I stumbled on an article in The Orange County (CA) Register, titled “Pension Obligation Bonds Are A Poor Fix For Pension Debts”. The gist of the argument is that by engaging in the use of a POB, one is simply transferring the debt from the public pension system to the sponsoring municipality, while basically kicking the can down the road to a future generation to pay for the current liability. While there is some truth to the fact that utilizing a POB doesn’t necessarily tackle the underlying issues that got the plan to this point, POBs aren’t necessarily bad on the surface. I believe that they have been implemented incorrectly which has given them the poor reputation that they have in many circles.

Trying to play the arbitrage between the bonds interest rate (say 3.5%) and the plan’s return on asset assumption (ROA at 7.5%) has led to many of the issues.  Trying to time markets is inherently difficult. If a POB is injected into a traditional asset allocation at the top of a market cycle, the sponsoring entity might just realize a significant loss on top of having to repay the bond. The Center for Retirement Research at Boston College has done extensive work on POBs and the aftermath.

We believe that the proceeds from a POB should be used to defease the Retired Lives liability ensuring that the promised benefits are now absolutely protected. The current corpus and future contributions will now go to fund any residual Retired Lives, terminated vested and Active Lives liabilities. Importantly, the plan sponsor now has the benefit of an extended investing horizon in order to generate the necessary return to accomplish the objective, while covering near-term liabilities with the proceeds from the POB. There are no timing games to be played. No lost benefits (multi-employer plans are facing this currently) due to deteriorating funded status.

This cash flow matching defeasement strategy is the backbone of the Butch Lewis Act legislation (H.R. 397) that has passed through the House of Representatives but now awaits action within the Senate. We’d be pleased to share with you our expertise on how one implements a cash flow matching strategy, and why we think that it is superior to injecting POB assets into a traditional asset allocation with the HOPE that markets will behave appropriately.

I am looking forward to speaking at the upcoming IFEBP in San Diego. I’ve been asked to speak about “Modern Asset Allocation”, which is a great topic. One of the key points that I will make is that plan sponsors should be looking to separate their Retired Lives from Active Lives liabilities and as a result, they should split the assets into beta and alpha assets resulting in two very different asset allocations. Historically, assets have been managed within the construct of one asset allocation and for the specific purpose of besting the return on asset assumption. That approach has generally failed, as the primary objective in managing a DB plan should be to SECURE the benefits and not eclipse a ROA target that is a made-up number in the first place.

Retired Lives are the most imminent and most certain liabilities. They are best funded by cash flow matching with bonds. On the other hand, Active Lives liabilities are the longest dated and most uncertain, and as you can imagine, come with a lot of actuarial noise. These assets need time and as a result, they are best funded with Alpha assets, which are your growth assets that are lowly correlated to bonds, as liabilities are very bond-like in nature.

In our modeling, we recommend that Retired Lives liabilities be cash flow matched for the first 10 years. This strategy creates an extended investing horizon for your growth assets (Alpha) that benefit from the passage of time. As the chart below highlights, stocks will outperform bonds over longer investing periods – not always – but with a high probability of success.

The Active Lives liabilities will now be matched against a higher octane portfolio of assets that benefit from the fact that they will no longer be a source of liquidity in the portfolio. As year one passes, extend the beta portfolio back to 10 years and keep this process going each and every year. This strategy works for plans that are well-funded as well as those that are less well funded. Intrigued? Call us.

We are pleased to share with you the latest Ryan ALM quarterly newsletter (9/30/19). As you will see, despite strong market returns achieved so far in 2019, DB pension liabilities have witnessed rapid growth as U.S. interest rates continue to fall, especially in longer maturities. See how pension liabilities have dramatically outperformed asset growth since the end of 1999. This is one of the primary reasons that pension America has seen an amazing exodus from offering DB plans in favor of DC offerings.

We have some other good stuff in this edition. Furthermore, we are always encouraging feedback and challenges to our ideas. Please don’t be shy.  We are here to answer any of your questions.

How have defined benefit plans faired in 2019? That depends very much on how you measure pension liabilities. If you believe that liabilities and assets grow at the same rate (the ROA under GASB), then 2019 is a very strong year for pension America’s public funds and multiemployer plans.  If, however, you believe that liabilities should be measured on an economic value basis, 2019 is proving to be a challenging year once again.

Let’s take a look at the numbers. Using a generic, and fairly conservative, asset allocation to represent pension assets of cash (5%), bonds (30%), domestic equities (60%) and international equities (5%), one gets a return of 15.7% year-to-date through September 30th. For plans that use GASB to measure and monitor liabilities, a 7.5% ROA objective would have liabilities appreciating by 5.6% YTD. Under that microscope, Pension America would be enjoying a banner year.

However, the Society of Actuaries produced a seminal piece in 2004 titled, “Principals underlying Asset Liability Management (ALM)” that stated the following: “Accounting and actuarial measures can sometimes distort economic reality and produce results inconsistent with economic value.” Given their desire to see the facts, and nothing but the facts (thanks, Sergeant Friday), let’s look at how pension America would be doing this year if plan liabilities were shown on an economic basis.  According to Ryan ALM, liabilities valued at the Treasury STRIPS curve would produce a 17.6% year-to-date return exceeding asset growth by 1.9% so far.

For corporate America, the year is even more challenging, as liability growth under ASC 715/FAS 158 would be 21.6% YTD. Ouch! What is right? Do we truly believe that assets and liabilities grow at the same rate? We know that liabilities are highly interest-rate sensitive and are bond-like in their price movement. Do we value equities and bonds at the same growth rate? Of course not. Given the recent significant move down in U.S. rates, liability growth has been robust. What we need is a protracted and sustained period of economic growth, a bit more inflation, and finally rising rates to keep liability growth in check.  In that environment liability growth could actually produce a negative return, making it far easier for assets to outperform liabilities. Regrettably, inflation isn’t on the horizon, economic growth is waning globally, and U.S. interest rates are not likely to rise substantially from these depressed levels. But, pretending that your liabilities have only grown by 5.6% YTD is very ostrich-like.

In keeping with the baseball season, we want to introduce Operation Homerun for defined benefit pension plans. We have a four base strategy for helping plan sponsors circle the bases while securing a pension victory.

First base: Separate Retired Lives (RL) from Active Lives (AL) – RL and AL are two distinctly different liabilities. RL are the most important, most imminent and most certain liabilities while AL are the more volatile causing actuarial noise. Your actuary can easily provide projected benefits for Retired Lives separate from Active Lives.

Second Base: Liability Beta Portfolio (LBP) – Contributions are the first source to fund RL benefits so current assets fund NET RL. Since the pension objective is to secure benefits in a cost efficient manner, only cash flow matching liabilities with bonds can accomplish this objective. We recommend cash flow matching the first 10 years of NET RL.  This will de-risk the plan gradually and buy time for residual assets to fund residual liabilities. Our LBP is a cash flow matching product that will also reduce funding costs by about 4%. The LBP will be an investment-grade corporate bond portfolio that will out-yield a traditional fixed income portfolio. As a result, the plan’s ability to achieve the return on asset assumption (ROA) will not be impaired.

Third base: Asset Exhaustion Test (AET) –  The AET will calculate the economic ROA that is necessary to fully fund all residual liabilities (RL past 10 years + AL). This is in contrast to the AET that is required by GASB 67/68 every two years, but it is recommended that the plan’s conduct the study more frequently. The GASB AET subtracts contributions from projected benefits. This net liability is then funded by current assets at the current ROA to determine solvency. If at some point the assets are exhausted and can no longer fund net liabilities, the discount rate from that point forward will be a 20-year AA municipal bond rate.

Home Plate: Alpha assets – Once the calculated economic ROA is known, the plan sponsor and consultant allocate the remaining Alpha assets (growth assets) with the goal of fully funding residual liabilities by earning the economic ROA. Bonds are removed from this asset allocation since they were used as the Beta assets. exceeding the ROA objective and future liability growth. Importantly, the assets should be allocated to products that have a low correlation with traditional fixed income, as liabilities are bond-like in nature and highly correlated to changes in interest rates. This is the final step of the process. Home plate has been reached and the plan has created a successful asset allocation strategy designed to stabilize the funded status and contribution expense. There is now a glide path in place to further de-risk the plan. As the return generated by the Alpha growth assets exceeds liability growth the excess profits should be ported over to the Beta cash flow matched portfolio which can now be extended to meet more of the Retired Lives liabilities.

Scoreboard: Custom Liability Index (CLI)– To keep score requires a Custom Liability Index (CLI), which calculates the economic liability growth rate while also measuring and monitoring  a plan’s specific liabilities (YTM, duration, interest rate sensitivity, etc.). With this information, the plan sponsor and their consultant can now understand the true funded status and the relative score of assets versus liabilities growth.

We hope that you are enjoying our national pastime’s post-season, and while you are watching we would encourage you to reach out to us for more details regarding our Operation Homerun. It is a winning strategy.

We recently got a question from one of our client’s consultants regarding the use of Callable Bonds in our cash flow matched bond portfolio. The consultant seemed surprised that we would include them in the universe of acceptable investment-grade bonds to use in an immunized portfolio.  Here is the answer from our head of trading that we provided.

“These day’s it is very difficult to find Corporate bonds that do not have a call feature.  The majority of them have call provisions.  The calls are most often “Make-Whole” call provisions. 

A make–whole call provision is a call provision attached to a bond, whereby the borrower must make a payment to the lender in an amount equal to the net present value of the coupon payments that the lender will forgo if the borrower pays the bonds off early.

The call provisions usually can be exercised until three months before the bond’s maturity date.

Although we do not have much choice these days, buying callable bonds is actually a good strategy when one thinks interest rates will stay relatively stable to maybe going down a little too possibly going up.

This is because an investor receives extra yield at the time of purchase over and above the yield on a non-callable bond plus the investor will receive a premium or prepayment penalty when the bond is called due to the Make-Whole call provision. 

The extra yield from a callable bond acts as a cushion if interest rates rise.   

If interest rates stay flat or go sideways no-harm-no-foul because the investor just reinvests into a new bond at about the same yield that he started with plus the investor received the extra yield at purchase plus the premium at the time of the call.  This means a pickup in income over a non-call bond.

If interest rates go down a little say 25 to 50 basis points then the extra yield received upfront at purchase plus the premium at the time of the call will offset some of the loss in yield due to having to reinvest into a lower-yielding bond.

Finally, the Liability Beta Portfolio cash flow matching strategy is 100% focused on income and not total return.  It is true that a non-callable bond will have better total return performance in a declining interest-rate environment but only if one sells the bond before maturity.  And then if an investor sold her non-call bond before maturity to collect a price gain she would effectively be imposing a self-call because then she would have to reinvest into that lower interest rate environment the same as a callable bond investor would.”

I am extremely proud of the fact that my Mom, Sister, and daughter are all nurses, so it was disturbing to read about the nurses and other hospital workers at St. Clare’s Hospital in Schenectady, N.Y, many of whom have lost their pensions completely. A minority of workers there are “fortunate” to have seen only significant benefit cuts.

St. Clare’s, which was founded by the Catholic Church, suffered financial troubles and as a result it was forced to merge into a larger hospital system in 2008. At the time, employees were told that there pensions would be fine, but 10 years later they were informed that there was no money left to provide the promised benefit. Sinful!

Regrettably, the St. Clare’s of the world are not unique. Because of a loophole, many religious organizations are not covered by a federal guarantee (the PBGC) that protects most other workers’ pensions, so the workers can get left with nothing. By one estimate, more than 1 million workers and retirees from religious organizations lack this federal protection.

The AARP Foundation wants people to be held accountable for this disturbing collapse and they have filed suit on behalf of the more than 600 workers who lost everything against the Roman Catholic Diocese of Albany and the pension fund’s board of trustees. I realize that most Americans don’t have a DB pension plan these days, but for those that were promised one and are counting on it for the bulk of their retirement, this development is shocking. It is unfortunate that religious organizations were not mandated to fund the insurance pool necessary to protect pensions from a collapse.  Incredibly, a Supreme Court decision in 2017 made it easier for religious organizations to opt out of the government sponsored insurance pool.

One can only imagine how many of the roughly 1 million workers at these religious institutions are in plans that are in difficult straits. Although St. Clare’s had the opportunity to opt out, they should still have responsibility to the employees who were promised a benefit. It will be interesting to see what transpires with the AARP Foundation lawsuit and whether it will spur those institutions that have opted out to seek alternative insurance protection. More to come.

When I first heard someone mention ASOP 51, I immediately thought that this individual was speaking about Aesop, a slave and storyteller believed to have lived in ancient Greece between 620 and 564 BCE, and one of his many fairy tales.  I suspect that many of our regular readers would accuse me of being the “Boy Who Cried Wolff” for my consistent pronouncements regarding the retirement crisis that continues to unfold.

In September 2017, the Actuarial Standards Board (ASB) adopted a new Actuarial Standard of Practice (ASOP) No. 51 entitled, Assessment and Disclosure of Risk Associated with Measuring Pension Obligations and Determining Pension Plan Contributions (otherwise known as AaDRAwMPOaDPPC or something to that effect). The new ASOP is effective for actuarial work produced on or after November 1, 2018.  It is intended to be used for both private and public pension plans, but not OPEBS.

Importantly, the new ASOP is applicable to actuaries performing funding valuations, pricing valuations, or other, where the actuary is retained to perform a risk assessment that is not part of a funding or pricing valuation. Obviously, risk is in the eye of the beholder, but for this purpose, risk is defined as, “the potential of actual future measurements deviating from expected future measurements resulting from actual future experience deviating from actuarially assumed experience”. And they claim that actuaries aren’t comfortable with small talk at cocktail parties. Phew!

ASOP 51 requires the actuary to identify risks that may reasonably be predicted to significantly affect the pension plan’s future financial condition. Examples include investment risk, asset/liability mismatch risk, interest rate risk, longevity and other demographic risk, and contribution risk. These are all doozies. In addition to identifying the risk, the actuary is asked (required) to assess the identified risk on the plan’s future financial condition. Have you had a conversation with your actuary on how they plan to execute this new requirement?

For decades, Pension America has focused almost exclusively on cobbling together a portfolio designed to exceed the return on asset assumption (ROA), and for decades many plans have failed.  As a result, the ROA objective continues to fall. As we discussed yesterday, in 2010 the median ROA target for public pensions was 8% and today it has fallen to 7.25%. During that period assets have continued to underperform liability growth insuring that plan funded status would decline despite the tremendous equity bull market, while contribution expenses have grown exponentially. Is there another approach that should be explored? Absolutely!

The objective of a pension system is to SECURE the promised benefits in a cost-efficient manner. Unfortunately, there are only two ways to secure benefits: 1) Insurance annuity buyouts, and 2) Cash flow matching liabilities through a bond portfolio. Many believe that duration matching strategies accomplish this objective but they don’t as they don’t have certain cash flows to meet the future benefit payments.

Importantly, getting ones arms around the promised benefits (plan liabilities) is the only way that a DB plan can de-risk. Through becoming more liability aware a plan sponsor can acquire the following:

• Greater transparency of the plan’s unique liabilities in multiple dimensions – discount rates based on GASB (ROA), FASB and a risk-free rate (STRIPS)
• Enhanced knowledge of both cash flow and liquidity requirements
• Greater accuracy in calculating the TRUE return on assets (ROA) that is required in a test of solvency
• The ability to establish a cash flow matching bond portfolio created to meet benefit payments
• Stabilization of both the funded status and contribution expense
• A much longer investing horizon for the portfolio’s growth assets in order to fund future liabilities
• Reduced costs
• Peace of mind that benefits are secure for the next 10 years or so (depends on funded status)
• Enhanced viability of the pension system

These benefits seem to be pretty significant, yet many plans fail to gain these advantages. Regrettably, most plans only get a once-per-year view of their specific liabilities, which is too infrequent to engage in these important activities. There are many reasons why we’ve witnessed a dramatic reduction in the use of defined benefit plans. Becoming liablity aware will help secure those that remain. Our participants are counting on our industry to take a different path to help them achieve a prosperous retirement.

The Florida Public Pension Trustees Association (FPPTA) will be hosting their next Trustee School event from October 6-9 at the Sawgrass Marriott.  My partner, Ron Ryan, will be speaking once again to the trustees and others that will be in attendance. His session: