Future Values Versus Present Values

Actuarial practices use present values (PV) to calculate the funded ratio and funded status. But benefit payments are future values (FV). This suggests that the future value of assets versus the future value of liabilities is the most critical evaluation, but this comparison is rarely seen in the consultants’ reports, if at all. Why? Most asset classes are difficult to ascertain their future value. Do you know what the price of GM’s, or any company’s stock will be three years from now? This is why the PV is used. Only bonds (and insurance annuities) have a known future value and that is why they have historically been used to cash flow match liabilities (i.e. defeasance, dedication, etc.). To prove our point as to the potential misinformation with using a PV calculation, let’s use a simple example below.

Pension

Composition

YTM

PV

FV

A

100% Treasuries

3.00%

$100 million

$150 million

B

100% Corporates

4.00%

$100 million

$180 million

Two pensions both at $100 million market value would have the same funded ratio in PV dollars. But pension B is 100% invested in corporate bonds that out-yield pension A (100% invested in Treasuries) by 100 bps per year. Certainly, plan B has a much greater future value (20% higher) and funded status if we used future values. This suggests that the funded ratio and funded status are not that accurate or even good indicators of the true economic solvency of a pension system.

The point of all this is that we need to focus more on the FV of assets versus liabilities. If we value liabilities at market rates, they would have discount rates of AA corporates (FASB method) or even better U.S. Treasury STRIPS (defeasance method). A corporate bond portfolio matched to liabilities that out-yields liabilities would enhance the funded ratio on a future value basis thereby reducing funding costs (i.e. contribution costs). This is why “cash flow driven investing” (CDI) of liability future values is the most prudent risk and lowest cost methodology to de-risking a pension through asset-liability management (ALM).

Not a Good Combination

I’ve been discussing during my conference presentations the need for American pension systems to take some risk off the table, especially given the fact that we have enjoyed 10+ years of a bull market for US equities. I wish that my crystal ball was better than everyone else’s, but it isn’t! Given that I have no idea when the next bear market will begin, I look for opportunities to reduce risk where and when I can. This bull market has been longer than any previous one and only falls behind the great run of the ’90s when discussing gains. Why let your exposure to equities continue to grow as if this were some game of chance in Las Vegas or Atlantic City?

As a result of this nearly unprecedented move, many pension plans have enjoyed improved funded status. Do we really want to jeopardize those improvements? Can Pension America truly survive another major market decline that causes funded ratios to plummet and contribution expenses escalate to perhaps unsustainable levels? I don’t think so, at least not based on the number of plans that were forced to take corrective action following the last two such cycles.

Today’s market action, supposedly related to the Coronavirus and its potential impact on global growth, may prove to be nothing more than a blip on the radar, but it may not. Who knows? But, I do know that the combination of falling stock prices combined with falling interest rates negatively impacts a plan’s funded status and ultimately its level of contributions. Are we going to wait until well after the fact to de-risk or do we take a more proactive (dynamic) approach to asset allocation and pension management that has us managing near-term pension liabilities so that the remaining growth assets now have the luxury of time to work through any potential corrections in this equity bull market run?

I once asked an audience at an IFEBP conference if they recall what they were thinking in the Fall of 2006 and the Spring of 2007 regarding their plan’s asset allocation and risk profile. Were they concerned about the next leg in the market cycle? If so, did they do anything about it?  Well, we may be approaching the next cycle in this market environment.  What are you thinking about right now? I would encourage you not to become complacent. Call us, as we have a roadmap that would be specific to your plan’s liabilities and risk profile.

 

Have We Outsmarted Ourselves?

I entered the retirement industry in 1981 when asset consulting was still in its infancy. At that time many defined benefit plans were managed by a single balanced investment program (60% equity and 40% fixed income), and often it was a bank trust department that was responsible for the program’s implementation. They had recently taken responsibility for pension assets from fixed income managers who defeased the pension liabilities in a similar fashion to how lottery systems were managed then as they are today. That low-risk approach was deemed to be too expensive.

Unfortunately, plan sponsors were coerced into believing that asset consultants possessed a better mousetrap and through this enhanced asset allocation framework asset performance would be superior and contribution expense would be lower. So specialist managers were added and then real estate when stock and bond managers didn’t produce enough return to meet the ROA objective. As U.S. interest rates fell and U.S. equities outperformed, more plans shifted assets further away from the only assets (bonds) in the portfolio that were highly correlated to plan liabilities thus creating a huge mismatch.

Things got much more interesting when interest rates continued to fall and equities got smacked around twice by significant bear markets. In an attempt to enhance returns and lower volatility, significant exposure was given to alternative investments including private equity and debt, timber, agriculture, commodities, infrastructure, and worse, hedge funds! When this combination of products became too much for many plan sponsors to handle from an education and monitoring standpoint, the OCIO model was introduced.  Unfortunately, funded status has plummeted for many plans, while contribution expenses have risen rapidly.

One must now ask are we better off today than we were in 1981?  It seems as if going back to a single manager – the OCIO – hasn’t necessarily improved performance, but it certainly has created a far more complicated structure. It is amazing to see how exposure to U.S. equities has fallen for all plan types to about 26% (P&I) for Union and Public plans, while corporates are at about 16.5%.  Most pension plans would have benefitted last year from a good old fashion 60% equity/40% fixed income portfolio, as it would have generated a roughly 22.4% return slightly topping plan liabilities that came in at 22.2% (FAS 715 rates). Unfortunately, the more complicated asset allocation with very little exposure to US equities generated a roughly 15.7% return that underperformed liabilities by 6.5% and a traditional 60%/40% mix by nearly 7%. OUCH! Public and multiemployer plans faired better as the slightly greater exposure to US large-cap equities helped plans to a roughly 17.9% and 17.6% returns, respectively.

We’ve been running around the country speaking about bringing the basics back to pension plan management with a greater focus on liabilities.  It seems that a return to basics on the asset side of the equation may be warranted, too. How about building a simple portfolio that has the first 10-years of Retired Lives liabilities defeased, which might take between 20%-40% of the assets depending on the funded status, while the remainder of the assets is invested in traditional equities.  I would favor small-cap value for periods greater than 10 years, but that is just me.

Ya Gotta Love New Jersey

I have lived in New Jersey my entire life. I can only blame my parents for the first 18 years of my existence in this state. Beyond that is no one’s fault but my own.  I mention this because NJ ranks LAST among all 50 states for their current fiscal condition. People and businesses are migrating to other parts of this country to get away from this fiscal mess, but here I remain. Please help me!!

When I have opportunities to speak at conferences around the U.S. I often mention my fate, but there are many others living in states that have similar situations to NJ, such as Illinois, California, Connecticut, etc., so I really don’t get much sympathy. Why mention this today? Well, back in 2018, state Senate President Steve Sweeney put together a commission to explore solutions to NJ’s fiscal woes. The commission put together legislation that went before the Senate last May calling for a hybrid pension solution, but nothing happened as the bill sat in the senate (sounds eerily familiar to what transpired with the Butch Lewis Act and the U.S. Senate). Shocking!

In addition to the legislation to create a hybrid plan, there was a bill introduced that would have created a New Jersey economic and fiscal policy review commission to “provide ongoing review of state and local tax structure, economic conditions, and related fiscal issues,” including employee retirement matters, according to a bill summary. But alas, Governor Murphy vetoed the proposed legislation without explanation.  Is this another example of don’t ask, don’t tell?

Not only does NJ have ridiculously high property taxes, but the state income and sales taxes create a melange of real pain for residents. Couple this burden with the gaping financial hole within the NJ pension system (estimated at about $80 billion) and you have a formula for disaster. I give Sweeney and his commission credit for trying to do something before it is too late.  As anyone knows who reads these blogs, I am a huge fan of DB plans, but NJ’s may not be salvageable. In that case, exploring a hybrid solution is certainly more appropriate than thrusting NJ’s public employees into a defined contribution vehicle.

When are we going to get real leadership willing to put aside political differences to tackle real problems facing our residents? Everyone can’t live in Florida and Texas, but it sure seems like the thing to do these days! I’ve always teased my family about wanting to live on a ranch in Montana. That is getting to be more attractive every day!

We Can’t Do The Same Old, Same Old

I frequently write about the state of multiemployer plans in the U.S. There is a “grading” system that makes it easy to identify more successful plans (Green) from those that are in trouble, which are defined in not so favorable terms as Critical and Declining. Regrettably, we don’t have a similar warning system for our public funds, although many of us know that states such as Connecticut, Illinois, and my home state, New Jersey, would certainly not receive a grade of green, but likely one that has them more appropriately designated as being on life support.

Pension plans used to be managed like a lottery system where future promises (liabilities) were known and a present value calculation was used to determine the assets needed to defease that promise. Those assets were then basically set aside until the promised payout was due. Regrettably, we’ve gotten away from that course of action and decided that generating the highest return was the more effective approach to ensuring that future promises were funded and paid. Unfortunately, what has happened is that the funded status for these systems has deteriorated, returns have fallen short, plans have had to reduce benefits, add tiers, and contribute significantly more to these pension plans.

Many of the states have resorted to significantly increasing taxes to meet their pension promises. How has that worked? Well, according to data from the US Census Bureau, millions of Americans have fled high-tax states, such as Connecticut, Illinois, New Jersey, and New York to find more economically palatable locations, such as Texas, whose population growth was greater during the last decade than all of Connecticut. In fact, four of the six highest-tax states in 2010 were among the nine with population growth below 1 percent for the decade in which the US’s population grew by 6%. None of the 10 states with population growth over 11% for the last 10 years were among the 20 highest-tax states early in the decade and it shouldn’t be surprising to read that four were among the seven with no personal income or investment taxes.

So if public pension systems think that they can continue to ramp up taxes on their residents without consequence they will be sadly mistaken. Those days are over. Pension systems need to reduce the volatility of the plan’s asset allocation and the variability in both funded status and contribution expense. Doing the same old, same old has proven to be an unsuccessful approach.  It is time to go back to the future! We can help!

Appalling!

I first mentioned Carol’s plight in August 2018 when her story was brought to my attention. As you may recall, Carol was a retired Teamster who had been promised a benefit for life upon taking early retirement. Regrettably, her union plan (Local 805) filed for benefit relief under MPRA and was granted that relief effective January 1, 2019. The impact on her financially has been harsh. The psychological impact may be more damaging.

Ron Ryan and I continue to run around the country bringing Carol’s and other’s stories to one conference after another (IFEBP, Opal, MIA, etc.) in an attempt to put a face on the pension crisis that is unfolding in our country. We find it shameful, and totally unacceptable, that we have legislation that permits the rug to be pulled out from under the feet of these retirees who worked hard every day believing that their hard work would be rewarded with a pension in retirement. But, through no fault of their own, that promise has not been kept.

I’m also guilty of not providing more frequent updates as to the impact that these decisions are having on the lives of people like Carol. For instance, the following was shared on Facebook several months ago.

“Hi everyone,
I haven’t been too active on the site lately…mainly because I started shutting down when the reality of a FOR SALE sign was stuck in my front lawn. I do my best thinking in the middle of the night, so last night I wrote down what I was feeling. I sent it to Russ Kamp and Karen Ferguson of Pension rights. I don’t know if I should send it anywhere else. I am pasting it in this message for some advice. Thanks, Carol
Carol Podesta-Smallen
Thu 8/22/2019 1:38 AM
  • russellkamp@gmail.com;
  • R Kamp;
  • Karen Ferguson
I am 8 months into my $1,578.00 monthly pension cut and I’ve completely depleted my savings. My house has been on the market for 1 month, I have been looking for an apartment to rent because, as my brother pointed out, no one will give me a mortgage because I don’t make enough money. But now it seems I am going to have a problem even renting because once they do a check on my income and see how little I make per month, there will be fear that I won’t be able to pay my monthly rent! I have tried to find out where I stand in the Section 8 line, and was told that the information I seek is not available to me…once again I ask, where do I go from here? I really prayed that this would be resolved by now, but it’s not, and that word SHELTER keeps popping into my head. All I did by draining my savings account was to put off the inevitable. I think I faked myself into thinking all was well by keeping up with the payments, and now that there is nothing left, all the fear came rushing back. A mental breakdown is not out of the question, as I think malfunction is the only way an overloaded brain can stop.

Time and again I’ve been told that I’m not alone… why then, do I feel so alone?…just like a needle in a haystack.

Sincerely,

Carol Podesta-Smallen
Local 805

We cannot allow these cuts to continue. Legislation needs to be enacted immediately before this punishment is levied onto others who are in plans that are designated as Critical and Declining. As you know, H.R. 397 (the Butch Lewis Act) was passed in July 2019. It has sat in the Senate since. Every month that goes by jeopardizes the financial future for nearly 1.4 million pension participants that reside in pension systems that are teetering on the brink of failure. It isn’t fair and it isn’t right! Each month of delay increases the likelihood of more failures while increasing the cost of corrective action by roughly $750 million per month (Cheiron). How is this acceptable to anyone?

There Are More Than Two Ways!

I am at the Made In America conference in Las Vegas.  I enjoy this particular event because the crowds tend to be smaller providing the participants with more of an opportunity to interact. This particular gathering has a really good mix of agenda items and presentations, but I was reminded once again how our industry continues to focus exclusively on the asset side of the pension equation. Hopefully, my session, “Managing Through A Liability Lens”, will wake them up to the fact that pension plan liabilities exist and that assets need to be managed against them.

Day one had us hear once again that there are only two ways to improve funding: 1) contribute more, and 2) earn more on the investments. Yes, those are two ways, but not the only way to see funded status improved. Unfortunately, as I stated above, pension liabilities are like Mr. Cellophane of the pension world, especially when plans elect to use the same discount rate for both assets and liabilities (ROA). In an environment that values liability growth at 7.5% each and every year, it is no wonder that most plan sponsors and consultants forget that liabilities are bond-like in nature and that they don’t grow at the same rate as pension assets.

Because liabilities are bond-like, they move up and down in value with changes in interest rates. Regrettably (for pension systems), we’ve basically been on a slippery slope of declining US rates for much of the last 4 decades. As a result, plan liabilities have dramatically outperformed plan assets during this period and particularly in the last 20 years. I would guess that most sponsors think that 2019 was an incredible year for pension funding as assets enjoyed a magnificent 12-months, but they would be mistaken as the significant decline in US long-term rates boosted liability growth to as much as 25.6% when pricing liabilities using PPA spot rates and 22.2% when using ASC 715 rates (AA Corporate).

Unfortunately, this phenomenon has had the biggest impact on public pension systems that have habitually maintained higher return on assets assumptions which acts to keep contributions lower than they should have been.  Pension America’s precarious position would not be so severe if WE, as an industry, had collectively focused more attention on the promises that were made to our employees. I’ll update you tomorrow on whether any rotten fruit was thrown in my direction during my discussion.