We have been doing an analysis on a fairly good sized municipality’s pension system using our Custom Liability Index (CLI). The fund appears to have a roughly 35% funded ratio when using standard accounting rules and actuarial practices. However, when you include projected future contributions (provided by the actuary), the plan is well over-funded. It begs the question, why aren’t contributions part of the funded ratio calculation? Does it make sense to have future liabilities in the equation but not future contributions? As a result of this inconsistency, plan sponsors are forced to make important decisions related to benefits, COLAs, ROA targets, asset allocation, etc. without having the full economic picture.
In this case, future contributions are massive and dramatically overstated. In our analysis we were able to suggest a reduction in annual contributions of $5 million/year for a savings of nearly $100 million during the evaluation period and the plan would still be fully funded. This is a tremendous savings that can now be used to support the other important programs within this city’s social safety net. Furthermore, the fund only needs a very modest return (i.e. 3%), far smaller than the current return on asset assumption (7.25%), to maintain a healthy funded status. Without this insight, the plan sponsor and their advisors would continue to manage a much more aggressive asset allocation injecting unnecessary risk into the process and jeopardizing the current funded status.
There are a lot of things that don’t make sense in our industry. Why do we have two accounting standards – GASB (public funds) and FASB (private plans)? Why don’t we account for future contributions (as assets) while including future liabilities? Why do pension systems focus on the ROA and not the promise (projected benefits) that has been made to the plan participants which is the only reason that these plans exist in the first place? Finally, how can a plan be managed when only focusing on the asset side of the equation? This would be like playing a football game and only knowing how many points you’ve scored. Every pension plan should have an x-ray (asset/liability review) taken quarterly that demonstrates the health of the pension system. Without this review, you could end up throwing a “Hail Mary” when 3 yards and a cloud of dust is all that is necessary.
Inflation is on everyone’s mind these days, and for most of the investment community higher inflation is not welcomed! But there is a group that might just benefit a little from a bit of inflation. I am specifically referring to Social Security recipients. Every October the Social Security Administration announces the COLA for the next year. Unfortunately, COLA increases have been running at 1.92% for the last four years, bringing with them annual increases of roughly $20/month to $39/month for a recipient who gets the “average” monthly payout. Clearly not enough to be life changing.
We’ve reported on these developments in the past, and have discussed using the CPI-E instead of the standard CPI-U, as the CPI-E measures the inflationary impact on senior citizens. The CPI-E has run about 0.2% higher than the CPI-U since it was first reported. That change has not been adopted yet. The Bureau of Labor Statistics recently released the inflation number for May, which showed a 0.6% increase following April’s 0.8% surge.
“In May, The Senior Citizens League (TSCL) released its first forecast of the 2022 COLA after analyzing the April CPI data and had it pegged at 4.7%.”(401(K)Specialist) Given May’s continuing inflationary upward trend, it is not inconceivable that the forecast for 2022’s COLA could rise further. If the COLA ends up being anywhere near the 4.7% increase or greater, it will represent a >3Xs increase on 2021’s 1.3% allocation. Again, the annual COLA is intended to help recipients stay one step ahead of inflation but given the use of the CPI-U instead of the CPI-E, our seniors may still be falling behind.
I just read this morning that ForUsAll Inc., a 401(k) provider to roughly 400 plans (total AUM of $1.7 billion) has entered into agreement with a division of Coinbase Global to offer access to cryptocurrencies – bitcoin, ether, litecoin, etc. – through the workers’ 401(k). The potential investment is limited to 5%. Do we really want unsophisticated employees making an investment in these instruments given the extreme volatility we are witnessing? There are on-going efforts within the 401(k) community to provide participants with access to private/alternative investments, but in nearly every other example, there is an underlying fundamental story or balance sheet supporting the product.
The WSJ article did not mention the cost of investing in cryptos, but they did highlight the fact that ForUsAll would notify the participant when their exposure neared or exceeded 5% so that they could rebalance their exposure. Are they going to inform the participant when the original investment has been cut in 1/2 or more?
A Bank of America research note published recently suggests that the significant improvement in corporate pension plan funding (Milliman calculates the collective funded status at >98%) will likely lead to a “massive rotation” from equities into corporate bonds. We absolutely agree that it should. Many private sector pension systems have frozen and terminated their pensions during the last 4 decades, but many 1,000s still exist. For those that haven’t yet terminated or frozen their plan, engaging in a de-risking strategy at these funding levels makes absolute sense. Why wait? Market timing, predicting equity markets and interest rates, shouldn’t be driving this decision. For instance, the US Treasury 10-year note has rallied despite inflationary expectations and the yield sits at 1.47% this morning down from 1.75% on March 31, 2021. Most market participants were expecting rates to continue to climb.
“I think this becomes a pretty big story, and it becomes a support for credit spreads in the back end of the curve especially,” Hans Mikkelsen, BofA’s head of high-grade credit strategy, said in an interview. We agree that it likely supports credit spreads, which have tightened, but we disagree that it particularly supports the back-end of the curve. Engaging in asset liability management (ALM) is NOT about buying long corporate bonds. Effectively managing assets versus plan liabilities calls for the cash flow matching of assets along a liability yield curve of projected annual benefit payments, with the next month’s benefit payment being the most important. Sitting with a bunch of long corporate bonds and thinking that you have somehow “immunized” the assets to match liabilities is just wrong, while opening the plan to significant interest rate risk.
There are only two ways to secure benefits – insurance buyout annuities (IBA) and cash flow matching (CDI). Doing a pension risk transfer through an IBA can be very expensive, especially relative to managing the plan’s liabilities through a cash flow matching strategy. Our experience and analysis suggest that a CDI approach can save the plan about 30% on the future costs of the benefit relative to engaging in an IBA. Furthermore, if a plan is focused on eventually doing a pension risk transfer a cash flow matching portfolio is the perfect vehicle to meet this objective as the insurance company will likely be happy to do a portfolio transfer-in-kind. Go to RyanALM.com to see multiple research pieces on this subject.
There is much chatter and speculation on social media regarding ARPA’s funding and ability to meet all the promises. There is growing fear among some circles that somehow the “pool of resources” will fall short of meeting the objective to fund ALL the benefits (and expenses) for the next 30-years for those plans filing for financial assistance. Please remember that no specific $ amount has been allocated and no estimate of the final cost was in the legislation. Sure, there was an estimate by the OMB that suggested that the ultimate price tag would be $86 billion, but that is only an estimate. Furthermore, the amount of Special Financial Assistance (SFA) will be predicated on multiple inputs yet to be decided. These inputs include the discount rate used to determine the present value (PV) of the liability and whether or not the current assets, future contributions, and projected return on the assets are included in the SFA calculation. Hopefully, we’ll get answers to these critical variables when the PBGC publishes their guidelines around July 10th.
Importantly, the legislation does specifically state that “there is appropriated from the general fund such amounts as are necessary for the costs of providing financial assistance under section 4262 and necessary administrative and operating expenses of the corporation. The eighth fund established under this subsection shall be credited with amounts from time to time as the Secretary of the Treasury, in conjunction with the Director of the Pension Benefit Guaranty Corporation, determines appropriate, from the general fund of the Treasury.”
The only possible fly in the ointment is the following: “but in no case shall such transfers occur after September 30, 2030. Given this restriction, the powers that be better get the discount rate and calculation of the SFA correct, or there could be significant shortfalls during the next 30-years in the amount of assets needed to meet those promised benefits!
The Illinois State Assembly has passed HB0417, a piece of legislation designed to provide funding flexibility in support of the Chicago Park District pension fund. According to the brief explanation of the bill, the legislation “amends the Chicago Park District Act and authorizes the Chicago Park District to issue bonds in the principal amount of $250,000,000 for the purpose of making contributions to the Chicago Park District Pension Fund”. There are other provisions within this legislation, but the ability to raise funds through bonding is the critical element.
We continue to live in a nearly historically low-interest-rate environment. As we’ve discussed previously, it is quite prudent to take advantage of these low rates to stabilize defined benefit plans that will not achieve full funding through investment returns alone. An investment of $250 million through a pension obligation bond (POB) will dramatically improve the plan’s funded status and help stabilize annual contribution expenses.
Now that this legislation has passed, the fund and its advisors need to consider how the proceeds will be invested. Historically, POB proceeds have been injected into the plan’s existing asset allocation. This has proven to be a mistake in many cases and is very much dependent on the “timing” of the investments. POB proceeds should be invested in a way that ensures that the liabilities (promised benefits) are secured through a cash flow matching strategy (CDI) that will match and fund each monthly liability (and expense) chronologically until the POBs assets are exhausted. This strategy is NOT dependent on future market returns, as the assets and liabilities are matched no matter what happens with interest rates, as there is no interest rate sensitivity since we dealing with future values.
Furthermore, the current assets and future contributions can be managed more aggressively and unencumbered, as they are no longer a source of liquidity to fund benefits. Buying time for the alpha bucket improves the probability that the fund will achieve its return on asset (ROA) objective. The S&P 500 dividends alone account for over 50% of its growth in the last 40 years. This cash flow matching strategy is a return to pension basics. It is also how insurance companies and lotteries work, and quite successfully I might add. Why pension America ever departed from this approach escapes me. But let’s not focus on past mistakes. It is time to use all the tools in our toolbox or arrows in our quiver to help stabilize these critically important retirement vehicles. America’s workers are counting on pension systems to deliver on their promises.
US males have seen their median lifetime earnings collapse relative to those entering the workforce in the late 1960s and early 1970s despite the tremendous cost increases related to housing, post-secondary education, healthcare, etc. One needs not to look any further than the chart below to understand why there is such discontent in the US at this time.
When I entered the workforce in 1981, it wasn’t unusual that your employer had a defined benefit plan, paid all or a significant portion of one’s medical insurance, and may have even supported education by paying for a class or two each semester. Wow have things changed. Today, you hardly find any examples of these being offered. Worse, we now have on-call workforces with little to no benefit of being a “full-time” employee.
Incredibly, lifetime earnings began to retrace at just about the same time that DB plans were supposed to be protected by ERISA. The demise of the private sector DB plan has put significantly more pressure on American workers to fund their own retirement benefits. But how? As the chart above reflects, compensation hasn’t come close to keeping pace with the tremendous growth in living expenses. There is a basic level of income necessary just to just “live” and for a significant percentage of the American workforce, they are not even getting to that level let alone have the disposable income to fund a defined contribution plan.
As I reported last week, it is forecast that 22% of the American adult population will be >65-years-old by 2050. While it is wonderful that we are living longer, not having a retirement benefit means that our golden years will not be so golden. It also means that a significant percentage of our population won’t likely continue to be active participants in the economy, as the average Social Security benefit is only $1,543/month.
There is a huge economic divide in our country. This crisis shows little sign of abating. The lack of a company funded retirement program is not helping.
Just this morning, I read an article from Bloomberg that highlighted the narrowing spreads available on high yield debt. In fact, they are so narrow that we are at historic lows! Here is a chart reflecting that fact:
Yes, the economy is once again opening up as Covid-19 becomes less of an impact and yes, this will positively impact businesses, but how much of the “good” news is already reflected in the prices? Are you really getting compensated for the additional risk?
Then I read a WSJ article, titled “Issuance of Bundles of Risky Loans Jumps to 16-year High”, which referred to CLOs (collateralized loan obligations) seeing a significant renaissance. These securities “buy up loans to companies with junk credit ratings and package them into securities, totaled over $59 billion as of May 20, according to data from S&P Global Market Intelligence’s LCD.” This is a record amount since data was first kept in 2005. The CLO market is now $760 billion. Market participants, BofA and Citigroup, anticipate CLO sales to be anywhere from $290 billion to $360 billion this year, which if realized, would shatter previous annual sales records.
I don’t know what the future will bring for either high yield or CLOs, but I do know that history repeats itself and after 40 years in this business, I’ve seen a lot of history. It isn’t always pretty. Haven’t we lived through previous blow-ups in both high yield and leveraged loans?
Last thought: anytime I hear someone talk about a new paradigm, I cringe, as I remember the late-90s being the start of a “new paradigm” reflecting the dawn of technology and the death of value investing. Oh, yeah, and then there is this beauty of a quote in that WSJ article: “The default environment has been very benign and will be (my emphasis) because the capital markets are open to companies that may be struggling a little bit”. Caveat emptor!
I am really pleased to once again be participating in a CAIA sponsored event. We will be sharing our thoughts on a variety of pension-related issues on June 1st. Please plan to join us.
Let’s talk #pensions. In CAIA’s upcoming webcast, leading experts will have a candid discussion on the #investment repercussions of the recently passed Butch Lewis Emergency Pension Plan Relief Act of 2021 and the American Rescue Plan Act of 2021.
We are working with a public fund prospect on a cash flow matching project to secure benefit payments as far out as the current fixed income allocation will permit. In our normal implementation we would cash flow match each monthly benefit payment (and expenses, if desired) chronologically. This particular project is unique in that this plan is cash flow positive through 2028. The current allocation to fixed income would allow for the matching of benefits from 2029 to 2033. Given the positive cash flow situation we were asked why the plan sponsor should implement the strategy now as opposed to waiting until they become cash flow negative. Good question. Here, I hope, is a better answer.
Ron Ryan, CEO, Ryan ALM, preaches to me and others that the longer the bond, the lower the cost. In addition, the higher the yield, the lower the cost. By implementing our CDI approach in 2021 instead of waiting until 2028, we are able to save substantially more for that four year period then we would if we waited. In fact, by investing in bonds with maturities of 8-12 years, as opposed to 0-4 years, we are getting substantially more yield resulting in cost savings equal to 24.5% on the future benefit payments. A current 4-year implementation beginning one-month out would result in “savings” of only 3-5% given the historically low-interest rates in the 0-4 year range. It is important to note that the savings is realized upfront allowing for the savings to be invested in alpha assets.
Speaking of alpha assets, the plan sponsor can now extend the investing horizon 12-years for the non-bond assets to grow unencumbered. This lengthening of the investment horizon allows for the greater use of less liquid assets since they are no longer a source of cash flow. It should also result in a higher probability of success in achieving the required return on asset assumption (ROA) since bonds will be used exclusively for their cash flows and not as a source of performance.
Cash flow driven investing approaches have been around for many decades. They are the backbone of many insurance products and lottery systems, and once were the dominant strategy to ensure that the promised pension benefit was funded with little to no risk. Unfortunately, we as an industry moved away from this effective strategy and began to focus more on return than low cost and low risk. We believe that CDI strategies work in every market environment, but we believe that they are especially important in today’s low-interest-rate environment in which bonds are not performance drivers.
LOGIC: Uncertainty is risk. It is always more prudent to be able to budget expenses now than to wait for a better opportunity to come along, which just might not.