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!

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!

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.

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.

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!

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.

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

Despite the recent equity and bond market rally, we believe that the Fed still has its work cut out for them. We published a post last week titled, The Fed’s Headwind? in which I wrote about strong employment and rising sentiment combining to create a substantial headwind for the Fed in trying to combat excessive inflation. Here is a wonderful chart that further supports our contention that demand for goods and services will not be thwarted at this level of interest rates given that the American consumer is still flush.

Nearly $1.3 trillion in excess savings are available to consumers. The Covid windfall peaked at nearly $2.1 trillion in July 2021. Consumption since then has eaten into this windfall but much is left to allocate to further economic activity. Given these surplus savings, strong employment, and rising wages, albeit less than inflation, the Fed will likely have to continue to aggressively elevate interest rates. A late-day rally has US equities rising once more, but bonds are off quite a bit today as yields once again rise. The ADP National Employment Report came in at 208,000 today when forecasters were looking for 200,000. We truly haven’t seen a chink in the employment armor at this time. Perhaps Friday’s US Employment Report will begin to show some weakness. I wouldn’t be surprised if it doesn’t.

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

I published a post on August 31, 2022, titled, “Let’s Get Realistic“. I provided a bit of a rant regarding the reporting for DC plan participants looking at an account balance of $1,000,000. I indicated that I thought any analysis done with this balance was unrealistic given that the median account balance for 55-64-year-olds according to Vanguard’s annual report was only a little more than $89,000. When applying the “4%” rule, a target percentage for withdrawals that would “ensure” that the participant didn’t exhaust their account balance in retirement, the annual amount to safely withdraw was a whopping $3,560/year. Oh, my.

Well, the news that I’m about to share doesn’t make this scenario any brighter. First, Vanguard has published additional information suggesting that <15% of their 401(k)/IRA participants have an account balance that is >$250,000. At $250,000 the 4% rule would produce an annual distribution of $10,000. That sum isn’t going to provide anyone with a dignified retirement. To make matters worse, recent research produced by Richard Sias and Scott Cederburg, finance professors at the University of Arizona; Michael O’Doherty, a finance professor at the University of Missouri, and Aizhan Anarkulova, a Ph.D. candidate at the University of Arizona, suggests that the 4% rule is really a 1.9% rule! The study is entitled “The Safe Withdrawal Rate: Evidence from a Broad Sample of Developed Markets.”

The implications are extraordinary. Regrettably, they too referenced an account holder with $1,000,000 in retirement assets. Why? Is this chosen threshold to make all of us in the industry feel as if we’ve really helped most people secure a dignified retirement? Let’s play the game. A holder of $1m would see their annual distribution fall from $40,000/year to a meager $19,000. But a more realistic application of the updated 1.9% rule would suggest that the median 55-64-year-old would now get to safely withdraw $1,691/year. Some retirement that will fund!

DC plans have been around for a long time, and many members of the private sector have only had exposure to DC offerings throughout their careers. We can’t use a lack of time in a plan as an excuse anymore. DC plans were intended to be supplemental to DB plans. They aren’t anymore. They are it! This social experiment is failing and those that we are supposed to be serving will suffer the consequences. I don’t know if the right answer for a plan participant is 4%, 1.9%, 6%, etc. I do know that DB plans provide a superior experience for the masses. The failure to maintain DB plans will produce profoundly negative outcomes. I’m not proud of our industry that this is the best we can do! Are you?

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

The US equity and bond markets rallied significantly yesterday. Why? What changed from last Friday, last week, last month, last quarter, or year-to-date? The US continues to live with excessive inflation and the US Federal Reserve continues to say that it is committed to raising the Fed Funds Rate until they have accomplished its objective of driving inflation down and creating price stability. They are motivated by not wanting to risk a repeat of the Fed’s two-step in the 1970s!

Inflation will not be contained until demand for goods and services is weakened. Have they impaired the consumer at this point? No, if one looks at the following graph from the Daily Shot.

The US consumer continues to be employed and they are spending what they’ve earned. It certainly doesn’t seem like anything has changed since last week other than the calendar flipped, and we are now in October bringing with it the first day of trading in 2022’s fourth quarter. Federal Reserve Vice Chair Lael Brainard said the “US central bank will need to keep interest rates high for some time to bring inflation down”, even as she acknowledged the need to watch global financial-stability risks from rising borrowing costs.

The global financial markets have benefitted tremendously from the incredible tailwind of accommodative Fed policy for nearly four decades. Have we forgotten that there are risks associated with “investing”? Believing that interest rates and inflation were always going to be low was a critical mistake. We are now paying the piper.

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

Members of the PBGC have their work cut out for them, as last week was particularly robust in terms of new applications for Special Financial Assistance (SFA) under ARPA. There were nine applications submitted last week, with six of those being initial applications (all Priority Group 1 or 2 members), two were supplemental applications, and the ninth was a revised supplemental submission.

The plans filing applications included the United Furniture Workers Pension Fund A, Plasterers Local 82 Pension Fund, Bakery Drivers Local 550 and Industry Pension Fund, Retirement Benefit Plan of GCIU Detroit Newspaper Union 13N with Detroit Area Newspaper Publishers, Ironworkers Local Union No. 16 Pension Plan, Graphic Communications Union Local 2-C Retirement Benefit Plan, Plasterers and Cement Masons Local No. 94 Pension Fund, Alaska Ironworkers Pension Plan, and the Local Union No. 466 Painters, Decorators and Paperhangers Pension Plan. The supplemental filings are in italics, while the plan submitting a revised supplemental application is highlighted in bold. The total amount of SFA sought is $518 million. The PBGC has 120 days to act on these submissions.

There was only one plan, Local Union No. 466 Painters, Decorators and Paperhangers Pension Plan, that withdrew an application (9/28), but they quickly resubmitted a revised application on 9/30/22. There were no applications approved or denied during the last week. With regard to plans being denied SFA under ARPA, there haven’t been any to date since applications were first filed in July 2021.

I remain concerned that there is a misunderstanding regarding the term return-seeking assets (RSA) for investments within the SFA bucket. As I’ve stated before, investments in investment grade (IG) bonds are return-seeking if they are not used to cash flow match (defease) the pension plans Retired Lives Liability chronologically from the first month’s payment as far out as the allocation lasts. Given the uncertainty in the bond markets because of high inflation, rising rates, and the Fed’s commitment to higher for longer, this misunderstanding could be quite costly. I’ve reached out once again to the PBGC encouraging them to provide clarification. 

We are supportive of the PBGC’s desire to minimize exposure to RSA (33% of the SFA), but given its current interpretation of IG bonds, we remain quite concerned. Generic bond indexes are producing significant negative year-to-date returns. The SFA bucket is a sinking fund and the sequencing of returns is critical to the success of this program. Witness steep drawdowns in the initial years and the SFA could be substantially and negatively impacted. As a reminder, the goal of the legislation is to FUND the promised benefits as far out into the future as possible. Putting all of the SFA into risky strategies does nothing to secure those promises. I’ll keep you informed as to whether or not I hear back from the PBGC.

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

The Bank of England certainly got a bunch of investors excited yesterday. They announced their intent of significant buying of long-dated Gilts which had nothing to do with a change in monetary policy, but everything to do with the very real systematic failure of LDI strategies supporting UK defined benefit pension systems. Had the UK central bank realized that monetary conditions had gotten too tight despite strong employment and decades of high inflation? Could the US Federal Reserve come to its senses and follow suit? It certainly seemed as if the collective investing community jumped to that conclusion. How silly. As I stated yesterday, what happens in the UK stays in the UK. 

As you may know, a significant percentage of the UK’s corporate pension system has engaged in “duration matching” strategies through derivatives and SWAPs. These instruments were often supported by leverage. According to an FT report, the use of leverage was as much as 7X. Incredible, but fiduciarily imprudent. Sure, these strategies had been working and pension funding had dramatically improved, but they’d only been operational during periods of falling interest rates. As we’ve said before, four decades of easy monetary policy that drove interest rates to historically low levels created a sense of false security. Once rates began to rise, and dramatically so, all bets were off. Amazing how quickly these derivative strategies called for additional collateral due to the rapid increase in interest rates this year.

Without the Bank of England stepping in and buying Gilts, the unwinding of these hedged strategies would have been magnified, as more Gilts would have been liquidated to meet prospective margin calls. The problem: UK pensions had adopted these leveraged positions so that they could have more of the assets dedicated to alpha-generating products such as private equity. As a result, liquidity wasn’t abundant and was mostly available through bond exposure. As the value of the Gilts plummeted (off 24% in short order), plans were going to need to find liquidity elsewhere. In many cases, this activity would have taken too long to meet margin calls and as a result, the swap and derivative exposure would have been unwound.

Warren Buffet, who is not a fan of leverage has said, “If you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke.” He’s also been less kind, stating, “When you combine ignorance and leverage, you get some pretty interesting results.” It wasn’t foolish on the part of DB sponsors and their advisors to try and mitigate interest rate risk by adopting LDI duration matching strategies. Ryan ALM does not recommend derivatives and SWAPs. We prefer the use of cash flow matching to fund benefits and secure the promise. There is no leverage! In cash flow matching, we carefully match up bond cash flows (principal and interest) with liability cash flows (benefits) to ensure that liquidity is sufficient to meet the plan’s obligations while allowing the alpha assets to grow unencumbered.

As for yesterday’s reaction in the US to the BOE’s bond purchasing in the UK, you need to stop thinking that the US Federal Reserve is going to do an about-face and begin to lower US rates. The Fed is committed to reducing inflation by raising interest rates. How many different ways must they state that message before US investors understand?