Cash Flow Matching =/= The UK Pensions Crisis

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I just returned from attending the IFEBP Annual Conference in Las Vegas, NV. First, it was great to have the IFEBP attendance back to pre-Covid-19 levels. There had to be more than 5,000 attendees. Congrats to the IFEBP for continuing to provide quality education to both the multiemployer and public pension trustees, administrators, and a host of other essential personnel.

I am always thankful for the opportunity to speak/teach at these events. During one of my sessions titled “Public Plan Investment Return Assumptions”, I was asked a question related to the UK and Cash Flow Matching and if the former was caused by the latter. Simply, the answer is NO. I did share that Cash Flow Matching (CFM) is but one arrow in the LDI quiver, but that it was a strategy known as duration matching and specifically duration matching using derivatives and leverage that nearly brought the UK’s pension industry to its collective knees.

As we’ve previously reported, leverage among UK pension plans was in far greater use than what we witnessed in the US. It was highlighted in numerous articles that plans were leveraged up to 7X. Duration strategies are primarily used within private corporate pension plans and levered exposure is used much more in the UK. As a reminder, duration strategies are trying to minimize (neutralize) interest rate movements between a plan’s assets and the plan’s liabilities. In duration-matching strategies, longer-dated bonds (primarily Treasury STRIPS) are used to accomplish this objective since the longest duration coupon bond is around 16 years. Key rate durations may also be used as a string or ladder of duration targets.

With regard to cash flow matching, corporate bond cash flows of principal and interest are optimized to match the plan’s liability cash flows chronologically. This strategy dramatically improves a pension plan’s liquidity to meet those monthly payments without having to force liquidity in asset classes that might not possess the necessary liquidity at that time. Furthermore, with cash flow matching a plan gets duration matching. With duration matching, you are not getting the necessary liquidity to meet benefits and expenses. In addition to the enhanced liquidity, a pension plan is mitigating interest rate risk for that portion of the portfolio using CFM, as future value benefits are not interest rate sensitive. There are other benefits from CFM, including the “buying of time” for the remaining assets (growth) that can now grow unencumbered.

The question of CFM’s role in the UK pension debacle was a good one. I was extremely pleased to be able to answer that there was no role for CFM. I’m also pleased to mention that rising US interest rates are creating an incredibly positive environment for CFM in which we at Ryan ALM are constructing portfolios that produce yields right around 6%. For more information on CFM, duration, and their differences please visit Ryan or call us at 201/675-8797.

Where’s the Hedge and the Yacht?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I believe that we have overcomplicated the management of DB pension plans. If the primary objective is to fund the promised benefits in a cost-efficient manner and with prudent risk, why do we continue to waste so much energy buying complicated products and strategies that often come with ridiculously high fees and little alpha?

Case in point, the HFRI Composite index reveals a -6.7% year-to-date (9/30/22) return. Worse, the 10- and 20-year compounded returns are 4.6% and 5.7%, respectively. We know that we didn’t get those “robust” returns at either an efficient cost or with prudent risk. What are these products hedging other than returns? Why do we continue to invest in this collection of overpriced and underperforming products? Are they sexy? Does that make them more appealing? Do we think that we are getting a magic elixir that will solve all of our funding issues?

Sadly, the story is even worse when you take a gander at the returns associated with the HFRI Hedge Fund of Funds Composite Index. I shouldn’t have been surprised by the weaker performance given the extra layer of fees. According to HFRI, YTD returns show a -7.2% return, while 10- and 20-year annualized returns fall to 3.4% and 3.5%, respectively. UGH! For those two time frames, the S&P 500 produced returns of 11.7% and 9.8% respectively, and for a few basis points in fees.

While pension systems struggle under growing contribution expenses and plan participants worry about the viability of the pension promise, the hedge fund gurus get to buy sports franchises because of the outrageous fees that are charged and the incredible sums of assets that have been thrown at them? I suspect that the standard fee is no longer 2% plus 20%, but the fees probably haven’t fallen too far from those levels. As Fred Schwed asked with his famous publication in 1952 titled, “Where are the Customers’ Yachts?”, I haven’t been able to find them. Unfortunately, I think that the picture below is more representative of what plan sponsors and the participants have gotten for their investment.

Participant’s yacht

Don’t you think that it is time to get back to pension basics? Let’s focus on funding the promised benefits through an enhanced liquidity strategy (cash flow matching) while allowing the remainder of the portfolio’s assets to enjoy the benefit of time to grow unencumbered. This bifurcated approach is superior to placing all of your eggs (assets) into a ROA bucket and hoping that the combination will create a return commensurate with what is needed to meet those current Retired Lives Benefit promises and all future benefits and expenses.

Worried About Retirement? You’re Not Alone!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Anyone of us can quote statistics from various surveys highlighting the fact that retirement is getting out of reach for many Americans. The Mind over Money survey by Capital One and The Decision Lab is the most recent one that I read. Their findings are pretty dire with 77% of Americans feeling anxious about their finances, with 68% worried about saving enough for retirement. I can’t say that I blame them! In an environment of spiraling inflation and deteriorating market performance for traditional asset classes, why would we think that individuals would be feeling anything other than uneasy?

Despite the fact that the US labor market continues to show incredible strength, decades of low real earnings growth have crushed the average American worker. We are witnessing some nominal growth in earnings at this point, but real wage growth continues to evade us by about 3%. If Americans aren’t saving in this environment, where is their income being spent? Look no further than housing costs. As the chart below reflects, being able to buy or finance a home has gotten incredibly challenging if not nearly impossible!

The Mortgage-to-income level has more than doubled since roughly 2013 and it is twice what it was at the Pandemic low. Furthermore, this study used a 20% down payment in the calculations. How realistic is a down payment of this magnitude for young couples who in many cases are still (and will be for the foreseeable future) burdened with student loan debt? According to the National Association of Realtors (NAR), the average down payment in 2022 is 13%. For those aged 23-41, the down payment drops to between 8-10%. Given that we are looking at a down payment that is roughly half of what was used in this analysis, we can quickly determine that the financial burden to buy a home is far worse than what is being reported at 42% of one’s median disposable income.

Asking untrained individuals to fund, manage, and then disburse a retirement benefit through a defined contribution plan is poor policy. Expecting those same individuals to have any “discretionary” income after paying for housing, education, food, energy, and healthcare is unrealistic! We have a broken retirement industry. Let’s hope that rising US interest rates will encourage corporate plan sponsors to once again provide a true retirement benefit to their financially anxious and struggling employees.

Ryan ALM Newsletter for 3Q’22

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

We are happy to share with you the Ryan ALM, Inc. Newsletter for 3Q’22. The newsletter highlights the challenges faced by the plan sponsor community in 2022, while also pointing out the inconsistencies among the accounting rules for both GASB and FASB. Given these significant differences, Corporate plan sponsors are feeling much better than those pension sponsors for public and multiemployer plans, as the present value of future benefit payments falls to a greater extent than pension assets. These differences will likely impact asset allocation decisions and contributions.

As always, we welcome your feedback on the newsletter and look forward to responding to any questions that you might have regarding our current environment. We’d be happy to share with you our ideas on how best to structure an asset allocation framework.

ARPA Update as of October 14, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I hope that you had a great week since our last update. It certainly seems as if the PBGC did, as there is nothing to report regarding activity for the week ending 10/14. NOTHING! There were no new, revised, or supplemental applications filed. There were no payments made on the two approved applications. Fortunately, there were no applications that were denied. There was no activity. Let’s chalk it up to the baseball playoffs, where there certainly has been quite a bit of excitement, especially for the underdogs!

Many of these pension plans fell prey to government regulation. They too have become underdogs! The ARPA legislation is finally helping to reverse some of the onerous impacts of decades of failed policy. Let’s hope that these underdogs can secure the promises that were made to their plan participants. They and their families are counting on it!

Ryan ALM Pension Monitor for 3Q’22

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

What a year! Inflation is rising, interest rates are rising, and asset prices are falling. What does this mean for Pension liabilities and pension funding? Well, it is very much dependent on the accounting rules that your plan follows – GASB or FASB.

We are pleased to share with you the Ryan ALM Pension Monitor for 3Q’22. As you will read if you are a corporate plan sponsor you aren’t nearly as upset with the asset price declines given that liability growth has plummeted (-25.9%) versus an asset deterioration of “only” -12%. As a result, corporate America is actually witnessing improved funded ratios so far in 2022.

On the other hand, sponsors of public and multiemployer pension plans are tremendously upset given the accounting rules under GASB which have the liabilities being priced at the return on asset (ROA) assumption (+5.6% YTD assuming a 7.3% ROA). In these examples, the average public pension plan’s asset growth is trailing liability growth by -17.5% while multiemployer plans have a meaningful shortfall of -18.5% YTD. Funded status and funded ratios are plummeting.

We won’t get into the fact that plans outside of the US operate under the IASB standards calling for even more conservative pricing of pension liabilities similar to FASB (market yields for high-quality bonds). Confused yet? Why we have two different accounting methodologies for discount rates on US pension plans doesn’t make any sense to me. In a year such as 2022, the significant differences impacting funded status will drive very different decisions. In the case of Corporate plans, improved funding will reduce contribution costs and should encourage greater derisking. With regard to public pension and multiemployer plans, the deterioration in funded status may lead to plans getting more aggressive. Which action is correct? Ryan ALM’s highly experienced team of LDI/CFM experts will gladly assist you in thinking through these issues. We welcome the opportunity!

What Surprises Will October 14th Bring?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

It has been quite a ride for UK pension “schemes” (I never liked the use of this word to describe pension funds) during the last couple of weeks. Significant damage to the funded status of UK pension plans has been inflicted through the use of levered LDI duration strategies implemented through derivatives and SWAPs, which in some cases used leverage at 7X. Come to think of it, perhaps the word scheme is more appropriate than I imagined.

We first addressed the subject on September 29th, when I posted, “LDI – aka Leverage Did It“! At the time we knew that UK pensions were rapidly unwinding Gilt positions in order to meet margin calls associated with said derivatives and SWAPs. Why? Well, it seemed that these financial instruments worked well in steady or falling rate environments but significantly less well as rates rose. Regrettably, UK rates were rising rapidly. The result of the forced sales in order to meet those pesky margin calls resulted in an almost infinite loop of more selling and more selling and…!

If it weren’t for the Bank of England (BoE) stepping into the fray and buying UK long-dated bonds (Gilts) despite previously being engaged in monetary tightening there is a very good chance that pension plans, plan participants, and financial institutions might have been permanently harmed. The BoE’s effort worked for a short period of time but rates have resumed rising and margin calls are ongoing. Worse, the BoE has indicated that all support will cease on 10/14 and that plan sponsors better get their acts together in raising cash to meet future margin calls. Some industry observers have indicated that as much as $350 billion Pounds may need to be raised to meet current margin calls. What happens if there is NO natural buyer for the Gilts and other pension assets (equities, real estate, etc.) that are being sold in order to raise the necessary liquidity?

I suspect that UK interest rates will continue to rise in order to entice potential buyers to replace the BoE and step into the void. Where rates eventually go and what it will mean for pension funds (schemes) and their margin calls is anyone’s guess. As far as the financial institutions that sit on the other side of these transactions, it is being reported that they are demanding great cash reserves as buffers. According to a recent Reuters article, “Pension funds were previously putting up cash to withstand a move in government bond yields of 100 to 150 basis points — normally a huge safety net, but which has been wiped out by some of the most volatile days on record.” Unfortunately, those collateral demands have increased to 300 bps of protection last week and in some cases as much as 500 bps of protection today.

If liquidity can’t be raised, plans will likely have to begin to reduce the LDI protection that they sought. Should rates eventually fall, the $ growth in pension assets will not keep pace with the $ growth in pension liabilities, and the significant improvement that had been witnessed in the UK regarding pension funding will have been undone. Shameful!

ARPA Update for October 7, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I have to admit that I almost forgot to provide an update on the ARPA activity. One quasi-day off and I’m thrown for a loop! Despite my failure to provide an update yesterday, there is some activity to discuss. Three pension plans filed applications last week, including U.T.W.A. – N.J. Union – Employer Pension Plan, the Milk Industry Office Employees Pension Trust Fund, and Local 584 Pension Trust Fund. These three mid-Atlantic funds filed either a supplemental or revised application (U.T.W.A.).

In the case of U.T.W.A, this Priority Group 2 applicant filed a revised application seeking just over $8 million in SFA to cover the promised benefits for the 449 pan participants. In the cases of the other two plans, supplemental applications were filed with no $ amount targeted, but they were looking to take advantage of the PBGC’s revised Final Final Rules in seeking additional financial assistance for 2,250 combined participants.

We are further pleased to report that two Priority Group 2 plans, Freight Drivers and Helpers Local Union No. 557 Pension Plan and the Sheet Metal Workers Local Pension Plan, had their applications approved during the last week. The Local 557 application was a revised submission and they will receive more than $192 million to help support the promised benefits for the fund’s 2,273 participants, while the Sheet Metal Workers anticipate collecting $28.8 million for its 1,649 members from its initial filing.

We still have no update from the PBGC regarding my concerns about fixed income investments being return-seeking unless used to specifically defease pension liabilities. Regrettably, but not surprisingly, both US bond and equity markets continue to operate under great stress caused by the US Federal Reserve’s action to fight inflation through a rising Federal Fund Rate, which reveals no stop in momentum at this time. The impact on SFA proceeds received and invested could be truly damaging.

Rates Aren’t high Yet, But They Might Get There!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

As I suspect that you do, I continue to read comments from pundits and industry “experts” claiming that the US is going to be driven into a recession through the Fed’s action of raising rates as dramatically as they have in an attempt to thwart inflation. Investors rightfully continue to focus on the war in Ukraine, inflation, Covid-19’s disruptions, and US interest rates, which some are calling high. First, I don’t think that we are close to seeing a top in rates, and most members of the Fed’s governing board would agree. Furthermore, I would definitely not refer to current US interest rates as high.

The current investment community’s perception has been tainted by four decades of falling rates and low inflation. Just how much economic activity will be reduced by US interest rates that remain well below historic averages? As of trading this morning, the US 3-year Treasury Note has the highest yield at 4.33% (8:56 am) among key rates along the Treasury yield curve. Sure, we haven’t had a 4% yield on this note since 2007, but this level is not high by any stretch of the imagination. As the chart below depicts, rates have been substantially greater, and they occurred during periods of exceptional economic and stock market performance.

We’ve experienced much higher US interest rates

The chart above highlights the yield on the 3-year Treasury note during the go-go ’90s. The average yield during that decade was 5.98%, a 1.6% premium to today’s yield. The ’90s was also one of the greatest periods ever experienced by the S&P 500 producing a >18% annual return. GDP growth averaged 3.3% during the same time frame. Clearly, a nearly 6% 3-year Treasury Note did little to tamp down US economic growth during the ’90s. Do we really believe that the Fed has gotten to a level of rates that would dramatically impact US growth, inflation, employment, etc.?

US pension plan sponsors have been on average more responsible than their peers in the UK with regard to the use of leverage. But it doesn’t mean that pension systems here aren’t getting walloped, as domestic equities, US bonds, real estate, and other asset classes dramatically underperform annual objectives. We begged you to take some risk off the table last year following the great market performance. You still have the opportunity to take advantage of the recent rise in rates by transitioning your current fixed income exposure from a return-seeking mandate to a cash flow matching strategy that funds benefits and expenses while the remainder of the fund’s assets buy time to recoup current shortfalls.

Markets may have rallied following the 2000-2002 and 2007-2009 market corrections, but contribution costs skyrocketed and they haven’t fallen back to Earth. A market correction greater than the one that we’ve experienced so far in 2022 could permanently impair pension America’s ability to salvage these incredibly important programs. Let’s NOT let that happen!

There is NO Pivot on the Horizon!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Another day of jobs data and another sell-off in the market by participants hoping for some sign that the US Federal Reserve will be forced to pivot away from its crusade to thwart decades-high inflation. Guess what? It isn’t going to happen – sorry. Once again, we’ve had an employment report that came in at roughly forecasted expectations (263k vs. 275k). In the process, the unemployment rate fell from 3.7% to 3.5%. Earlier this week I produced a post titled, “What Has the Fed Accomplished?”, in which I questioned what had changed from last week, month, quarter, or year-to-date, that would have had equity and bond markets rallying significantly to begin this week.

We continue to see a historically strong employment picture in which wages are growing, albeit by a lesser amount than inflation. Furthermore, there is still “excess” savings (estimated at $1.2 trillion) as a result of the incredible stimulus provided during the peak of the Covid-19 pandemic. Many US consumers are flush despite the inflationary impact. We will continue to witness strong demand until the employment picture is significantly altered. That clearly hasn’t happened yet. Yes, initial jobless claims were higher than last week and job openings fell relative to previous releases, but in neither case were they substantial enough to change the minds of Fed governors, who continue to sing from the same hymnal.

If 4.625% is the target for the Fed Fund’s Rate at some point in 2023, there is a lot more pain to be realized in traditional fixed income and equity allocations. Sitting back and letting this scenario unfold is not prudent. Yes, we’ve seen markets come back from the depths before, but in every case during the last four decades, we had an accommodative Fed to help prop up risk assets. They aren’t in a position to do that this time. Convert your current fixed income exposure from a return-seeking mandate to a cash flow matching strategy that will fund promised benefits, improve liquidity, and mitigate interest rate risk for that portion of the account, while buying time for equities and other alpha-generating assets to grow unencumbered. Plan sponsors and their advisors can continue to hope that the Fed was only kidding, or they can act to limit the damage already inflicted in 2022 before it gets much worse as we move into 2023.