correlated with plans and pensioners taking on more risk to try to create additional income. It has also proven to be a disaster.

Ideally, we would enter a protracted period of asset appreciation and rising interest rates that would lead to a fairly quick recovery in pension funding. For instance, at such low market interest rates, a 30 bps increase in rates would create negative liability growth for the plan. Given that dynamic, a Funded Ratio of 60% could improve significantly to 89.4% if in the next 5 years average asset growth was just 4% and average liability growth was -4%. The improvement is even more dramatic if during the next 5 years assets grew by 5%. In this case, the funded ratio would improve to 94.0% if liability growth proved to be negative 4% during this period. But given that our economy is just opening up now, how much economic growth, inflation, and rising rates can we expect in the near-term?

Action 5, the trimming of promised benefits, (yes, I jumped over my fourth “opportunity”) is a last resort action, and in many cases individual state laws prohibit such an action. Since the Great Financial Crisis (GFC), a majority of public pension systems have altered benefit formulas directed at new employees, but that does little to tackle the current under-funding. Furthermore, these plan participants have invested both years of time and their own contributions into a system with the expectation that they would receive the promised benefits. Anything less is truly an affront.

With regard to action 4 and the borrowing of funds, I believe that for states such as NJ, IL, KY, CT, etc. the issuance of a pension obligation bond (POB) is the only way for these systems to climb out from the huge hole that was dug by years of habitually under-funding their plans. POBs have been tried many times before and with mixed results, but I believe that the investment of the bond proceeds was implemented inappropriately, which ultimately lead to the failure of the action.

Historically, a pension plan would take the proceeds from the bond and invest those assets in a traditional asset allocation. As a result, the proceeds are subjected to the whims of the markets. In many cases these assets have been injected at an inappropriate (market peaks) time leading to losses. The plan is then on the hook for the original interest payment on the POB and the loss suffered on the “investment”. To mitigate this risk, any proceeds from the POB MUST be used to defease the plan’s retired lives liability. The current assets in the plan and any future annual contributions would then be used to meet future liabilities. Given the magnitude of the funding crisis, HOPING that assets will dramatically outperform, while interest rates rapidly rise is a lot to ask for. Cutting benefits is a non-starter. Issuing a POB and injecting significant assets into the system to SECURE pension promises seems to me to be the most viable alternative.

Let us know what you think.

That’s Some List!

Representatives from the Federal Reserve Bank in St. Louis recently discussed on a defined contribution webinar the implications for the retirement industry as a result of the Covid-19 crisis. The key action items discussed were all significant issues prior to the virus’s impact on our economy and markets, but the magnitude of the issues has certainly been exacerbated. Many of the following items have been highlighted in this blog before.

There is an urgent need to address these issues, which include: 1) Americans’ lack of emergency savings, 2) racial and economic inequality in retirement savings, 3) lack of access to workplace retirement plans, and 4) the Millennial cohort. As you can see, there is a host of critical issues just involving retirement savings, let alone all the other issues that are dominating our political and cultural landscape today.

Most of these issues have to do with the fact that a majority of Americans just don’t have wages that provide them with more than enough to just meet their basic needs. As a result, they don’t have funds to meet emergency expenditures. We’ve been reading about this for years how the average American can’t meet a $400 medical or auto expenditure without having to borrow. Even if these American workers had access to a retirement plan, and only about 50% do, they don’t have the disposable income to put money aside.

With regard to inequality, two-thirds of white families have 401(k) plans, while only about 1/3 of nonwhite families are participating in a DC-like plan. For those that are participating in a DC retirement plan, white families have saved on average $155,000, while non-white families have about $60,000, and those figures are from before the recent market sell-off. Trends in the American labor force (on-call arrangements) and the impact of that trend on wages and benefits are constraining one’s ability to save. Nonwhite Americans suffer as a result of the lack of wealth transfers from one generation to the next.

Lastly, as the father of five children (4 millennials), I am particularly concerned about the continuing impact of one crisis after another on this generation. The children of the ’80s and early ’90s have been stung by the burden of excessive student loan debt and the Great Financial crisis, just as they were entering the workforce, which had a profound impact on their starting salaries. At the point where some of this cohort may have just been recovering, they are hit with the Covid-19 crisis. This generation is clearly losing the “birth lottery”. According to recent studies, this generation’s wealth is 34% below where one would expect it to be at this age. Clearly, the implications for the long-term are devastating.

With so many Americans living within 200% of the poverty line, we need to address income inequality, but that might not be enough to help close the retirement gap. We need to rethink the inappropriateness of DC plans as one’s primary retirement vehicle, and once again consider them nothing more than supplemental income funds. If an American has a job, they should be receiving credit towards a defined benefit system. If this needs to be done outside of their employer/employee relationship – so be it! Asking untrained and underpaid employees to fund, manage, and disburse a retirement benefit is a failing policy that is leading to a disastrous outcome.

CHAPTER and Verse on Cash Flow Matching

We, at Ryan ALM, are proud to share with you Ron Ryan’s chapter on Cash Flow Matching, also known as cash flow driven investing (CDI), that will appear in Dr. Frank Fabozzi’s latest edition of the “Handbook of Fixed Income Securities“. This is quite an honor and recognizes Ron, and the Ryan ALM team, as one of the true experts on this subject. Fabozzi’s Handbook is usually required reading for the CFA degree, university Finance courses, as well as a valuable reference for many fixed income practitioners.

Importantly, this work highlights the differences between cash flow matching and duration matching, which has been the preferred pension de-risking strategy in the U.S., while CDI is the preferred method among plan sponsors in Europe. We would encourage you to take a look. One of my favorite sections is the “seven flaws of duration” in the CDI versus LDI section. I think that you’ll find Ron’s thought on this subject to be incredibly insightful.

As we’ve recently witnessed, once again, stock and bond market performance can dramatically impair even the best funded pension systems when the unexpected presents itself. Adopting a cash flow driven approach helps Pension America protect critically important plans in the short- to near-term, while the growth (alpha) assets enjoy an extended investing horizon to overcome recent weakness without becoming a source of liquidity. We would certainly welcome an opportunity to respond to any questions that you have regarding this subject.

Talk About a Long Liability!

I read with both interest and fascination an article in the WSJ today that mentioned that the last surviving Civil War pension recipient had just passed away. Irene Triplett was born in 1930. Her dad, Mose Triplett, was 83 when she was born. His wife at the time was nearly 50 years his junior. As a result of his military service, his daughter, who was 90 when she recently passed away, received a $73.13 monthly benefit from the Department of Veteran Affairs. The pension liability lasted 156 years! I’m not sure that is a record, but it has to be close.

One of the issues impacting pension America is the fact that pensioners, on average, are living longer, and as a result liability tables are being rewritten to account for this extended aging. That said, I doubt that anyone expected a pension liability earned in 1864 to extend to 2020.

When we at Ryan ALM ask for liability data – estimated benefits and contributions – we ask for a minimum of 20 years so that we can produce our Custom Liability Index (CLI). I guess that we will now need to rethink our request. Do we really need to get the actuary to forecast the next 150 years?

Another data point

Yesterday’s blog post highlighted once again why asking untrained individuals to fund, manage, and disburse a retirement benefit (DC offering) is incredibly challenging. We highlighted the fact that fund flows for the month of April showed a significant bias toward fixed income and away from equities. Not surprisingly, U.S. equities massively outperformed during April 2020. Unfortunately, May’s performance results once again reveal a similar outcome, although not quite as dramatic.

For May, the S&P 500 was up 4.8%, while the Bloomberg Barclays Aggregate index advanced only 0.5%. Although bonds have produced two consecutive positive months (2.3%) the opportunity cost associated with moving out of equities in April has resulted in a roughly 16% “loss” for those plan participants that migrated away from equities.

Human nature being what it is, it isn’t surprising to see many investors move away from exposure to equities in April when they’d been tanking day in and day out for more than one month. When a 401(k) balance may represent your only savings, it is troubling to the individual to see one’s hard earned money losing value on a consistent basis, especially for those nearing or recently retired. This is exactly why a defined benefit plan is superior to a DC offering, as pooling of risk and a monthly benefit payout can mitigate this fear-factor.

Why DB Pensions – example 1,977!!

The equity market reaction to the Covid-19 lock-down was destabilizing! Many professionals were torn on what to do in the face of this unprecedented event. Why would we believe that less-trained 401(k) “investors” would behave in a manner different than how they have reacted during most, if not all, market corrections? Regrettably, they didn’t.

Data from Alight Solutions 401(k) index show that in April bond funds received 31% of all retirement fund flows, while money market funds received 18% of the flows. Somewhat surprising was the fact that 19% of the money went to self-directed brokerage accounts. Which funds were the big losers? Target-date-funds accounted for 44% of the outflows, while company stock (24%) and large cap equity (16%) also saw meaningful withdrawals.

It is really disappointing to see the flows from the TDFs, since they are professionally managed asset allocation pools designed to be long-term holdings for individual investors geared to projected retirement dates. What is equally troubling is that equity markets rallied tremendously in April, as the S&P 500 advanced by 12.8%, while the Barclays Bloomberg Aggregate Index was up only 1.8%. Interest rates continue to rise slowly, which will further erode the principal in bonds.

Defined contribution participants have once again shown that they often time their allocation decisions at the most inappropriate time. Selling equities and buying bonds in April locks in substantial losses. If our economy opens up in any meaningful way it is likely that bond yields will continue to rise putting pressure on bond prices. For many 401(k) investors, this activity is damaging to their ability to build a meaningful retirement fund that will provide them with the opportunity to retire with dignity, if they can retire at all.

For those individuals fortunate enough to be in a professionally managed defined benefit plan, you were not asked to make an asset allocation or funding decision during this volatile time. You may have been wondering how your fund was holding up, but as we reported last week, most DB plans have the financial wherewithal to meet benefit payments long into the future. The anxiety and uncertainty experienced by defined contribution participants are palpable. Recent government legislation permitting early withdrawals from DC plans is only compounding the long-term implications!

Not Nearly As Bad As Depicted

Most of us have read numerous articles discussing the “excessive” cost of maintaining a state or municipal pension system, and there are certainly examples of states that are seeing a fairly significant percentage of their annual budgets going to support these entities, such as KY, NJ, and IL to name just a few. However, the majority of states and municipalities are just fine! Sure, funded status will have taken a hit and contribution expenses are likely to rise as a result of Covid-19’s economic toll, but for a significant majority of public pension systems, the hit won’t dramatically alter their ability to meet pension obligations well into the future.

Importantly, these funds are engines to economic growth. Recent studies, as reported by the National Association of State Retirement Administrators (NASRA) highlight the fact that in 2018, state and local government retirement systems in the U.S. distributed $173 billion more in benefits than they received in taxpayer-funded contributions. Incredibly, there is more income produced from these retirement systems than that which is received from the nation’s farming, fishing, logging, and hotel/lodging industries combined!

Another study by the National Institute on Retirement Security (NIRS) found that “retiree spending of pension benefits in 2016 generated $1.2 trillion in total economic output, supporting some 7.5 million jobs across the U.S. Pension spending also added a total of $202.6 billion to government coffers, as taxes were paid at federal, state and local levels on retirees’ pension benefits and their spending in 2016.”

Of greatest importance to me is the fact that these systems are professionally managed lessening the responsibility of individuals to fund, manage, and then disburse a retirement benefit. As we know, a majority of Americans don’t have the discretionary income to fund a plan, nor the expertise to manage one, and lastly a crystal ball to know how to adequately disburse their principal. That’s a lot for even the pros to handle.

My support for defined benefit plans doesn’t mean that there aren’t issues that need to be addressed, such as making sure that an appropriate ROA is used and required annual contributions paid in full. But, DB pensions, with their monthly annuity payout are superior to the glorified savings accounts that are 401(k)s, 403(b)s, etc. Next time you read about how much of the social safety net is being chewed up by state and local pension systems, please refer to the chart above. It tells a much different story.

Stealing From Peter To Pay Paul

It should come as no surprise that Americans who have recently lost jobs, and there are roughly 40 million of those, are now tapping into whatever retirement account that they have to help bridge the loss of their paycheck. According to MagnifyMoney, the average withdrawal is roughly $6,800. Given that 70% of those that now find themselves on unemployment contributed <$1,000 in the last year, the average withdrawal is substantial.

The CARES Act is permitting penalty-free withdrawals (up to $100,000) for those not yet 59 1/2 years old. This may be enticing some to take these early withdrawals, but for many American workers these premature withdrawals are proving to be necessary to pay for basic needs, such as groceries and rent. It is shameful that many working Americans still can’t earn enough to cover their basic living expenses, let alone save for retirement. The American middle class has been substantially reduced, as costs associated with housing, education, food, healthcare, insurance, transportation, etc. have ballooned and the labor force has been transformed into a “on-call” work force.

The Covid-19 crisis may be the final nail in the financial future for many Americans. What we need to do is seek ways to help these fragile households gain access to some emergency funds without having to tap into their retirement accounts. There have been a variety of discussions related to creating side-pocket accounts that would receive payroll, tax-deferred deductions that could fund these emergency savings accounts. I would recommend that 50% of each $ contributed goes into an emergency fund until $1,500 has been saved. Any contributions above that amount would go to fund a retirement account, although SimplyWise is reporting that 70% of those folks that recently lost their jobs contributed <$1,000 in the last year. This once again highlighting how little the average American is able to save after meeting their everyday needs.

We can and should do better. The movement to an on-call work force is destabilizing the American household and fueling the economic crisis that has unfolded during the last eight weeks. A good percentage of American households had seen their wealth fail to regain levels achieved prior to the Great Financial Crisis despite a 10+ year bull market for equities. The additional hardship brought about by Covid-19 may be too much for many to overcome. It is shameful!

Don’t Be A Forced Seller

A terrific article appears In the May 18th issue of P&I, titled, “After extinguishing fires, asset owners turning to liquidity”. The article cites examples from many large overseas plans on how they are handling or preparing for greater cash needs as the Covid-19 pandemic carries on.

Not surprisingly, as this happens in every market crisis, investor’s income has declined as companies have cut or eliminated dividends ($26 billion as of 4/28 according to a Barron’s article), private distributions have trailed off, and interest rates have plummeted. Investor needs for liquidity go beyond pension benefit payments, as investors deal with settle losses from hedging activities, fund margin calls, and meet capital calls from their private market portfolios.

Public funds have dramatically increased their exposure to the alternatives area during the bull market run following the GFC. As a result, exposure to “liquid” assets available to meet these cash needs has fallen. Regrettably, trying to create liquidity often means being a forced seller. Plans can avoid this unfortunate occurrence by restructuring their portfolios into two buckets. First, transform the current fixed income exposure into a cash flow driven investing (CDI) approach to meet both near-term benefits and expenses. We refer to this allocation as the beta bucket. According to the P&I article, many of these mega plans still had significant exposure to traditional fixed income instruments that contain lots of interest-rate risk.

Second, create an alpha bucket with the goal to meet future liability growth. This allocation should contain all non-bond instruments. Because the beta bucket provides all of the necessary liquidity, the alpha bucket can invest with a much longer time horizon and in instruments that no longer have to provide liquidity.

We witnessed back in 2008 and 2009 many E&Fs that were forced to sell assets into weakness, which exacerbated the decline in the value of those instruments. Unfortunately, history has once again repeated itself. By adopting the Ryan ALM CDI strategy, pension systems of all types, can insulate their plans from the damaging impact of being a forced seller. Lock in benefit and expenses for the next 10 years and allow your alpha assets to grow unabated.