Just a quick post today to share with you an article written by John Manganaro, PlanSponsor, that followed a conversation that we had on Tuesday. We touched on a number of issues, but focused a great deal of attention on the need to get the Butch Lewis Act (BLA) passed. We also discussed the Ryan ALM Pension Obligation Bond (POB) strategy to support public pension systems. I hope that you find my insights to be useful. As always, please don’t hesitate to reach out to us with any questions/comments.
It is wonderful that everyone and their sister acknowledges that the US is facing a pension crisis within the multiemployer community, if not more broadly to include public and private plans, as well. As anyone who regularly reads this blog knows, we have been highlighting this situation for years. But, as Congress fiddles, more and more plans fall into Critical and Declining status. A significant percentage of Americans continue to struggle with the fallout from Covid-19. This certainly includes the 1.5 million American pensioners who were promised a benefit only to have that benefit either slashed through the poorly designed MPRA legislation or find themselves in a plan that may become insolvent at some point within the next 15 years. Compounding the issue is the fact that the PBGC insurance pool designed to protect these plans is forecast to become insolvent by 2026 – how comforting!
Since the Butch Lewis (BLA) Act passed the House of Representatives in July 2019, I’ve been cautiously optimistic that we were finally seeing progress that would address this untenable situation. Regrettably, as Covid-19 hit, other funding priorities rose to the top of the agenda. Where was the support for these men and women who worked with the understanding that they would have a pension upon retirement? These workers often deferred salary increases to further support that promise. Yet, they continue to wait and wait and wait! As we’ve mentioned before, the BLA is terrific legislation, and the price tag is estimated to be about only $40 billion over 10-years. That is a drop in the bucket compared to the trillions being handed out by Congress for stimulus 1 and 2.
Furthermore, the economic activity and subsequent tax revenue produced through these benefit payments dwarfs any of the costs associated with this legislation. It makes absolutely no sense to me why Congress continues to treat these American workers with such little regard. Again, it is great to acknowledge that there exists a problem, but that is only the first step in the process and certainly not the last. Regrettably, a December 14th press release by Senators Grassley and Alexander announced that despite very good intentions from representatives on both sides of the aisle, pension legislation would not be included in the year-end spending bill because they had run out of time to score the cost of the legislation, etc. Come on! We’ve heard this same story for years. We know the cost of the BLA legislation. Instead of trying to ram through a proposal that forces partitioning, higher premium costs per participant paid to the PBGC, and a lower discount rate that would weaken the financial position of EVERY multiemployer plan… pass the BLA!
Our multiemployer plans cover industries that are getting crushed by this virus. As an example, just look at what it has done to Broadway and all of the folks whose livelihoods have been shuttered. Do you think that these plans will be helped by reducing the discount rate and increasing PBGC fees? Absolutely not, but that is what is creating the stalemate in this fight. Sure, if we were designing a defined benefit system from scratch, we would consider some of the elements in the competing legislation to the BLA. But we aren’t! We live with these legacy plans and all of their foibles. We must address the current situation at hand before 1.5 million Americans get mere pennies from that promise that was made decades before.
Too much time has been wasted trying to solve this problem. The answer is the BLA! Let’s get this legislation passed before more plans fail and more retirees receive a letter announcing that their pension plan has filed for benefit relief under MPRA and that their new “benefit” will be 50% or so lower. That just isn’t right!
I frequently read many of our industry’s publications. I often find the articles to be spot on. However, there is one area where I continue to question the reporting, as it is based on yesterday’s approach. I am specifically referring to pension obligation bonds (POBs). I’ve reported on POBs many times in this blog during the last few years. I believe that they can be effective tools for public pension systems, similar to Ryan ALM’s input, which became a critical part of the Butch Lewis Act (multiemployer legislation). However, our appreciation for POBs is predicated on the fact that the proceeds from the bonds must be used appropriately.
Now, to be fair, POBs have had a checkered history, as many of these instruments have been issued at the peaks of market cycles. Compounding the problem has been the fact that the proceeds have been invested in a “traditional” asset allocation. The thinking was that there exists an arbitrage between the cost of the bond (it’s yield) and the return on asset (ROA) assumption. By investing the assets that cost 4-5% in an asset allocation with an assumed 7.25% ROA, the plan would “capture” this differential. But, as I mentioned previously, these instruments were often brought to market at the peak of an investing cycle dooming the implementation from the start. Instead of capturing that arbitrage, the POB proceeds had a negative return that the plan had to make up as well as fund the debt service on the POB. It is no wonder why POBs get a bad wrap in some circles.
Why are we hearing more about POBs at this time than we have for many years? First, interest rates are at historic lows, and the old arbitrage crowd is salivating at the possibility of finally achieving the promised reward of a major spread between the ROA and the interest payment. Second, many public pension systems are poorly funded, and in this current covid-19 environment additional contributions are not likely, as states and municipalities deal with troubled budgets because revenues have fallen, while expenses have escalated. Making the annual required contribution may not be possible without dramatically impacting other critical spending needs. Given this situation, POBs seem a logical funding solution. Third, high equity P/E valuations and historically low interest rates make achieving the ROA less likely in the near-term.
So, why do we like POBs? Well, it isn’t for the interest rate spread and it certainly isn’t because I believe that injecting the bond proceeds into a traditional asset allocation at these valuations makes sense. I like POBs because public pension systems need liquidity to meet the promised benefits and expenses, and they can meet that need by issuing a POB at this time. However, we are not going to take the proceeds and inject them into the plan’s current asset allocation. Hell no! We are going to calculate what it would cost the plan to defease the Retired Lives Liability (RLL). Once that is determined by the plan’s actuary, that becomes the amount that should be borrowed in the bond offering.
When the proceeds from the POB become available, the plan should immediately (don’t pass go, don’t collect your $200.00) use those funds to defease the RLL through a cash flow matching bond portfolio. This action will ensure that the promised benefits are paid. The current assets in the fund and any future contributions can now be invested in a more aggressive implementation, as they are no longer a source of liquidity. Asset allocation can now reduce or eliminate their exposure to fixed income since the POB is providing the bond funds. Furthermore, the current assets now have a long runway of time to grow unencumbered. Their objective is to beat future liability growth.
The benefits are numerous: 1) dramatically improved funded status, 2) enhanced liquidity to meet benefit payments, 3) a likely greater allocation to risk assets, 4) a longer investing period that protects the fund during choppy markets, and 5) more stable contribution expenses, among other benefits. Does this sound to good to be true? We recently did a project for a municipality that was interested in possibly issuing a POB. Our analysis indicated that this very poorly funded plan could save roughly $10.2 billion in future contributions, reduce the ROA needed to fully-fund the plan from 7.75% to 6.75%, stabilized contributions at $800 million per year as opposed to the forecast of increases to >$1.4 billion, and repay the $5 billion POB back to the city in 30 years. It isn’t magic – just math! Furthermore, it isn’t gambling, as our process isn’t betting on the markets outperforming the cost of the bond, as plans and their advisors have done for years. We think that you should consider POBs. Just don’t rely on yesterday’s implementation!
In our December 3rd blog post, “Tough Sledding Ahead?”, we highlighted the CAPE index while raising concerns that equity valuations appeared stretched based on this metric. As you may recall, the forecast equity return was -2.3%, including dividends. As a follow-up to that post, we would like to highlight this sobering chart:
John Authers, Senior Editor at Bloomberg, published this chart in his daily Point of Return newsletter. He got the chart from a Michael Finke article that was published by Advisor Perspectives in July 2020. The chart shows that the CAPE has been incredibly accurate in predicting future 10-year equity returns even without taking bond yields into account. According to Finke, a higher CAPE meant a lower subsequent 10-year return, and vice versa. The R-squared was a phenomenally high 0.9, which explained 90% of stocks’ subsequent performance over a decade and the standard deviation was ONLY 1.37%. This 25-year period has been a roller coaster for markets, as we’ve witnessed an equity bubble (’90s), a credit bubble (’07-’08), two epic bear markets (it feels like we’ve had more than two), and a decade-long bull market that recently went pop!
As if that isn’t enough to possibly shake the confidence of your favorite pension plan sponsor in being able to achieve the return on asset assumption (ROA), we also wanted to mention that the Buffett Indicator, which is the ratio of the total market capitalization of the US equity market ($45.2 T)/US GDP ($21.7 T) is currently at 203%. This is 71% above the long-term average. The only other time that had this level of richness was the top of the technology bubble in March 2000 (also at 71% above average).
So, why is buying time important? If in fact the US equity market is peaking, the next 10-years could be quite troubling. If equities are a source of funds to meet future benefit payments, being a forced seller in this environment may create further downward pressure on your holdings. By implementing a cash flow driven investing (CDI) approach that insulates your fund by defeasing the Retired Lives liabilities with bond cash flows (next 1-10 years), your alpha or growth assets, including US stocks, now have significant time to wade through the periods of poor performance. They are allowed to grow unencumbered, as they are no longer a source to fund benefits and expenses. We believe that adopting a new asset allocation framework that consists of beta (CDI) and alpha (growth) assets is the most prudent approach to managing pension assets. Given the current environment any delay in adopting this structure may prove detrimental to the long-term health of your pension plan.
We’ve reported previously on output from the annual Amundi–CREATE series that started in 2014. There is always a plethora of great insights that are shared from among leading pension voices from multiple pension markets. This year’s survey included 158 plan sponsors (74% private) from 17 markets representing nearly $2 trillion in pension assets. I think that this year’s survey took on an element of greater urgency given the impact that Covid-19 is having on markets and economies, and thus pension systems. Obviously, there remains great uncertainty as to the duration of this crisis and the long-term implications for every aspect of our society.
As one would suspect, there were many asset allocation questions posed in this survey, including expectations for returns during the next decade and one that asked whether markets would once again reflect underlying valuations. But the one that caught my attention the most was the one about liquidity. I was pleasantly surprised that 57% of respondents felt that liquidity management will become the third pillar of asset allocation after risk and return. We couldn’t agree more that managing liquidity in this environment will prove to be absolutely critical. As proponents of cash flow driven investing (CDI), we believe that plans MUST secure their benefits and expenses in the near-term providing a longer-term runway for the plan’s growth/alpha assets to perform. This is especially true in this environment as plans have been aggressively building alternative portfolios in an attempt to add some juice to their returns.
In addition to having a greater exposure to alternative investments with lock-up periods, which reduces available liquidity, plans of all kinds are likely to see little to no increase in contributions given the impact on business, union hours, and state and municipal budgets. Having to “make do” with what they currently have, plans will need to restructure their asset allocation and investment structure to reflect this new reality. By dividing the asset base into beta and alpha assets, plan sponsors and their consultants can dedicate a portion of their portfolio to liquidity assets (Beta assets) to fund near-term benefits and expenses (i.e. 1-10 years). This allows the Alpha assets to grow unencumbered, as the last thing one should want is to be forced to raise liquidity from assets that are growth assets and might not have natural liquidity. We refer to this as “maximizing the efficiency of the asset allocation”. You can read about our thoughts on this subject in the July 21, 2020 Ryan ALM blog post.
Protecting and preserving defined benefit systems is critical to the US having a retirement system that will actually allow workers to retire with dignity. Conducting business as usual, especially in this environment is not a winning formula. It is time to get back to basics by focusing on plan liabilities and the generation of cash (liquidity) to meet those promises. Are you ready?
America’s pension system is already facing many challenges whether we are discussing private, public, and/or multiemployer plans. The issues may vary depending on the type of plan, but the one thing that they have in common is their participation in our capital markets. For many (most) plans, they continue to believe that a 7.00%+ return on asset assumption (ROA) is doable. Well, I’m sorry to be the Grinch in this story, but given current equity valuations, it is unlikely that returns from domestic equities will help them achieve their return objective. As the chart below highlights, we are currently (dotted line) at a very inflated valuation for equities, as measured by the Cyclically Adjusted Price/Earnings Ratio (CAPE).
CAPE, also referred to as the Shiller P/E, is a valuation measure usually applied to the S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. There have been only three previous examples when the CAPE was higher than it presently is today (P/E = 34X). In each of those cases, the S&P 500 produced a 10-year real return that was negative (2001, 1999, and 2000). Now, market observers would tell you that given the low interest rate environment valuations can be stretched beyond where they have historically have been, which is a fair comment. But, this chart highlights real returns that are adjusting for inflation. The long-term real return for stocks has been 6.8%. In no case for those periods of high valuation has the subsequent 10-year real return eclipsed the long-term average for the equity market.
Given the impact that Covid-19 is having on the ability of plan sponsors to increase contributions, a lower return environment will further challenge these plans trying to maintain or improve funded status. What should plan sponsors do? Well, it will be important for them to “buy time” so that they can navigate the next 10-years that might prove challenging. They should look to improve the plan’s liquidity profile by cash flow matching (CDI) the Retired Lives Liability for the next 10-years utilizing their fixed income exposure. This strategy will then allow the alpha assets to grow unencumbered. Importantly, by creating alpha and beta buckets, plan sponsors will no longer be forced to sell alpha assets at inappropriate times for funding purposes.
I hope that you had a wonderful Thanksgiving holiday despite the many impediments that we are facing this year. It is still my favorite holiday, and I might actually be hungry by Friday!
I came across a comment in a ValueWalk.com article that mentioned that pension plan allocations to hedge funds were down in Q3’20. I’m not shocked: just dismayed. What took so long? A quick comparison of hedge fund returns through September 30, 2020, for a variety of time frames reveals consistent underperformance for hedge funds relative to equities (S&P 500), but more shockingly, to bonds as measured by the Bloomberg Barclays Aggregate index. In fact, there is not a single period (1-year, 3-, 5-, 7-, 10- or 20-years) in which the HFRI Hedge Fund Composite tops the BB Aggregate. The 10-year time period reveals that the two indexes actually produced the same result at 3.6% annualized.
Now, I don’t expect HFs to keep pace with equities longer-term, but we’ve gone through a number of difficult markets during the last 20 years, so the fact that HFs (and all of their fees) trailed the S&P 500 by 1.6% per year is troubling. Worse, HFs underperformed the bond market by 0.2% per year for 20-years. A plan sponsor and their consultant(s) may not think that 20 bps per year is much, but bonds haven’t only outperformed HFs, they’ve also been a terrific source of income to meet the promised benefits (and expenses), while being the only asset class that adequately hedges the plan’s liabilities.
As a reminder, defined benefit plans have a relative liability objective (asset growth versus liability growth) that are bond-like in nature and the present value of that liability rises and falls with changes in interest rates (discount rates). An allocation to hedge funds creates a mismatch between the plan’s assets and liabilities. E&Fs and HNW individuals that have an absolute return objective (positive spending each year) should have a greater interest in HFs that also have an absolute return objective. Hedge funds may be much more sexier than bonds, but they certainly aren’t helping the average DB plan given their poor returns and outrageous fees.
Oh, and the extra 20 bps per year that were generated by bonds relative to HFs for 20-years ending 9/30/2020 produces an additional $9.93 million ($100 million starting account) in additional assets that can be used to fund promised benefits. That’s not chump change for most of us.
For years I’ve written about the importance of conducting asset allocation studies based on the plan’s specific liabilities and cash flow needs, as liabilities are like snowflakes in their uniqueness. I recently read an article in P&I that reported the details of an upcoming asset allocation study. The review was to include the “Systems” three plans. It was reported that each of these plans has the same asset allocation targets and the same return on asset (ROA) objective. I wasn’t surprised to read this, but I was disappointed.
As of the end of 2018, this System’s three plans had very different funded ratios: 70.7%, 55.2%, and 82.2%. Given the very different funded status, how is it that they have the same asset allocation? Does that make sense at all? Wouldn’t you think that a plan with an 82.2% funded ratio would have a very different asset allocation from a plan that is only 55.2% funded? Why would you want to subject that plan to a more aggressive asset allocation then is required? Furthermore, if the asset allocation is geared more to the plan that is 82% funded, the one that is 55.2% funded may never see improvement.
As I wrote just the other day, it is neither the asset allocation nor the ROA that dictates how a pension system should be managed. It is the funded status and the cash flows needed to meet the benefit promises that should drive the asset allocation bus. Once those cash flow needs are understood, then the asset allocation and the ROA target can be determined. Regrettably, defined benefit plans are quickly evaporating in the private sector. We must do what we can to preserve public and multiemployer plans. Setting the right ROA and asset allocation targets that are based on the required cash flows will help reduce cost, volatility, and will ultimately stabilize the plan’s funded status. It is pretty elementary my dear Watson.
The pension industry has its own version of the “which came first: the chicken or the egg” riddle. For years, members of our community have debated whether the return on asset (ROA) assumption is set and then asset allocation is determined or the plan’s asset allocation is derived and then the ROA is calculated from that combination of asset class exposures. If you ask actuaries, asset consultants, and plan sponsors this question, you’d likely get 1/3 saying that asset allocation is first determined, another 1/3 saying that the ROA is set first, and another 1/3 that just don’t know. Well, we, at Ryan ALM, believe that none of those are right.
We believe that a DB plan (and E&Fs) must first determine their liability cash flow needs (benefits and expenses or spending requirements) over some prescribed period, which will then inform the plan’s asset allocation from which the ROA will then be determined. How can an asset allocation be determined without a true understanding of the plan’s liability cash flow needs? We’ve witnessed significant market dislocations within the last couple of decades that have challenged plan sponsors from a liquidity standpoint. The Great Financial Crisis (’07-’09) contributed significantly to the use of secondary markets for transactions involving the sale of private equity, private debt, and real estate partnerships when plans needed to raise cash to meet outflows.
Once an understanding of the liability cash flows has been determined, plans can match those needs with a bond portfolio to ensure that the asset cash flows will be on hand when it is required. Bonds are not performance generating instruments, especially in this low interest-rate environment, but they are great for creating cash flow through interest payments, reinvestment of income, and principal at maturity. These “cash flows” can be modeled. The use of a cash flow driven investment approach (CDI) to fund liability cash flows creates a much more efficient asset allocation normally requiring fewer assets allocated to bonds (beta assets), while enabling the remaining alpha assets to grow unencumbered.
The Science community believes that the egg came first when two birds that were almost-but-not-quite chickens mated and laid an egg that hatched into the first chicken likely answering that longstanding argument. We believe that focusing on liability cash flows first puts to bed the pension riddle. We’d be happy to discuss (debate) this subject with you. We are looking forward to hearing from you.
A recent article in PlanSponsor highlighted the fact that Pension Risk Transfers (PRT) have impacted the premium income collected by the Pension Benefit Guaranty Corporation (PBGC). During the 2015-2018 period, 8% of the companies insured by the PBGC transferred some or all of their plan liabilities. The cumulative impact of these actions may produce a fall in premium income received by the PBGC of just under $200 million for 2019’s plan year.
The PBGC is expected to generate roughly $2.23 billion in premium income for 2019, so the $196 million equates to an 8.7% hit. During the 2015-18 time frame, the PBGC saw 44% of large plan sponsors (>1,000) of DB plans engage in some form of a PRT. This activity caused more than 2.4 million American workers (from a pool of 30.9 million in 2014) to no longer be covered by the PBGC, either because they accepted a lump sum distribution or saw their benefit no covered by an annuity product.
Furthermore, in addition to a flat fee per participant ($80 in 2019), the PBGC collects a variable-rate premium (VRP) based on the plan’s underfunding. For the 2019 premium filing year, the VRP rate was $43 per $1,000 of unfunded vested benefits, with a cap of $541 per participant. The PBGC is estimated to have collect nearly $4.8 billion in VRP in 2019. There is no question in my mind that these additional fees are driving plan sponsors to seek alternatives to maintaining their DB pension plans further diminishing the use of these critical important benefits.
According to the PBGC, small plans are three times more likely to participate in a PRT than larger plans. In 2018, 168 plans paying a VRP, covering 117,050 workers, participated in a PRT thus reducing PBGC income by another 1.3%. This isn’t entirely all bad news for the PBGC, as the plans paying the VRP are less well funded and they reduce the participant population and the benefits that PBGC is responsible for insuring.
What may not be bad news for the PBGC, is in fact very bad news for the American worker, who is left with reduced benefits (PBGC cap in 2019 was $67,295 per participant in a single employer plan and $12,870 for a participant in a multi-employer provided plan) or no DB plan for a new worker and reliance on a defined contribution alternative, if they are fortunate to work for a company that offers one. According to a Brookings Institute study (2018) 44% of the American working population (53 million workers) are making on average $10.22/hour or $18,000/year. Do they really have the ability to fund a retirement benefit? This is a travesty!