Is The Muni Market Foreshadowing Public Pension Funding Issues?

The WSJ has an article in today’s edition that frankly is pretty scary, but has gotten little press. According to Municipal Market Analytics Data, ten municipal borrowers defaulted in May and another 10 in June, the most for these months since 2012, as municipalities and states deal with the dramatic impact on revenues from the loss of income, sales, and hotel taxes, lotteries, airports, and other sources like tool roads, etc.

As these municipalities and states bootstrap their budgets, where do pension contributions fall within the pecking order? In some states there is no wiggle-room as the required annual pension contribution must be paid in full, but other states, such as NJ, don’t have such a mandate, and have rarely made the full contribution even under the best of economic environments. Just how bad can this situation get? New Jersey is forecasting a $10 billion shortfall for the next two years. The state’s annual budget is only $38.5 billion.

“The many U.S. towns that thrive on local or regional tourism are in particular distress, and nearly 90% of cities are projecting budget shortfalls, according to April surveys by the National League of Cities and the U.S. Conference of Mayors. More than a third reported they were having to make cuts to capital improvements, infrastructure maintenance and other critical public works services.” WSJ

Given that there are still more than 19 million continuing unemployment claims and the promise of more furloughs and cuts in public employees – NYC is forecasting that 22,000 furloughs/cuts are likely in the fall – it seems unlikely that full pension contributions will be forthcoming in the near future. Couple this development with asset value losses and rising liabilities, and you have a formula for disaster. As a result, these pension systems need to buy time. Implementing a CDI program allows for ample time (10-years) to see asset values once again rise, full contributions restored, and hopefully rising interest rates that will reduce the present value of the plan’s liabilities. RyanALM.com has a terrific research piece on buying time. Check it out!

We wish for you and your family a Happy Fourth or July!

Maximize The Efficiency of The Asset Allocation

We believe that the primary objective of managing a pension plan is to secure the promised benefits through a cash flow driven investing (CDI) approach. However, there is a very important secondary benefit when using CDI and that is the fact that a plan’s asset allocation becomes much more efficient.

In this era of very low US interest rates, exposure to both cash reserves and traditional fixed income can weigh on a plan’s ability to achieve the ROA. How excited would you be as a plan sponsor if you could take your current 20% exposure to fixed income and reduce it to 3.5%, while still having the cash flow to fund all of the net benefits and expenses each year for the next 10 years? It would be quite beneficial to the long-term success of the plan to use the 16.5% that had been sitting in fixed income in a more aggressive implementation.

Let me present a hypothetical case for you. ABC public pension has $2.5 billion in assets, a 7.5% ROA objective, 20% in fixed income, and net benefits and expenses of $10 million / year (after contributions). The traditional fixed income portfolio is generating a 2% YTM in this market, which exceeds the Bloomberg Barclays Aggregate index by about 40 bps. If the fixed income account is the primary source of cash flow to meet the $10 million in annual net benefits and expenses, then the $500 million that is currently allocated will just about do the trick ($500 million X a 2% YTM gets you $10 million/year).

In this example the remaining 80% of the corpus is invested however the plan sponsor and their consultant(s) decide with the goal to achieve a rate of return greater than 7.5%, since the 20% of fixed income exposure generating 2% earns the plan only 0.4% of the 7.5% goal. Given this example, the remaining 80% would need to generate a return of 8.875% to accomplish the objective.

Now, consider the following example using a CDI approach to secure and fund the net benefits and expenses of $10 million/year. In a CDI approach income, principal, and re-invested income are used to fund the net benefits. If the goal is to secure the next 10-years of net payouts, an allocation to fixed income would only have to be $84 million in present value $s to meet the future $100 million in payouts. The remaining $416 million (original allocation was $500 million) would now be available to use in the alpha bucket to help generate additional excess returns.

In this example, the 3.5% allocated to the CDI program will generate a roughly 3.3% yield, as it is invested in investment grade corporate bonds contributing roughly 11.6 bps to the overall return. If the residual 96.5% in the alpha bucket can achieve the 8.875% that was needed in the previous example, the “expected” ROA moves from 7.5% to 8.68%, far improving the probability of success. In addition to this improved performance, the plan has secured the benefits and expenses for the next 10 years, reduced funding volatility, eliminated interest rate risk, improved liquidity, and extended the investing horizon for the alpha assets to grow unencumbered for the next 10-years. Seems like a much more efficient implementation to me. Questions? We are ready to help you think through this strategy enhancement.

Not Your Father’s POB

I was reading an opinion piece in The Press-Enterprise, titled “Game-Changer For Riverside’s (CA) Budget”. The piece discussed The Riverside Council’s action to reduce the budget by 10% due to a loss of revenue and rising expenditures related to Covid-19. I was impressed. As a Councilman in Midland Park, NJ, I know how difficult it must have been to identify those cuts. But, more important for me was the fact that they had approved going to the market for a Pension Obligation Bond (POB).

What I found interesting was the fact that the author was opposed to the use of POBs, and cited the fact that the Government Finance Officers Association (GFOA) “isn’t a big fan of pension obligation bonds because of downside risks”. Historically, POB proceeds were invested in a plan’s traditional asset allocation with the hope that the ROA would be achieved and the arbitrage between the ROA and the cost to borrow would be realized. In many cases, the bond proceeds were invested at the height of the market only to suffer significant losses. Yes, that implementation comes with downside risk!

We don’t believe that you engage in a POB to play roulette with the proceeds. We believe that sound policy has you investing those assets in a cash flow driven investing (CDI) implementation that defeases as much of the plan’s retired lives liability as possible. This significantly reduces the downside risk, insures that retirees get their promised benefits, stabilizes contribution expenses and the funded status, extends the investing horizon for the remaining alpha assets, and eliminates interest rate risk. There are other benefits to this implementation, but I think that you get the drift.

Based on what has transpired since the outbreak of the Covid-19 virus, it is highly likely that state and municipal budgets will be impacted for years to come. DB pension systems are too important to the participants, their communities, and to the local economy to mess around with the funding. Now is the time to adopt a POB, but utilize our implementation and don’t play games with the proceeds. We stand ready to assist you in any way that we can.

Another Fallacy

Countless articles mention the burgeoning US federal deficit, as if it is a rival to the Covid-19 virus, getting ready to unleash long-term harm the likes of which we’ve never witnessed. They are WRONG! Yes, deficits for individuals, businesses, states/municipalities, etc. must be closed or financial harm could be realized, but the US federal government enjoys the benefits of a fiat currency. As such, we are NOT constrained by what is raised in taxes or issued through bond sales.

In fact, deficits ADD to private saving, as witnessed in April when record savings were achieved, and people’s incomes. To the extent that people spend this money, MORE goods and services will be sold. According to my former colleague, Charles DuBois, “all else equal, this stronger business will increase investment spending”. There is no crowding out. Regrettably, there is very little pushback regarding this misconception except for proponents of Modern Monetary Theory (MMT). We should embrace the recent activity as a positive action to support the US private sector.

A fly In The Ointment?

We are huge fans of cash flow driven investing (CDI). We believe that securing pension benefit payments is the number one objective for a DB plan. Maximizing the efficiency of the asset allocation process is also critical, especially for those pension plans focused on achieving the ROA. Plan sponsors and their consultants use CDI approaches to match every cash flow net of contributions (the first source to fund benefits) each month from the next payment to as far out as their program allocation can afford to go.

Most CDI implementations favor the use of publicly traded bonds, as they are the only instruments with a known terminal value allowing for the greater efficiency in matching those monthly payments. This universe may include Treasuries (lowest yielding), agencies (prepayment risk), and investment grade and high yield corporate bonds (credit risk). In some cases, senior secured debt, bank loans, and other private investments have been used sparingly to potentially enhance the yield reducing the overall cost to implement the strategy.

We are also aware that some investment managers are incorporating dividends in their attempt to capture many sources of liquidity within an overall plan. However, we would caution the use of dividends to help secure benefit payments, as dividends are not guaranteed. The current environment is a perfect example of companies that are cutting or eliminating their dividends. It is too early to know the full extent of the impact, but it has been substantial. As a point of reference, in the great recession, nearly $100 billion in dividend income was lost in 2008 and 2009.

The uncertainty surrounding dividend payouts makes the securing of benefits very difficult, if not impossible. One way to overcome this issue is to accumulate a significant reserve to meet those futures payouts, but given where yields on cash are in this current environment that is a less than desirable implementation. Corporate spreads on investment grade and high yield bonds certainly widened considerably early this year, but they have narrowed significantly since March. In addition, widening doesn’t impact the semi-annual payout of the interest, and in fact, made for a greater cost savings with any new money coming into the program. Don’t hesitate to reach out to us if we can help you create an efficient CDI program.

Wouldn’t That Be Loverly!

Every once in a while I read something that just makes me shake my head in disbelief. Today I had such an experience. The gist of the article to which I am referring had to do with a question that was posed regarding the funding of one’s retirement account while on unemployment.

For most Americans – yes, most Americans, having an abundance of financial resources is a pipe dream. Unemployment, as we’ve witnessed during the last 3 months, can be financially devastating in a relatively short period of time. Furthermore, most studies suggest that American workers truly only save for retirement through an employer-sponsored plan. Losing one’s job eliminates both the financial resources AND the access to a retirement vehicle. The fact that this question was asked is actually mind-boggling.

There has been little real wage growth during the last several decades, while expenditures for education, housing, healthcare, food, etc. have grown substantially. As a result, the Covid-19 impact on the economy and workers revealed the fragility by which most Americans live. We’ve seen a dramatic increase in loans not being paid, mortgage and rent relief, and unemployment benefits dramatically enhanced (extra $600/week), and it still isn’t enough for many displaced workers, especially if they live in a major city, such as NYC or San Francisco.

Furthermore, the article went on to discuss the establishment for a rainy day or emergency fund. Yes, I agree wholeheartedly that it is wise to set aside funds for an unexpected life event, but in reality most Americans are living paycheck to paycheck, and barely have the means to meet life’s necessities on a daily basis. This is not because they are buying lattes or eating avocado toast everyday. For Millennials, the reality is that twice as many representatives of this cohort have 50% more in student loan debt than the Gen Xers who preceded them.

My favorite line in the article was “when you’re unemployed, your emergency fund should ideally be heftier than normal”. Now there’s a brilliant statement. Well, if every American knew the day that they would become unemployed, I’m sure that they would do everything in their power to save a little more. Regrettably, the Covid-19 virus didn’t give us a heads up and I suspect that most employers didn’t do the same thing for their employees: they seldom do.

We have significant economic issues in our country, and worrying about whether or not someone on unemployment should continue to fund a 401(k) isn’t near the top of the priority list nor is it realistic. It would be wonderful if the general working population were earning enough in wages that their basic living expenses were more than covered, but we know that is just not the case. Until we get to that desired outcome, we will have to live with the knowledge that shocks to our economy can happen at anytime.

A Penalty That Should Be Eliminated

The Covid-19 crisis has raised awareness regarding many social ills, including the lack of emergency funds, the fragility of the labor force, especially for older workers, and inequality in general. These all need to be addressed in time, but there is another issue that should be a priority for immediate consideration. I am referring to the Social Security “earnings test” that penalizes workers who are collecting SS benefits prior to achieving full retirement age. As an FYI, “full” retirement age is different for workers based on the year of your birth. For instance, anyone born 1959 (my year of birth) I am considered at full retirement age when I am 66 years old and 10 months.

Why is this important? It has taken on greater urgency because of the significant job losses experienced during this crisis. Many older Americans will have a difficult time reentering the labor market and may in fact be forced to take an early SS benefit to supplement any savings that have been accumulated, which we know are scant for a significant percentage of the population. Those taking early SS benefits will be required to forfeit $1 for every $2 earned above $18,240. The penalty becomes less onerous once you reach the year in which you achieve full retirement age. For someone born in 1959, they would have 46 months of the $2 penalty, and 1-year of the $1 for every $3 earned above an income threshold of $48,600.

Even without this crisis, it seems unreasonable that American workers can’t supplement their “retirement” incomes without incurring a penalty. I’m sure that critics of this proposal will cite the Federal government’s widening deficits and fears of a collapsing SS system that is forecast to go bust at some point in the future. Those concerns are unfounded as the US government can always meet their obligations thanks to possessing a fiat currency. When many Americans find themselves unemployed, and economic activity has taken it on the chin, we should be looking for ways to further stimulate demand for goods and services. Allowing American workers collecting SS benefits prior to achieving full retirement age would now have additional spending power.

Retirement Plans Being Tested?

Of course they are!

Recently, there has been more reporting about 401(k) participation taking a hit amidst the COVID-19 pandemic. Now, that is a shocker.

According to folks at LIMRA Workplace Benefits Research, their findings reveal that among workers with access to a DC plan, roughly 36% say they have decreased or eliminated contributions. For those participants who once contributed but stopped (that’s about 10% overall), more than half (56%) ceased their participation in the wake of the COVID-19 crisis.

Regrettably, the change in behavior is not limited to the plan participant, as the sponsoring organizations are also reacting to market forces with more than 30% having either eliminated or reduced the company match. For those employers (with 10 or more employees) who have a DC plan in place they’ve also noted other behaviors that will likely impact wealth creation for the participants, including the fact that 13% of the plans have seen an increase in hardship withdrawals, while another 10% have seen increases in loan demand. Lastly, they note that more than 20% of plan participants have made asset allocation changes, which likely means (and I’m speculating) that equities were sold in late March or early April before the rally.

I know that I tend to come down harshly on DC plans, but they were never designed to be anyone’s primary retirement vehicle. I think that they are great for accumulating supplemental income. Furthermore, asking untrained, and lowly compensated workers, to fund, manage, and disburse a benefit that many professionals have difficulty handling is just not acceptable.

It is because of these issues that Ron and I are trying to reeducate the DB market on strategies that will secure the promised benefits while preserving DB systems for future generations of workers. The millennial cohort is already behind Boomers in wealth creation by roughly 34%. The lack of access to DB plans will likely increase that deficit and make the hope of a dignified retirement more unlikely!

Question: Did You Win?

Here is the question of the day: If your pension plan beats the ROA, but loses to liability growth, did you win?

I suspect that most plan sponsors and many consultants would suggest that they have won the game. But, have they really?

Despite the “fact” that GASB permits public pension systems to discount their plan’s liabilities at the ROA, liabilities are bond-like in nature and are repriced based on interest rate changes. As we’ve witnessed during the last nearly four decades of collapsing rates, pension liabilities have blown out. The impact on funded ratios and contribution expenses has been particularly onerous this century, creating a very challenging environment for sponsors of public and multiemployer systems.

On the other hand, if your plan generates only a 4% annual return failing to achieve the 7.25% ROA, but liability growth is -2% during the same time frame: didn’t you win?

The good news for Pension America going forward is that historically low interest rates are not likely to fall much further, if at all. A rising interest-rate regime will negatively impact liability growth creating an environment that will allow modestly growing assets to add significant value in a relatively short period of time.

Unfortunately, most plan sponsors do not see this relationship because of the accounting rules. Going forward, all pension plans should be given multiple views of their liabilities, including a risk-free rate. Of course, a pension liability in this low-interest-rate environment will look atrocious and the funded status very weak. However, given the likelihood that rates will rise going forward, plans could see a dramatic improvement in all metrics. Decisions by trustees should be predicated on the truth, including an accurate funded ratio/funded status, but without complete transparency with regard to plan liabilities (benefit payment), this is not possible.

That’s NOT The Correct Objective!

The New Jersey Pension Fund has reported that the system generated a -2.47% return for the 10-months ending April 30, 2020, which is obviously quite poor given their annual return on asset target (ROA) of 7.5%. Furthermore, they are reporting that the benchmark return to which they compare their assets produced a net return of 0.72%, or more than 3% better than the fund. However, neither the ROA nor the asset benchmark is the right objective.

Let’s stop playing these performance games, especially since NJ seems to underperform on a very consistent basis trailing the asset benchmark on a 3- and 5-year basis, while besting the hybrid index by 5 basis points over 10-years (but, trailing the ROA). The only reason that the NJ pension fund exists is to pay the promised benefits to the plan participants, which means that the only true objective for the assets are the plan’s liabilities. Despite the fact that liabilities do not grow at the same rate as assets, GASB accounting rules permit the discounting of plan liabilities at the ROA. Even under this misguided accounting methodology, NJ’s system is woefully funded.

Unfortunately, it is being reported that NJ will once again fail to make the annual required contribution, as the impact from the Covid-19 crisis weighs on revenues while expenses rise. Not surprising, the state’s funded status continues to deteriorate, and the growing required contribution is negatively impacting the funds available to support the social safety net. If a true measure of the plan’s liabilities were determined, the funded ratio would be in the low 20% range and the underfunded liability would be about $300 billion! Yes, that is correct that a state with a roughly $40 billion annual budget is saddled with a $300 billion unfunded liability.

NJ’s public fund participants, who have worked for and funded this benefit, deserve a better outcome. The plan’s investment team and board of trustees need to finally understand that managing assets against an asset benchmark accomplishes very little. NJ will not get their arms around this funding crisis until they recognize the true objective is plan liabilities. Once they comprehend that fact they will then be able to begin to tackle this problem.