I read with interest about a public pension system approving the issuance of a pension obligation bond (POB) to sure up their plan’s poor funding (this is not unusual in today’s environment). I applaud them for doing so, as the historically low-interest rates are providing a unique opportunity. However, the proposed implementation leaves a lot to be desired in my humble opinion.
As we’ve written before, POBs that have failed have done so because they have not captured the potential arbitrage that existed between the plan’s return on assets assumption (ROA) and the interest rate on the POB. That failure has led to increased costs when both the bond’s interest and the loss on the bond’s proceeds have to be paid. We believe that this failure has been caused by injecting the POB’s proceeds into the plan’s existing asset allocation subjecting those assets to the whims of the markets. Given the current fundamentals for both stocks and bonds, the risk of the markets working against this asset allocation is greater than it is being supportive.
The plan that I’m referencing recognized this issue and they plan to invest 1/6th of the assets each quarter hoping that dollar-cost averaging will smooth the returns and reduce the risk that they are injecting a significant sum of money at the peak of the market’s cycle. I’m glad to see that someone is thinking outside the box, but this strategy comes with the potential for significant opportunity cost, as the POB’s non-invested proceeds will be kept in very short-term instruments. This will clearly have an impact on the plan’s ability to achieve the ROA during the next couple of years.
We, at Ryan ALM, would suggest that the POB’s proceeds be used to cash flow match or defease the plan’s benefits and expenses for the next 10-years or more through cash flow matching with investment-grade bonds. This is where the bond allocation belongs, as a liquidity strategy. This strategy would provide for an enhanced yield relative to cash (cash flow match through a corporate bond portfolio) while securing the benefits and reducing the cost of future benefits through the defeasement. Furthermore, it is likely that only a modest portion of the POB’s proceeds would be needed to accomplish this objective. The remainder of the assets (we call alpha or growth assets) would then be used in concert with the existing corpus and future contributions to meet the plan’s future liabilities. Importantly, the cash flow matching creates an extended investing horizon for the growth assets to grow unencumbered, as they are no longer a source of liquidity. These Alpha assets can be managed more aggressively in strategies without bonds that provide a liquidity premium.
The longer the investment horizon the greater the probability of success. The S&P 500 doesn’t outperform bonds in every 10-year period, but they do so more than 80% of the time. Creating that extended horizon and removing the bond allocation improves the odds that the ROA will be achieved longer-term, if not enhanced. Furthermore, being able to secure the plan’s benefits and expenses for the next 10-years reduces the volatility of both the funded status and contribution expense. To repeat, our strategy secures benefits and expenses, reduces the future cost of these benefits through the defeasement, extends the investing horizon improving the odds that the ROA will be achieved while reducing the volatility of the funded status and contributions. Seems almost too good to be true: but it isn’t!
Ryan ALM has produced a position brief on various ALM strategies, including cash flow matching (CDI) and duration matching, but with a twist.
The purpose of duration matching is an attempt to match the interest rate risk sensitivity of assets to liabilities. The objective is to have the market value or present value (PV) changes (growth rate) in the bond portfolio match the market value or PV changes (growth rate) in liabilities for a given change in interest rates. But duration matching is only accurate for smallparallel shifts in the yield curve. However, the yield curve rarely moves an equal number of basis points at every point along the curve. For more info, Ron Ryan wrote a research paper “The Seven Flaws of Duration” while he was the head of Ryan Labs.
Fortunately, bond management evolved to remedy these flaws by using Key Rate Durations, which attempt to match the duration of multiple points along the yield curve. Key Rate Duration is an improvement over using a single average duration, but it still has several deficiencies, including the fact that duration is a present value calculation requiring pricing each projected benefit with a discount rate yield curve (i.e., ASC 715 discount rates). As a result, 30 annual benefit payments require 30 separate discount rates.
Further evolution within fixed income has brought us to Dollar Duration Matching (DDM). DDM matches the Dollar Value change per basis point change in yield for assets with the Dollar Value change per basis point change in yield for liabilities. When the Dollar Duration of assets is matched to the Dollar Duration of liabilities for every year in the term structure of liabilities, then DDM is the most preciseform of Key Rate duration matching because it matches the Key Rate durations at every point along the liabilities yield cure or benefits payment schedule (30 years = 30 key rate durations).
The Ryan ALM DDM approach greatly improves the accuracy of Key Rate duration matching by matching the Dollar Value changes in liabilities with the Dollar Value changes in assets across the term structure and yield curve for both assets and liabilities. The liabilities are represented by using a Custom Liability Index (CLI) to more precisely measure and monitor the dollar value movement in liabilities given any movement in interest rates.
Pension plans need to pay more attention to their plan’s specific liabilities. Using either CDI or DDM is a step in the right direction to securing the promised benefits, while reducing cost. Please don’t hesitate to reach out to Ryan ALM with any questions that you might have on either of these disciplines that we bring to asset/liability management.
We are pleased to share with you the Ryan ALM quarterly newsletter for Q1’21. As you will read, a terrific quarter was logged for both private and public pension systems that benefited from rising rates (liabilities down) and strong markets (assets up). The combination lead to improved funded ratios and funded status. We hope that you find our insights beneficial. As always, please don’t hesitate to reach out to us at (561) 656-2014 or visit us at ryanalm.com or kampconsultingblog.com. Thank you for your on-going support.
The WSJ has published an article today titled, “Corporate Bond Gauge Signals Dwindling Economic Risk”, in which they speculate that the narrowing of spreads for non-investment grade bonds (High Yield) relative to Treasuries reveals confidence in the economy’s rebound. But does it really?
“The average extra yield, or spread, investors demand to hold speculative-grade corporate bonds over U.S. Treasuries dropped below 3 percentage points this month to as low as 2.90 percentage points for the first time since 2007, when it set a record of 2.33 percentage points, according to Bloomberg Barclays data” (WSJ). As we mentioned the other day in our post, Private Pension Alert: Lock it in! Any reference to an event last accomplished in 2007 sends shivers down my spine.
I would say that there are a number of factors leading to this trend, including the need for yield in a low-interest-rate environment among retirees/pension plans. I would suggest that a spread this narrow signifies a market that has gotten ahead of itself from a fundamental perspective. Again, we are discussing non-investment grade bonds in this case. They are rated this way for a reason. Despite the fact that there has been a decline in the default rates recently, we live in an ever-changing landscape. According to S&P, “even though we expect very low funding costs through 2021, higher leverage and a large share of vulnerable corporates are likely to induce further defaults, resulting in the 12-month speculative-grade default rate rising to around 9% in the U.S.” Do you really want so little relative yield to navigate through such a challenging environment as the one described by S&P? I certainly don’t.
Again, we would suggest that one use investment grade fixed income for its cash flows and defease pension liabilities chronologically for the next 10 years. Don’t chase yield in when you aren’t getting paid to do so. This strategy will provide a longer investing horizon for the balance of your assets that will now have time to work through the uncertainties brought about by the global pandemic. 2007 may have started off on a strong footing, but we certainly know how it ended. Let’s not repeat the mistakes of the past.
Great funding progress has been made by the average US private pension plan that has benefited during the last 12 months from rising equity values and rising bond yields. As the chart below suggests (thanks, Mercer), the funded status for corporate America now stands at 95%, having risen from a low of 70% in 2012 and 77% just 12-months ago. Given this great progress, now is not the time to sit on one’s laurels. With equity valuations at all-time highs, we believe that corporations would be best served by locking in these tremendous funding gains, even if the goal isn’t to freeze, terminate, and/or engage in a pension risk transfer for your specific pension plan.
Despite the fact that US interest rates continue to be near their lows, a cash flow matching strategy designed to defease the plan’s Retired Lives Liabilities will secure benefits chronologically and protect the funded status even in a rising rate environment, as assets AND liabilities will move in lock-step. Continuing with a traditional asset allocation potentially risks underperformance from both equities and core fixed income, given the latter’s interest rate sensitivity. Furthermore, a cash flow matching strategy can be accomplished with cash bonds and doesn’t need to involve more esoteric instruments, such as swaps and derivatives, which can introduce a different set of risks and provide no cash flows.
The last time that corporate America enjoyed a funding surplus was 2007. We know what soon transpired. It would be tragic if market declines once again sabotaged the funded status. We also got close to full-funding in 2013, but a significant decline in interest rates conspired to drive the collective funded status much lower. We don’t know when or by how much markets will move, but given their current valuations, there is likely less upside than downside. Secure your gains! Just like in Las Vegas, when you win BIG… take chips off the table!
Fidelity Investments is out with their 2021 State of Retirement Planning Study. Given the impact of Covid-19 on many Americans, in terms of health, employment, etc. it isn’t surprising to read that pre-pandemic retirement plans may have been altered. What is surprising is the percentage of responders that indicated a negative impact. In fact, Fidelity is reporting that 82% of Americans said that their retirement plans have been impacted, with 55% indicating that retirement was likely pushed back by at least 2 years, and another 33% indicated that the delay may be 3-years or more. Ouch!
Importantly, 79% of the survey responders indicated that they had re-evaluated their priorities, as a result of the pandemic and many (36%) remain stressed about their ability to maintain a retirement nest egg: and they should be given the low level of US interest rates and significantly inflated multiples for equities that have been fueled by the short-term benefits from stimulus. That combination doesn’t bode well for future returns. Couple the investment concerns with the lack of longevity protection and professional management, and you have the basis for a lot of STRESS.
The demise of the traditional DB plan has created a lot of issues for Americans hoping to retire one day. Sure, some higher earning Americans have been able to stash away “significant” sums of money in a DC retirement account, but that certainly isn’t the norm for a majority of American workers. Furthermore, that balance is subject to great risk should markets experience similar results as those realized in 2000-2002 and 2007-2009 when 401(k)s became 201(k)s seemingly overnight. DC plans were originally contemplated as supplemental retirement vehicles. They should once again assume that role allowing for defined benefit plans to be the true retirement plan that it is.
I am pleased to share that I recently completed a webcast on behalf of the IFEBP. The topic was “Rethinking Pension Obligation Bonds”. POBs have gotten a bad reputation since their introduction in 1985, and several organizations, including the GFOA, continue to warn their members to steer clear. Given Ryan ALM’s unique implementation of the POB proceeds, we believe that our strategy increases the probability that the POB will be successful.
Important: Please note that the webcast is only available to members of the International Foundation. If you are a member, please log onto the IFEBP’s website and view the presentation there.
Please don’t hesitate to reach out to us at Ryan ALM if you’d like to learn more about our approach.
I am pleased to share a terrific podcast brought to you by Traci Dority-Shanklin and the World of Multiemployer Benefit Funds. Traci has cobbled together comments from Jack Marco, John Elliott, Jason Russell, and me from previous podcasts. Our comments address the multiemployer retirement crisis that has been unfolding for years. The recent passage of the American Rescue Plan Act (APRA) addresses many of the extreme funding issues, but more work is necessary to ensure that causes that led to previous issues don’t once again surface.
I hope that you’ll take the time to listen, as the podcast is only 30 minutes long. I believe that you’ll appreciate the views expressed by some of the leading industry voices in Jack, John, and Jason. There are several other multiemployer-focused podcasts that would provide you with additional terrific insights. I encourage you to visit their website.
Since the first use of Pension Obligation Bonds (POB) in 1985 (Oakland, CA), results have been checkered at best. Boston College Center for Retirement Research (CRR) has produced two studies related to POBs and neither shines a great light on the use of POBs to improve funding for public pension systems. Furthermore, the Government Finance Officers Association (GFOA) has come out strongly against the use of POBs “regardless of the economic cycle”, which I guess is a reference to the current environment of historically low-interest rates in the US. But are they thinking about the use of POBs in the right light?
As we know, states and municipalities have issued these securities “hoping” to capture the arbitrage between the ROA (plan’s asset return forecast plus the discount rate) and the interest payment on the bond. For most cases from 1992-2009, the bonds were issued and invested at the wrong time in the cycle leading to underperformance and an increase in the plan’s liabilities. In the 2014 study, CRR found that bonds issued in 2009 and later had shown improved results once again highlighting that timing is an important factor, and we all know how difficult it is to time the market, especially when the POB assets are injected into the plan’s traditional asset allocation, with all the gyrations that markets can create.
All that said, there is a strategy that can be used that can dramatically increase the probability of success. Sure, taking advantage of low interest rates is still an important consideration, but this prudent strategy significantly reduces the “timing” element of when the assets are invested. I think that the GFOA would appreciate a strategy that bifurcates a plan’s assets into two buckets – beta and alpha. The beta assets would use some of the POB’s proceeds to defease the plan’s retired lives liability chronologically for the next 10-years or so. This provides the remainder of the POB proceeds and the current plan assets to be managed more aggressively since they now have a longer investment horizon of 10 or greater years.
As the chart above reflects, a traditional asset allocation with a one-year investment horizon has a tremendous amount of volatility associated with it. By providing the portfolio with a 10-year investment horizon, the standard deviation declines dramatically increasing the probability of achieving one’s return objective. Furthermore, by defeasing the plan’s near-term liabilities, liquidity to meet benefit payments and expenses is enhanced allowing the alpha assets to grow unencumbered. Importantly this change in asset allocation converts fixed income from a performance-seeking investment to a cash-flow-producing investment, which is the true value in bonds, especially in this current environment.
But the proof is in the pudding. A recent analysis that we did for a struggling public pension plan showed that with the injection of a POB and the adoption of this implementation we could dramatically improve the Funded Ratio, freeze contributions at the current level (saving the plan >$10 billion in future contributions), reduce funding costs by >20%, and cover the debt-service while determining that the fund could accomplish all of this with a ROA that was 80 bps lower than their current objective. You may be thinking that this just seems too good to be true, but we would be glad to take you through both our process and this analysis. Call us, especially if you are affiliated with the GFOA.
It has been reported that the American Federation of Musicians and Employers’ Pension Fund (AFM-EPF) has decided to pull the application for benefit reductions under MPRA and “bet” that the recently passed American Rescue Plan Act will provide a superior outcome. The latest MPRA application by AFM-EPF filed in December (the first application was rejected) called for an across-the-board 30.9% reduction of the multipliers used to calculate benefits for contributions earned before Jan. 1, 2010. Under ARPA, plans designated as Critical and Declining or Critical can file an application with the PBGC for a grant that would ensure that benefits would be paid through 2051 with no requirement that the grant is repaid.
It seems fairly obvious to me what I would do if I were responsible for that plan. But, there are outstanding issues that need to be resolved with regard to the legislation. This determination falls onto the PBGC, which is responsible for providing guidance on the legislation’s provisions, including how the Special Financial Assistance (SFA) is calculated in the first place. I’ve seen multiple interpretations as to how the SFA will be determined, and the size of the assistance varies tremendously under the most extreme differences.
Personally, I can’t imagine that it was the goal of Congress to have legislation passed that doesn’t accomplish the objective of securing the promised benefits for these struggling plans through 2051, especially given that there are roughly 1.4 million Americans in these plans who are expecting to get what was promised. So, what would you do? Would you cut benefits under MPRA, even if the pain is quite severe in order to extend the viability of these entities, or would you “roll the dice” on ARPA and the PBGC’s interpretation of how the SFA should be calculated? I firmly believe that the PBGC will produce guidelines that provide the necessary SFA to ensure that there is enough money in 2051 to meet the plan’s liabilities at that time.