What’s Lurking Below The Surface?

Keith Jurow, an excellent real estate analyst, has published another piece on the current state of home ownership in the U.S. His latest article can be found as an opinion piece on the MarketWatch website. Titled, “The COVID-19 lockdown is squeezing real estate from all sides and threatens to burst the housing and mortgage bubble”, this article is scarier than a Steven King plot. Although things appear relatively calm on the surface, Keith points out that rough seas are about to set upon us.

I would encourage you to read his article, especially if you are a current institutional owner of real estate or more importantly, thinking about increasing your allocation. Here are some of the low lights:

In New York City, sales in July collapsed by 35% from July 2019. Even worse for New York, listings soared by 65% in July as residents continued to flee the lock-down calamity in the Big Apple.

Online apartment broker Apartment List publishes a monthly survey of roughly 4,000 renters and homeowners. The most recent survey published in early August found that 33% of those surveyed had been unable to make a full rent or mortgage payment the first week of August.

Denver — one of the hottest markets in the nation a few years ago – led the nation in August with 41% of home sellers compelled to reduce their asking price.

The latest survey published by the National Association of Independent Landlords (NAIL) revealed that the percentage of small landlords who received a full rent payment from their tenants plunged to 55% in June from 83% in February. As a point of reference, there are roughly 15 million small landlords who count on this income to support their livelihoods and properties.

These are but a few of the frightening statistics that Keith shares in his article. Covid-19 has delivered a significant blow to our economy. Likely not strong enough to knock us out, but it certainly has us staggering. Some sectors will recover nicely, but like the equity market (S&P 500 -2.1% as I write this) many will take much longer to regain their footing. Pension systems cannot just do the same old, same old, and expect a different outcome. Caveat emptor.

It’s Just Not Right!

Why do we need pension reform? Here is another example of action being taken by a pension system as it tries to protect what little is left in the pot. The Teamsters’ Building Material Drivers Local 436 Pension Fund of Valley View, Ohio, has applied to the Treasury Department for a reduction in benefits under the Multiemployer Pension Reform Act of 2014 (MPRA). Without these cuts, the plan is expected to deplete the fund’s assets by 2023.

Under the board of trustees’ proposed reduction plan, the benefits of plan participants would be reduced to 110% of the Pension Benefit Guaranty Corporation (PBGC) guarantee, which is the maximum reduction in benefits allowable by law (aren’t they so generous). Remember, this is a multiemployer plan, and not a single employer plan that has the PBGC protecting benefits to as much as $67,295/year for a 65-year-old. No, the benefits are protected at just $12,875 for a 30-year veteran at age 65. Shocking? Absolutely!

There are some minor exceptions to how much the benefits can be cut. For instance, excluded in the benefits reduction under federal law are disabled participants and their beneficiaries, and participants who are at least 80 years old on May 31, 2021. The benefits of participants who are at least 75 years old as of that date, and their beneficiaries, are partially protected, and the older the person is, the less the benefits can be reduced. How magnanimous!

Can you imagine investing more than 30 years in a career only to be told that your promised benefits are to be reduced despite the fact that the participant likely contributed to the plan, while also deferring salary increases? Worse, the US government is sanctioning this activity. Just how bad is the impact? Well, a member who has 32 years of credited service who will be 70 years and 5 months old as of May 31, 2021 would see their $2,148.24 monthly benefit reduced (slashed, gashed, hacked) to $1,258.40 beginning on May 1, 2021, under the proposed reduction plan.  Can you believe that a 70-year-old, who has likely been retired for years, is going to be whacked with a nearly $900/month cut. How are they to make up for that loss?

Please don’t think that this is an isolated event. As we’ve been reporting for years, there are more than 130 plans and nearly 1.5 million American workers who are on the verge of receiving draconian cuts to their promised benefits. The impact of these cuts won’t just be felt by the individual participants and their beneficiaries, but also the communities that they live in that depend on their spending to support local businesses.

Action to sure up our pension system is long overdue. A further delay is not acceptable.

At What Point Does It Matter?

I was reading a research report from Fitch related to a Prince William County bond issuance. The proceeds from the bond sale would go to support a number of school projects – great. That is fairly standard and necessary. What concerned me was the following line that appeared under the header “key rating drivers”. The last line of the analysis stated: “The county enjoys strong control over revenues given its independent legal ability to increase property taxes without limitation”. Wow, do they really believe in this difficult economic environment that residents of these various states, counties, and municipalities will provide these taxing authorities carte blanche to raise taxes “without limitation”?

We are seeing the impact of unabated tax increases on populations throughout America. States like Illinois, New Jersey, Connecticut, New York, etc. are suffering from out-migration trends that damage the long-term economic outlook. There is definitely a need to continue to invest in schools, bridges, roads, pensions, etc, but to think that there is no limitation is just silly!

The US Government’s Thin Mint?

All of a sudden the US Senate has reached its limit on what can be spent? We are in the midst of an estimated $3.8 trillion budget shortfall for 2020. To put that in perspective, the previous budget deficit record was $1.4 trillion set in 2009. Do Senators fear that the Butch Lewis Act (multiemployer legislation), which continues to be ignored, would be analogous to Mr. Creosote’s thin mint (Monty Python’s “The Meaning of Life”)?

The Senate refuses to address the Butch Lewis Act because it doesn’t produce shared sacrifice. This legislation was estimated to cost $31.9 billion when it was last scored in July 2019. That is a 10-year score or just under $3.2 billion / year. An annual cost of $3.2 billion on a budget deficit of $3.8 trillion seems as if it wouldn’t carry the same weight as Mr. Creosote’s aforementioned thin mint!

But, here we sit. Senator Rob Portman (R, OH) who sat on the Joint Select Committee that failed to come up with proposed legislation to improve the financial future for roughly 130 failing multiemployer systems has recently been on the Senate floor imploring his fellow Senators to pass pension reform legislation.

Senator Portman was recently asked if it was appropriate to blame Senate Majority Leader McConnell for blocking the Senate’s ability to get pension reform done, including not taking up the Butch Lewis Act or the Heroes Act (which included pension reform). His response: “In order to solve this, both parties must work together to achieve consensus in both the House and Senate. The proposal passed by House Democrats only uses taxpayer money to bail out these plans – and there is no bipartisan support for it in the Senate. Republicans have reached out to Democratic leaders in the House and Senate to try and discuss a shared responsibility approach that can gain consensus in both chambers.   We’re ready to find an acceptable compromise that works for both parties.”

So, I repeat, the Republican-led Senate was fine passing a series of stimulus packages that resulted in a massive deficit, but legislation to support nearly 1.4 million American workers, who I remind you are also taxpayers, is a no go? This rounding-error of a proposal also provides great economic stimulus to the local communities in which the plan participants live. Given the economic hit that many communities/states have endured this year, one would think that our leadership would be looking for any way possible to produce economic activity that might just create or maintain jobs.

Let’s stop playing games with the financial future for these Americans who have done nothing wrong. They showed up to work with the promise of a pension upon retirement, while often deferring salary increases to help support those pension promises. Pension reform has been kicked down the road for too many years. There is nothing left of the proverbial can at this time!

It Shouldn’t Be The Participants’ Responsibility

I wasn’t always a fan of pension obligation bonds (POBs), as study after study revealed in most cases that pension plan sponsors that had issued a POB failed to improve the long-term financial viability of the program. The Center for Retirement Research at Boston College has produced a couple of studies related to the success(?) of POBs. Their last update was in July 2014. Their analysis makes some of Steven King’s most frightening plots seem like little more than a fairy tale.

It would be very appropriate to ask me why the change in opinion nearly 40 years into my career. Well, you can thank my involvement in the Butch Lewis Act (BLA) for adjusting my opinion. I’ve expressed my feelings about the BLA legislation many times during the last several years, and for the record, I still believe that this legislation would accomplish the goal of securing the promised benefits for participants in critical and declining multiemployer plans. It is truly sinful that the financial well being of 1.4 million Americans, who are in these struggling plans, hangs in the balance because the US Senate has failed to act.

That said, the BLA team put together a strategy to stabilize these trouble plans by departing from the status quo of trying to maximize returns and instead focused on securing the promised benefits by defeasing the Retired Lives Liability with the loan proceeds. Brilliant! This action enabled the plan sponsor to use the fund’s current assets and future contributions to meet future liabilities and the repayment of interest and principal on the loan, because the defeasing strategy bought essential time for the plan.

Unlike that which we’ve witnessed in many public pension systems throughout the country since the Great Financial Crisis (GFC), this proposed legislation did not achieve financial security on the backs of the participants. In fact, for multiemployer plans that had already gotten approval from the DOL to reduce promised benefits, the original benefits would have to be reinstated should they wish to take a loan out to further stabilize their system. Importantly, there was no calling for increased contributions from employees, longer careers until full benefits were achieved, increased retirement age, reduced benefits, etc.

The proposed legislation worked because the “reforms” were to be adopted by the sponsor and focused on how they managed the plan’s assets.

Taking the proceeds from the POB and injecting them into a traditional asset allocation subjects those new assets to all the risks of the markets with NO guarantee of achieving success. The arbitrage that they are seeking to capture between the target ROA and the interest on the bond comes with great risk. By defeasing the Retired Lives Liability the plan is no longer engaging in a game of chance, but is instead protecting all of the entities that ultimately fund that monthly benefit payment.

Given the current financial condition for many public pension systems, significant funding gaps are not going to be closed through annual budget contributions and market returns. These significantly negative cash flow funds must receive a financial lifeline to stop the bleeding before they are nothing more than pay-as-you-go entities. The POB, long distained by me, is the best option at this time. The fact that we are in an historically low interest rate environment only makes the use of these financial instruments more appropriate. But, time is wasting.

A Very Damaging Trend

In a blog post from yesterday, titled “Same Old Story”, I wrote the following: for those individuals who either chose to retire or were forced to retire prematurely through job losses in 2007-2008, they had no time to make up for the catastrophic decline that turned their 401(k) into a 201(k). I remain very concerned about the American worker who involuntarily “retired” following a job loss that occurred later in one’s working career. But is my fear rational? Well, yes!

The New York Times has recently published an article, “When Retirement Comes To Early”, that specifically speaks to the troubles that older Americans have when they are involuntarily removed from the labor force. There was a time that older workers were held in high regard because of the experience that they had garnered, which lead to greater compensation and generally more protection during recessions. Regrettably, that “premium” has dissipated and the protection of experience is no longer evident during difficult economic times, including our current economic crisis.

Just how bad is this trend? According to an Urban Institute study that followed 2,000 full-time employees with generally higher levels of education than that of the average 50-year old and above from 1992 to 2016, nearly half of this cohort suffered an involuntary job loss. Incredible! According to Teresa Ghilarducci, a labor economist at the New School (and some one that I know and admire for her work) the coronavirus and recession that followed have intensified job insecurity for older Americans (people like me!!).

According to the New School’s Retirement Equity Lab, 2.9 million workers age 55-70 have left the labor market since March, and they were counted as having left because they were neither working nor actively looking for employment. Worse, they are predicting another 1.1 million older Americans will suffer a similar fate by November. When a job loss occurs at an older age there is less time for the employee to recover financially, which can create a series of spiraling events from bridging the unemployment with savings, to taking Social Security prematurely, to taking on debt.

Outrageously, only 1 in 10 of those suffering an involuntary job loss ever earns as much again. At age 65, “their median household income was 14% lower than for those that were not pushed out”. Just as bad, it takes older American workers longer to get back into the workforce. For those 62-years-old or older, only 41% had found employment within 18 months of their layoff. As a comparison, for those age 25-49, 78% had been hired within the next 18-months.

With regard to the financial hit of losing a job later in one’s career, many American workers are truly only able to begin to sock away money after paying for their home, raising their children, and meeting other more immediate needs. It is great that workers over 50-years-old have a make-up contribution of $6,000 available each year, but according to Vanguard only 15% of older workers take advantage of this elevated contribution limit. That isn’t surprising since most Americans don’t come close to earning $100,000, so the thought of contributing $25,000 is a pipe dream for a vast majority.

Losing a job later in one’s career that forces workers to forgo important saving years is very challenging. Compound that experience with having to tap “retirement” funds prematurely or take on additional debt or access Social Security earlier than desired and you’ve created a formula for financial disaster. Regrettably, this is what is transpiring today.

We need to do more for our workers. Financial security won’t happen for most of us if defined contribution plans are the only game in town. We need to preserve DB plans for the masses. We also need to consider extending unemployment insurance benefits, raising Social Security benefits, and providing an enhanced healthcare benefit. We don’t have the money, you say? We’ve proven that we do through the recent Federal stimulus programs. Remember: federal deficits translate into private sector spending. We need all the economic activity that we can muster at this point.

That is enough for today.

Same Old Story!

The WSJ is hailing the individual investor boom as if it is something new. They are attributing this explosion of activity, roughly 20% of the daily trading volume, to new phone apps, a bull market fueled by technology stock leadership, and more time on their hands, as a result of Covid-19 lock-downs. Though some of that might be true, the real reason, in my very humble opinion, is the fact that Federal Reserve policy has driven US interest rates to historic lows FORCING retirees and near-retirees to pursue riskier investing strategies to create any return on their investment.

The fact that equity markets are at all-time highs fueled by incredible federal stimulus and not the underlying fundamentals of the US economy is scary enough. Individual investor participation at twice what it was in 2010 is truly frightening, and it puts these “investors” in a very precarious position. As we mentioned in a previous post, the $1 million retirement account goal that might have produced $50,000 per year through dividends and interest years ago needs $3-5 million today to generate that same amount.

The demise of the defined benefit plan in lieu of defined contribution plans forces untrained individuals to fund, manage, and then disburse their retirement benefit with little knowledge. Worse, there is no longevity pooling of the risks. For those individuals who either chose to retire or were forced to retire prematurely through job losses in 2007-2008, they had no time to make up for the catastrophic decline that turned their 401(k) into a 201(k).

As history has shown, it won’t be different this time!

Come On, Folks!

Roughly at this time every year, we start to get the reporting of fiscal year pension returns for the various state and municipal public plans, and every year we get the same mixed message. I happened to catch a glimpse today of a recent report that had a mid-Atlantic fund up 3.6% for the 12-months ending June 30, 2020. Interestingly, the sub-title of the article was “Fund beats its benchmark to raise its asset value to $54.8 billion.” Well, isn’t that just grand that the fund beat the total fund asset benchmark by 0.44%!

Further down in the article it was mentioned that the fund’s return on asset objective is actually 7.4%. Based on this comparison, the plan trailed their yearly objective by 3.8%. As everyone knows, these plans must make up in contributions what the plan fails to generate in return. However, it gets worse: in highlighting the performance of the various asset classes, it was noted that the fund’s “rate-sensitive investments” were up 18.1% during the year, while cash was the second-best performer at just over 5%.

“Rate sensitive investments” is another way of saying bonds. What the article didn’t discuss was that plan’s liabilities, which are bond-like, as they move with changes in interest rates just like bonds, would have been up at least 18% as liabilities grew substantially with the massive decline in long-term interest rates. So, not only didn’t the fund meet its ROA objective, the asset side of the equation dramatically underperformed plan liabilities. Although assets may have grown to $54.8 billion, the plan’s funded status would have declined significantly.

Being a plan sponsor is a very difficult task, especially in this environment where state and local budgets are being negatively impacted by Covid-19 events and the likelihood of catch-up contributions being nothing more than a pipe dream. Masking the true nature of the funding problem only exacerbates this difficulty, as decisions are often made based on incomplete data.

A Difficult Job Made More Challenging – Part II

On Tuesday I shared with you my thoughts related to the difficult job facing asset consultants in this market environment. Today I share with you a wonderful chart prepared by Callan Associates and extracted from the WSJ (thanks, Chris) that highlights exactly what I was describing.

As recently as 1995, a pension plan could invest 100% in U.S. Bonds and generate a return that was commensurate with the plan’s return on asset objective, and they could get that return with a very modest 6% standard deviation. In 2005, pension systems could still put significant assets to work within Bonds (52%), but had to diversify into other asset classes in order to achieve the same 7.5% projected return. Although the standard deviation increased, it did so marginally.

By 2015, we had an incredible situation in which a 7.5% forecast return comes with a standard deviation of 17.2%. What does that mean? Well, it means that 68% of the time the return that a plan can expect to receive will be between 7.5% +/- 17.2% or -10.7% to +24.7%. Worse, a plan should expect 95% of the time to have that performance fall between -27.9% and +41.9%. Wow, you could drive a dozen semis through that gap! Furthermore, the fund’s new asset allocation has introduced the plan to greater complexity and transparency issues. Do you think that 2020’s asset allocation needs will be any better than 2015’s? No way! Interest rates continue to decline to historic levels, while equity valuations are stretched creating a challenging combination, and alternative investments are not a panacea either.

As we’ve mentioned many times, one way to reduce the annual standard deviation associated with today’s markets is to cash flow match near-term liabilities through the matching of benefit payments and expenses with the cash flow from a Liability Beta Portfolio (bonds). Adopting this strategy will significantly increase the investing horizon for the non-cash flow matched assets and dramatically reduce the variability that one should expect given a 10-year view, as opposed to managing one year at a time. Furthermore, the bonds that remain in the portfolio will be used solely for their cash flow and NOT as a performance generator, especially difficult given the low rates.

Given what has happened to state and municipal budgets, additional contributions are not on the table as a way to make up for underperformance relative to the 7.2% average ROA for public plans. Worse, they certainly can’t afford to have another 2 standard deviation event that has their total fund down >20%. Think that isn’t likely? Just remember 2001, 2008, Q1 2020, etc. Let’s talk!

A Difficult Job Made More Challenging

The asset consultant has always been tasked with a difficult assignment, as they try to secure the promises (benefits) that have been made by their client to the client’s plan participants.

When I first got into the pension/investment industry in 1981, asset consulting was still in its infancy. The job at that time was easier in the sense that U.S. interest rates, both long and short, were providing double-digit returns, and a traditional 60/40 asset allocation (equities/bonds) was providing more than enough return to meet the long-term return objective (ROA). In fact, the average yield in 1981 for the U.S. 30-year Treasury was an incredible 13.45%.

As we’ve moved through time, U.S. interest rates have plummeted to where the U.S. 30-year Treasury bond is now yielding 1.42% (8/18 at 9 am) and a traditional 60/40 asset allocation will likely not produce anything close to what plan sponsors need to meet long-term funding requirements. In addition, as more and more money is put to work in a variety of asset classes, expected returns continue to be compressed to the point that the average manager of domestic active strategies for both equities and fixed income have failed to exceed their benchmarks on a fairly consistent basis.

Asset consultants are thus tasked with two major challenges: asset allocation and manager selection, both of which have become incredibly difficult. With regard to asset allocation, the original 60/40 asset mix has evolved into a much more sophisticated blend of traditional and alternative investments that often require the plan sponsor to learn a completely new vocabulary. They also present challenges related to liquidity, fees, transparency, etc.

Manager selection requires a consultant’s research team to dive deep into an asset manager’s investment process to determine if the stock (or bond) selection criteria still have forecasting ability. If they do, have those ideas been eroded over time as more money chases too few good ideas creating a hurdle to achieve the forecast excess return objective. This is absolutely an unenviable task. We witnessed a collection of systematic managers go through a period of outrageously poor performance in the late ’00s, as too much money was chasing the same ideas. These managers didn’t get stupid overnight. The fundamentals of the market changed without warning.

Given the current environment for DB pension plans, mistakes regarding either asset allocation or manager selection cannot be tolerated. The idea that public or multiemployer DB plans can make up for difficult investing environments through greater contributions is just not based in reality. What the asset consultants need today is greater certainty than ever before. They need to know that the plan’s benefits are secure and that the long-term return objective will be achieved with moderate risk. Again, this is not an easy task.

That said, we believe that a Cash Flow Driven investing approach (CDI) is up to that challenge that will help asset consultants and plan sponsors accomplish both objectives. As a reminder, a CDI process matches cash flows from bonds with monthly benefits and expenses. It doesn’t matter whether interest rates are rising or falling or if spreads among various fixed income instruments are widening or narrowing. All that matters is that the cash is there to meet the plan’s cash flow needs. While this is occurring, the remainder of the portfolio, especially important for the alternative investments, has bought time by extending the investment horizon in order to capture the liquidity premium that exists in those strategies.

The securing of the plan’s benefits and expenses is THE primary objective in managing a DB pension plan. Wouldn’t it be so comforting to be able to tell a plan sponsor’s participants that their benefits are secure for the next 10 years? I know that if I were back on the consulting side of our business where I’ve spent about 20 of my 39 years, I would want to engage in a strategy that removes so much risk from the equation.

As a result of adopting a CDI approach, I would no longer be worried about liquidity to meet benefits, interest rate risk in this low-interest-rate environment, or manager selection risk in choosing the “right” fixed income manager. I would be able to focus my attention on putting together a world-class alpha portfolio consisting of traditional and alternative strategies to meet the long-term return needs that now have 10-years to achieve the objectives. With the longer the investing horizon, we greatly increase the probability of success. Let’s improve the odds!