Is this how an Institutional investor should behave?

I would have preferred to use a saltier title for this post, but I watered it down quite a bit. In any case, I have just read about a major public pension system that decided to purchase 229,643 AMC shares during the second quarter. It hadn’t owned any shares of AMC as of 3/31/21. You may recall that AMC benefited tremendously as a MEME stock. In fact, the stock rocketed 27 times in value in the first quarter! This price appreciation was powered by individual investors using social media to push up the stock.

Amazingly, AMC, which had filed to sell more shares in June, warned investors that its stock was very risky at that time. So far in the third quarter, AMC stock has slipped 35.4% (as of 8/4 at 1:48 pm). In comparison, the S&P 500 has gained 2.3% so far in the third quarter. I am shocked by this decision. The behavior exhibited is certainly not institutional in nature. Aren’t we all taught to buy low and sell high? Purchasing this stock based on retail investor enthusiasm after the stock has appreciated 27 times and with little fundamental support speaks to desperation. Oh, yes, I forgot to mention that this public fund ranks as one of the most poorly funded plans in the country.

As of this afternoon, that stock purchase ($13 million at the time it was bought) is down more than $6 million or 46.4%. Yes, the $13 million “investment” is small relative to the size of the plan, but it seems as if the purchase was more like placing a bet on RED in Las Vegas or Atlantic City than it was an investment. Come on folks. This is no way to run a pension plan. A pension can not afford high volatility in its investments, which leads to volatility in the funded status and then contributions. If a higher contribution is required during the down cycles, the pension does not get this money back in the up cycles.

Pension Open or Closed? It Doesn’t Matter!

I’m thrilled that pension plans both large and small, private and public, are focusing more attention on their plan’s liabilities. It is about time, especially given that the only reason that DB plans exist is to meet the promised benefits (liabilities) that has been made to their employees/participants. As regular readers of this blog know, we, at Ryan ALM, have two ALM strategies – cash flow matching and $ duration matching – that help plan sponsors de-risk their pension systems.

When should a plan consider de-risking? Our answer: all the time! The plan’s funded status should determine the return on asset objective (ROA) and asset allocation. For instance, a plan with an 80% funded ratio should have a very different ROA from one that is only 50% funded. Seems obvious, right? But you would be surprised by how often we’ll see two plans that have the same ROA objective and asset allocation yet have very different funded status. As a reminder, DB plans were once managed like lottery systems and insurance companies. They knew what the promised benefits looked like in the future and they defeased that liability from day one. There was no hoping that a combination of investment strategies would achieve the ROA. There was only one objective – fund the promised benefits with both reasonable risk and cost.

We were asked recently if there is a difference in our approach if a plan is open versus one that is closed. Our answer is that it doesn’t matter. When implementing a cash flow matching strategy (aka Cash Flow Driven investing or CDI) we are focused on defeasing the Retired Lives Liability, which is the more certain liability. It is also the most important as it is the liability that must be paid first. Our approach provides the necessary cash flow (liquidity) to meet each benefit payment from the first month as far out as the allocation to our strategy permits. In most cases, we are managing a Liability Beta Portfolio™ (LBP) for roughly the first 10-years. This implementation allows for the alpha assets (performance or non-defeased assets) to grow unencumbered as they are not a source of liquidity to meet benefit payments.

DB pension systems – both public and private – have seen terrific improvement in the funded status of their plans since 2009. The equity markets have provided returns well above historic norms, while fixed income markets have continued to enjoy a nearly 40-year bull market as US interest rates continued to plummet. If you believe in regression to the mean, absolute returns in the next decade or so will likely be below the long-term average for both major asset classes putting pressure on plans to achieve the ROA target. Now would be the perfect time to take some or more risk off the table, secure the funded status and stabilize contribution expenses. Again, it doesn’t matter if your plan is open or closed. Don’t subject your plan’s assets to the whims of the markets, especially at these lofty valuations.

Why Accept This As Our Fate?

The following is from a CTPost article (my editorializing in parentheses); “For most people who work for a living, a pension is something from a bygone era. (true) Maybe their grandparents had one. (maybe, as more than 40% of those in the private sector participated in a DB plan at one time) Retirement planning (whose decision?) for the masses long ago made the move from defined benefit — meaning you know what you’re getting every month (much preferred) — to defined contribution, which means you know what you put in, but what you get is up in the air (how unsettling).”

I can’t argue with the writer’s interpretation of our current “retirement” situation, but why should we accept such as our fate? Defined benefit pensions (DB) are the only true retirement benefit available to workers and regrettably the number of employees covered by DB plans has dwindled precipitously. Retirement in years gone by was really quite simple. You worked hard for a prescribed number of years and you knew that upon the end of your time working you received a monthly check that would be there for you each and every month until you passed, and it might even be there for your spouse after your demise. Simple and wonderful! My dad has enjoyed a 31-year retirement because of his company’s pension plan.

Today, we have a situation that isn’t quite as simple. As the author of the CTPost article suggests, we get to know what we contribute to a defined contribution plan, but we certainly don’t know how much we will have to live on for the remainder of our time on earth. This is a math problem that most of us don’t have a clue as to how to solve. Why do we think that it is good policy to ask untrained individuals to fund, manage, and then disburse a “retirement” benefit with little knowledge on how to accomplish this objective? Some people have amassed small fortunes in DC plans, but for the masses that is just not the case. First, nearly half the workers in this country don’t have access to a retirement vehicle through work. We know that most Americans only save when provided with a savings vehicle through their employment. Secondly, many of us don’t control when we will last work, either because of health reasons or loss of jobs. Find yourself leaving the workforce in early 2007? Oops, your 401(k) is now a 201(k), and that “benefit” isn’t going to stretch nearly as far as you had hoped and prayed! Lastly, there are roughly 40% of Americans living within 200% of the poverty line. Do you really believe that they have the financial means to fund a retirement benefit?

We may not be able to reverse the course of DB plans going by the way of the dinosaur in the private sector, but we can certainly do a better job of protecting the plans that remain whether private, public, or multiemployer. It is time to get back to basics in how they are managed. We need to stop treating these asset bases as anything more than the means to meet a promised benefit. Insurance companies and lottery systems have figured out how to fund their promises with low risk and low cost by focusing on their liabilities. They don’t try to shoot for an unreasonable return hoping to achieve success so that funding requirements might be reduced. They understand that the future liability has a present value, and they determine how much needs to be funded in order to meet that obligation. America’s pension system used to be managed this way. Regrettably, we’ve gotten away from the basics. We’ve created an arms race (return focus) ensuring that there is considerable volatility in both the plan’s funded status and contribution expenses, while failing in many cases to achieve the desired outcome. This is a silly game. It is nothing short of going to Las Vegas and hoping to hit RED.

Let us, as an industry, refocus on pension basics so that millions of Americans can count on a retirement benefit that will provide a known $ amount each and every month. Remember, for every American worker who retires with little to no retirement savings they quickly find themselves on the social safety net of federal and/or state programs. This pay-as-you-go system is far more expense to run than a well-managed defined benefit plan. Just think about how better our economy can be with a majority of our senior citizens still participating in our economy because they have the financial means provided by a pension. Think of how many jobs and how much tax revenue is created when you have 18% of our population demanding goods and services. Now that seems pretty simple.

Between a Rock and a Hard Place!

The American Rescue Plan Act is wonderful news for plan participants stuck in struggling multiemployer plans, especially in those specific cases where benefits have been cut under MPRA (18 plans in total). It is found money that improves the plan’s funded status. But as I’ve mentioned through various outlets the legislation falls far short in providing the necessary assistance to ensure that the promised benefits are actually paid until 2051. Worse, it appears that many of the roughly 130 plans eligible for this federal assistance will become insolvent prior to then.

We, at Ryan ALM, have been espousing that the Special Financial Assistance (SFA) should be managed with a liability focus that will ensure that benefits and expenses are matched carefully with SFA assets (100% fixed income). We have also been saying that the legacy assets and the SFA should be looked at as a single team of assets for asset allocation purposes. In that scenario, the legacy assets can be managed with a greater exposure to performance assets by removing the allocation to fixed income here since fixed income is 100% of the SFA portfolio. This should enhance the probability of achieving a higher ROA on the legacy assets. The SFA assets are liquidity assets whose mission is to cash flow match (defease) benefits chronologically which will buy time for the performance assets to grow unencumbered.

Since the new SFA assets enhance the funded status, a new adjusted ROA should be calculated for the legacy assets only, so they know the economic hurdle rate to reach a fully funded plan. This new economic ROA is best calculated on a net liability basis including projected contributions. We highly recommend an Asset Exhaustion Test (AET) as the methodology to calculate this new economic ROA hurdle rate. Once this new ROA is calculated, the asset allocation for the legacy assets can now be assessed with a clear knowledge of its return mission. 

By defeasing liabilities for an extended period of time (8-12 years or more) the asset allocation investing horizon for the legacy assets is dramatically increased allowing for these assets to grow unencumbered as they are no longer a source of liquidity. The S&P 500 has outperformed bonds in 82% of rolling 10-year periods. I like those odds, but the current equity environment may not be a “normal” environment. Two charts produced by Bloomberg provide me with ample angst! The chart titled American Revenues Don’t Come Cheap highlights the US P/S multiple versus the rest of the world and reflects a valuation more than twice as great as the S&P 500/MSCI ACWI. As a point of reference, the US P/S ratio was only 0.9 when the market crashed in October 1987.

Worse, Robert Shiller’s cyclically adjusted price-earnings multiple, or CAPE, which compares an index’s price to average inflation-adjusted earnings over the previous decade is at a level not seen since 2000, which represented the all-time high. The chart below forecasts the subsequent 10-year return for US equities versus bonds by calculating the excess CAPE yield, or ECY, which is the gap between the CAPE earnings yield (the inverse of the ratio) and the 10-year bond yield. At 3%, the forecasted outperformance of equities to bonds is not nearly enough to get plans to the ROA especially with the 10-year Treasury note currently sitting at a yield of just 1.28%.

Given where equities are at this time, plan sponsors and their consultants will need to get quite creative with their asset allocations for legacy assets in order to create a potentially winning formula in their quest to achieve the new economic ROA. It appears to us that the only certainty of success resides in the SFA bucket if the assets are defeased to the plan’s liabilities and expenses. Time will help this situation, but is 10-years a long enough time horizon given where valuations currently reside? If the markets aren’t going to help mitigate some of the funding shortfall, perhaps we can hope that Congress will once again take up pension reform to provide the necessary resources to ensure that the currently struggling pension systems can remain solvent long after 2051.

The Custom Liability Index (CLI) – A Necessary DB Pension tool

I stumbled onto an article from 2008 that spoke to Ron Ryan’s “genius” when it comes to indexing. As most of you know, Ron was the Director of Research at Lehman in the ’70s and he has been credited with creating many of the world’s leading fixed income indexes, most notably the Aggregate, now known at the Bloomberg Barclays US Aggregate Bond Index. This article mostly dealt with his (Ryan ALM’s) work with ETFs, but I think that his most notable contribution to indexation has been the creation of the Custom Liability Index (CLI). I believe that every DB pension plan should have a CLI produced for them as each pension liability stream is unique and NO generic bond index can adequately match.

I am still amazed, even after 40-years in this business, that a plan’s liabilities aren’t driving asset allocation and investment decisions. The lack of liability information is certainly one of the primary reasons why this continues to occur. With a CLI, plan sponsors have the necessary information at their fingertips when it is needed. In 1991, Ron Ryan and his team invented the first CLI as the best representation of the true client objective. Although funding liabilities is the true objective of any pension, liabilities tend to be missing in action in asset allocation, asset/liability management, and performance measurement. The reason for this disconnect is the absence of a Custom Liability Index (CLI) that best represents the future value, present value, term structure, and risk/reward behavior of liabilities. Once a CLI is installed as the proper benchmark, then and only then can the asset side function effectively on asset allocation, asset/liability management and performance measurement.

As mentioned, liabilities are like snowflakes… you will never find two alike. Pension liabilities are unique to each plan sponsor since they each have a different labor force with a different salary structure, mortality, and plan amendments than any other pension. As a result, only a Custom Liability Index could ever properly represent or measure the unique liabilities of any pension. A CLI should be calculated accurately and frequently so the plan sponsor and its pension consultant can be informed with timely data that can support the asset allocation decisions.

Assets need to know what they are funding. The economic truth is that assets fund the net liabilities after contributions. A CLI should provide a net liability valuation based on all discount rates that apply (ASC 715, ROA, ROA bifurcated with 20-year munis, Treasury STRIPS, PPA spot rates, PPA 3-segment, PBGC). Ryan ALM is one of few vendors supplying ASC 715 discount rates since 2008. Our discount rates are consistently higher than other vendors providing a lower present value on liabilities thereby enhancing funded ratios and balance sheets. It may be wise for the CLI to have the economic valuation (U.S. Treasury STRIPS) as one of the discount rates to compare actuarial and accounting valuation versus economic valuation. Moreover, the CLI will provide a monthly or quarterly calculation of the economic present value of liabilities so the funded ratio and funded status can be updated, as well as a quarterly calculation of the economic liability growth rate so performance measurement of total assets versus total liabilities can be assessed.

Since current assets fund net liabilities after contributions, current assets need to know the projected benefits and contributions for every year as far out as the actuary calculates benefits. Noticeably, contributions usually play no role in the asset allocation strategy of most pensions, yet they are a major future asset. Given the size of contributions today, it is critical that contributions are a major consideration in the asset allocation strategy. For many plan sponsors, the contribution cost has risen as much as 5x to 10x or more from the fiscal 1999 level.

Don’t hesitate to reach out to us if you are interested in learning more about the Ryan ALM CLI. Without this pension X-ray, it is difficult to truly know what is ailing your plan.

Ryan ALM Quarterly Newsletter – 2Q’21

We are pleased to share with you the Ryan ALM Quarterly Newsletter. The newsletter contains important insights on pension assets and liabilities during the quarter and for the last 20+ years. In addition, we share with you the latest research and a sampling of blog posts produced by us during the last 3 months. We hope that you find our insights beneficial. Lastly, please don’t hesitate to reach out to us with any questions and/or comments.

Ryan ALM’s Pension Monitor

Each quarter, Ryan ALM produces the “Pension Monitor” to reflect how pension liabilities are behaving versus plan assets. We believe that pension plan liabilities need to be measured and monitored regularly. Without knowledge of plan liabilities, the allocation of plan assets cannot be done appropriately. 

The funded ratio/status of pension plans are present value calculations. Each type of plan is governed by accounting rules and actuarial practices, which determine the discount rate used to calculate the present value of liabilities. Single employer corporate plans are under ASC 715 (FASB) discount rates (AA corporate zero-coupon yield curve); multiemployer plans and public plans use the ROA (return on asset assumption) as the liability discount rate. The difference in liability growth between these plans can be quite significant, which will affect funded status and contribution levels. 

Given the strong rebound in markets following the onset of Covid-19, it shouldn’t be surprising to see that assets have outperformed liabilities during the last 15 months. Whether the plan is a public, corporate, or multiemployer plan, assets have been aided by strong equity markets and liability growth has been muted by rising interest rates. This combination has been great for pensions that have witnessed strengthening funded ratios and improved funded status.

Please don’t hesitate to reach out to us if we can answer any questions related to asset/liability management.

ARPA – “The Almost Rescue Plan”

The Pension Benefit Guaranty Corporation (PBGC) released their long-awaited American Rescue Plan Act (ARPA) guidelines. They had 120 days from the time that the legislation was signed by President Biden to inform the public on how this legislation would be implemented. I’d give them a C-, at best!

Importantly, retirees who had seen their benefits slashed under MPRA will FINALLY be made whole (18 multiemployer plans). I still shake my head at the fact that our “leaders” had passed legislation in 2014 that permitted promised (earned) benefits to be taken away from retirees, and in many cases after they had already retired through no fault of their own. Thankfully, help is now arriving for these retirees, but it could be a ways off based on the PBGC’s priority filing schedule. According to PBGC’s release, participants in these plans can have their benefits restored prior to their priority group (Group 2) being able to submit an application, but they must file with the US Treasury Department to accomplish this objective. Make up payments for those that had received cuts can only be made after their pension fund submits an application and receives Special Financial Assistance (SFA). This could take some time.

Where I take great umbrage is in the PBGC’s interpretation of how the SFA should be calculated. Instead of taking a present value calculation of what it would take to secure the next 30-years of promised benefits (until 2051), the PBGC has decided that plans should include current assets, future contributions, and the earnings from both before determining the “gap” that exists in order to meet the 30-years of benefit payments. What this does is effectively doom those plans that are receiving the SFA to insolvency in 2051, as NOTHING will be left to meet benefit payments in 2052 and beyond. Again, great that current retirees are going to be made whole, but it does nothing to secure the benefits of those younger workers that will be just starting a career and contributing to their union’s plan with the hope that they too will have a retirement benefit waiting for them when they finally retire. Can you imagine making a mortgage payment only to have someone else live in your house?

It gets worse. The discount rate used in the legislation does not reflect reality. The legislation calls for the PPA’s 3rd segment rate plus 200 bps (5.5% currently) instead of PPA’s 1st, 2nd, and 3rd rates weighted to the projected benefit payments that will be made during the next 30 years. This higher discount rate will significantly reduce the SFA so that the SFA will likely fall about 40% short of what is truly needed to ensure that the promised benefits are there until 2051.

According to the PBGC they were not able to address this discount rate because it was specifically stated in the legislation. Where are the pension experts in the room when you need them? Furthermore, the PBGC has reiterated that the SFA assets received should be segregated from current assets. The SFA assets must be invested in investment grade (IG) bonds with the exception of a maximum 5% that could be held in High Yield instruments that may have started out as IG but suffered downgrades since being purchased. The yield differential between the discount rate and the potential return on the SFA assets is what creates that additional roughly 40% shortfall. Again, good luck!

It appears to me that the legislation was passed with a targeted dollar amount as a goal, but that fact wasn’t disclosed. The legislation scored by OMB had an $86 billion price tag. According to PBGC’s Friday release, the “price tag” is estimated at $94 billion today. If the discount rate and SFA calculations had been adjusted as I suggest, the price tag would have been far greater. Instead of doing the right thing to secure the benefits for retirees without destroying these plans in the future, they chose to be penny wise and pound foolish.

The social safety net is going to be a lot more expensive when current employees see their pension plans collapse in less than 30-years. What appeared to be landmark legislation when it was first signed in March is now just another “Almost Rescue Plan Act”. When will we finally do right by the American worker?

After a brief respite…

With most of the pension world expecting US interest rates to rise, the opposite has occurred and rather dramatically. US 30-year Treasury bond yields have collapsed 51 bps since May 12th, while the US 10-year Treasury note yield is down 41 bps during the same time frame. Since most DB pension plans, especially in the public sector, have liabilities with 10-15 year durations the impact on liabilities and funded ratios has been significant. For instance, a -40 bps move on 10-year duration liabilities = 4% growth, while a similar interest rate change on a 15-year duration liability = 6% growth. The improved funded status that we witnessed earlier this year may prove to be an illusion if asset levels follow a similar path to bond yields. Why subject plan assets to the whims of the markets? Cash flow match a portion of your assets (perhaps your bond allocation) to your plan’s liabilities and secure the promised benefits while eliminating interest rate risk for that portion of the liabilities that are defeased.

Creating more volatility

An interesting analysis by Deutsche Bank suggests that public pension systems should have rebalanced a greater sum of plan assets to fixed income following the terrific first quarter performance provided by US equity markets. DB’s analysis found that public pension system’s added only $3.6 billion to fixed income as opposed to >$130 billion had they maintained a static allocation from the previous quarter. Clearly, this hesitancy to rebalance has helped in the short-term as equities continued to advance, but what does this suggest for the future? We’ve been taught that buying low and selling high is a winning strategy. We also know that trying to time markets is also incredibly difficult, which is why asset allocation targets and ranges around those targets have been established as a tried and true discipline.

There are numerous forces at work impacting this lack of an asset allocation action, including an expectation that the US would experience rising interest rates due to escalating inflationary concerns. A move upward in rates would likely lead to a very challenging environment for the typical bond manager. There is also the continuing focus on achieving the return on asset objective (ROA) that drives most asset allocation decisions. However, markets don’t always behave as we might expect. Instead of rising, US interest rates have resumed their march lower, with both the US 10-year Treasury note and US 30-year Treasury bond hitting interest rate levels not seen since early to mid-February.

By continuing to expose these pension systems to greater equity exposure than long-term asset allocation frameworks have determined is appropriate injects more risk into these plans. I don’t know how equities will perform during the next 6-months to a year nor do I have any clue as to where interest rates will go. Unless one is truly confident in one’s ability to forecast these markets, prudence suggests following the course that has been determined through previous analysis. We think that taking equity risk off the table at this time makes sense. Furthermore, we’d suggest using bonds for their cash flows by matching the plan’s liabilities, which provides the plan with a number of benefits that have been discussed in previous posts.