Since peaking at $68,789 per Bitcoin on 11/10/21, the price has fallen by more than 35% to just over $44,000 as I write this note. So much for the inflation hedge expectation and uncorrelated nature of this entity to other “asset” classes. Furthermore, it continues to trade like a “meme” stock. Oops!
Thank you, Alanis Morrissette, for coming up with a song title that is just perfect for today’s blog. Many industry practitioners have been complaining loudly, including us at Ryan ALM, that the discount rate used in the ARPA legislation (the 3rd segment under PPA + 200 bps) is wrong! This discount rate understates the “true” level of a plan’s liabilities. Instead of the one that was in the legislation, we should be using all three segments under PPA without any additional basis points penalty. As a result, the Special Financial Assistance (SFA) is much smaller than these struggling pension plans should be getting to fortify their funded status and preserve the promised benefits to pensioners through 2051.
However, many of the same industry voices are arguing that it is absolutely appropriate to use the return on asset assumption (ROA) to value a plan’s liabilities on an ongoing basis. HUH? Public pension systems operate under GASB accounting rules that permit this inappropriate accounting methodology instead of the discount rate required under FASB, which is much more of a true market-based rate. Multiemployer plans operate under a FASB hybrid system, with many (most?) using the ROA to “value” their plan’s liabilities. As a result, most multiemployer pension plans have funded ratios that are overstated, as their plan’s liabilities are understated in this historically low-interest-rate environment.
This action causes many problems, including the belief that the “ONLY” objective for multiemployer plans is to achieve the ROA! That is so wrong! The primary objective in managing a pension plan is to SECURE the promised benefits at a reasonable cost and with prudent risk. The pension objective is absolutely not to achieve a ROA target that in many cases has been determined through a “Goldilocks” approach. Pension plans of all types have been hurt by the significant decline in US interest rates since the bond bull market began in July 1982. As a result of this incredible fall in rates, the present value of plan liabilities has grown disproportionately relative to the benefit that the assets would have gained from a similar fall in rates, given the difference in the duration of a plan’s liabilities and its average fixed income exposure.
However, the absence of a true focus on pension liabilities, especially among public and multiemployer plans, masks this development. It doesn’t mean that the problem isn’t real, it does mean that many decisions with regard to asset allocation and benefits have been based on the wrong set of valuations. Now is the time for a re-thinking as an industry no matter what the accounting rules might suggest. After 39-years of US rates falling to incredibly low levels, we may finally be on the verge of seeing rates rise given the current inflationary environment. If rates rise, the present value of your plan’s liabilities will fall. In this scenario, a plan “wins” if assets outperform plan liabilities whether the targeted ROA is achieved or not. A 3% absolute return on pension assets outperforms a -3% on liabilities growth rate. It won’t take much of a backup in rates for a plan’s liabilities to dramatically underperform.
Most pension systems have an average duration of their liabilities between 10-15 years depending on the maturity of the plan. In an environment in which US rates move 100 bps higher, a plan with a 12-year duration would see the present value of those liabilities decline by 12%, and with a YTM of liabilities (@ 2%) the pension plan experiences a -10% liability growth rate. A plan’s assets achieving only a 3% return would look heroic relative to liabilities despite not achieving the ROA’s hurdle. During the truly remarkable decline in rates, pension liabilities dramatically outperformed assets, even for those plans that regularly achieved or exceeded their return target.
So, is the SFA understated because of the wrong discount rate being used, or is the average multiemployer pension system’s funded ratio/status wrong because we are hiding behind accounting rules that mask the true story? Unfortunately, it is both! As an industry, can we finally commit to a TRUE accounting of our liabilities? Not having the truth means that actions taken are likely based on the wrong set of data which will invariably lead to the wrong conclusions. Ron Ryan wrote an award-winning book several years ago titled, “The U.S. Pension Crisis”. He lays the blame for our current situation on the “inappropriate accounting rules”. I couldn’t agree more. Pension America’s DB plans need to be protected and preserved, but that won’t happen until we truly know the scope of the funding issues.
As anyone knows who regularly follows this blog, Ryan ALM and I are huge fans of defined benefit pension plans (DB), and we work tirelessly trying to preserve and protect them. This doesn’t mean that we don’t appreciate defined contribution plans (DC) – we do – but supplemental (to DB plans) as savings vehicles. We also understand the motivation on the part of sponsors to migrate from DB plans (they don’t want to own the liability), but we still feel that it is an unfortunate trend. All that said, 2021 was a terrific year for sponsors of DB plans whether they were public, multiemployer, or private pensions. Capital markets and legislative initiatives combined to create an extremely favorable environment for Pension America. A year in which the average funded status improved, and in some cases, to levels not seen since the end of 1999. There are so many possible highlights to focus on, but I want to keep this post relatively short, so I’ll focus on the American Rescue Plan Act (ARPA), pension obligation bonds (POBs), equity markets, and US interest rates.
Legislation: It was extremely disappointing that the Butch Lewis Act (BLA) was never taken up by the US Senate in 2019, but we did get “Son of BLA” in the form of the American Rescue Pension Act (ARPA). This legislation was passed and signed into law in March. The Pension Benefit Guaranty Corporation (PBGC) was tasked with implementing this legislation. We are pleased to see following months of review, the “First Tier” applications are finally being approved (two so far). The Special Financial Assistance (SFA) will begin to flow to these plans soon. As a reminder, these grants are being given to multiemployer plans that are in Critical and Declining status and either currently insolvent or on the verge of insolvency. Importantly, benefits to participants that were cut under MPRA are to be reinstated if their pension plan receives an SFA grant.
Pension Obligation Bonds (POBs): Municipalities and states are aggressively using POBs to improve the economics of their pension systems. The historically low US interest-rate environment is providing a unique arbitrage opportunity. POBs have been around since the mid-’80s, but the pace at which they are being offered has established a new record. Only 2003 saw more $s committed to POBs than in 2021. Several entities, including the Center for Retirement Research at Boston College and the League of Municipalities, continue to be opposed to their use. We, at Ryan ALM, are supportive of POBs provided that the proceeds from these bond offerings are used to defease the plan’s Retired Lives Liability and NOT injected into the plan’s existing asset allocation, especially given current market fundamentals and valuations for both bonds and equities. Ryan ALM believes that POB proceeds should mirror the same asset allocation and objective of ARPA – secure the benefits! Plan Sponsors should invest POB proceeds in investment-grade fixed-income securities to defease projected benefits chronologically.
Equity Markets: The US stock market, as measured by the S&P 500 is up more than 27% YTD. This is the second-best annual return since 2013’s +32% result. Despite the wonderful performance result, all is not rosy. The Federal Reserve’s historic stimulus has potentially created an asset bubble rarely seen before. Equities have benefited tremendously since the Great Financial Crisis through this abundant liquidity (QE1, QE2, QE forever). Despite the stimulus, GDP growth has been modest at 2.3% per year since 2010. Wage growth, until recently has been weak with real annual increases of only 0.26% compared to 0.7% during the ’90s, and the labor market, as measured by the Labor Participation Rate, has shrunk to levels not seen since 1976 (<62%). Furthermore, roughly 85% of active equity managers have failed to beat the S&P 500 this year. A major contributor to this relative underperformance is the concentration within the S&P 500 to mega Technology stocks that continue to lead markets higher. This concentration in leadership tends to favor passive investment vehicles and 2021 is no exception. We should all be asking what the next 10-years will bring for equities.
US Interest Rates: The onset of Covid-19 brought the US economy to its knees in early 2020. As a result, US interest rates fell to levels not seen before (1.02% for the 30-year and 0.50% for the 10-year). As we began 2021 expectations were firmly established that rates would have to rise, and that expectation was quickly realized, as the US 30-year Treasury Bond saw its rate rise from 1.66% on the first trading day to 2.46% by early March. With inflation picking up to levels not seen since the early 1980s, most market participants felt that rates would continue to rise throughout the year and into 2022. Well, that didn’t happen, and as of today’s writing, the yield on the US 30-year Treasury sits below 2%. Will it remain there? Unlikely, as the Federal Reserve is expected to raise short rates at least 3 times next year. For pension America, any rise in rates helps reduce the present value of a plan’s liabilities, but it can be nasty for the plan’s fixed-income exposure if the allocation is focused on total return and long maturities.
So, in conclusion, 2021 was a terrific year for pensions. Now what? Given the improved funding and general expectations for more challenging environments for both equity and bond markets, plan sponsors should seriously consider reducing risk. It would be a travesty to waste all this good news by letting asset allocations remain static and subject to the whims of the markets. Use this unique time to reconfigure your fixed-income exposure to better manage assets versus plan liabilities. This reconfiguration will dramatically improve the plan’s liquidity while eliminating interest rate risk for the portion of the portfolio that will now focus on defeasing liabilities. This action will also buy time for the plan’s alpha assets (non-fixed income) to grow unencumbered, as they are no longer a source of liquidity to meet benefits and expenses. Furthermore, the buying of extra time allows markets to recover should we witness another major market correction. As we conclude 2021 we celebrate the great success enjoyed by Pension America. But, now is not the time to sit on one’s laurels.
The passage of the American Rescue Plan Act (ARPA) earlier this year was wonderful news for struggling multiemployer pension systems. For those Tier one plans eligible to file for Special Financial Assistance (SFA) immediately (July 2021) it was the life preserver needed to keep these plans afloat. For Tier 2 filers (beginning December 27, 2021) it is an opportunity to reinstate previously cut benefits under MPRA making whole participants who have struggled under the unfair economic burden brought on by sometimes massive reductions. Given these developments, I hesitate to once again raise concerns about the legislation and possible PBGC rule changes.
The PBGC was tasked with providing ARPA implementation rules. They presented their “Interim Final Rules” this past July. Those rules were met with a lot of industry blowback, especially as it related to the discount rate used to value plan liabilities, potential investments in the segregated SFA bucket, and the calculations used to determine the possible SFA allocation in the first place. Both Ron Ryan and I submitted comments to the PBGC during the feedback period. I won’t rehash those now. That said, I am very concerned about one possible revision that I am hearing may be included in the PBGC’s “Final Final Rules” that might be released as soon as January 2022.
The original intent of this legislation was to provide funding that would “ensure” benefits and expenses were paid for 30-years or until the end of the plan year 2051. Based on how the SFA is to be determined that “goal” is nothing more than a pipe dream. Based on our analysis and those of other industry experts, we believe that most plans won’t receive enough SFA funding to be able to protect benefits beyond 8-10 years. The disconnect is startling!
Currently, the SFA assets are only permitted to be invested in investment-grade (IG) bonds, with a maximum of 5% held in high yield securities, but only if they were originally purchased as IG bonds. There is also a provision within the legislation that allows for the PBGC to determine potentially other investments as being acceptable, too. In their Interim Rules, they did not expand the list of permitted investments, but we are hearing rumors that the January Final Rules may include an expanded list. This is where I am most concerned.
If the original intent of the legislation was to “SECURE” the promised benefits, how does expanding the list of acceptable investments to include equities (my guess) do anything to secure those promises? The PBGC was right in limiting the original list of permissible investments to only IG bonds. Bonds are the only asset with a known terminal value and cash flows that have been used for decades to defease liabilities (lottery systems, insurance companies, and yes, pension plans). The SFA assets should be used to defease the plan’s liabilities as far out as possible. This is a “sleep well at night” strategy that ensures those promises will be met for as long as the SFA assets exist. While the segregated SFA portfolio is paying benefits (and expenses), the legacy assets and future contributions can grow unencumbered. It is in this portfolio (alpha/growth) where the list of acceptable investments should be as broad as possible.
One can debate all they want about the current valuations for US equities, but the fact remains that equities are much more volatile than bonds. Given that the SFA assets are likely much smaller than needed to ensure 30-years of benefit payments, why does a plan, their consultant/actuary, or the PBGC want to inject more risk into the process potentially reducing further the timeframe to meet benefits? One doesn’t have to go back too far in history to know that we’ve experienced two shocking market corrections in the last two decades. Do we really want 8-10 years of “guaranteed” benefits to become 4-5 years or worse?
If the PBGC does anything to “improve” the Interim Rules they should address the discount rate embedded in the legislation. It is the use of the 3rd segment (PPA) plus 200 basis points that is having the greatest negative impact on the amount of the SFA to be received by these troubled plans. The use of an appropriate discount rate of all three segments under PPA with no added kicker would dramatically increase the size of the SFA and guarantee many more years of benefit coverage. But we know that the cost of this legislation (roughly $95 billion) is a source of “great concern” despite the government spending trillions of $s on other projects. Expanding the list of permissible investments does very little to secure more benefits, but it would dramatically increase the uncertainty regarding how many years of benefits are actually protected. More to come!
Christmas came early for participants in the Idaho Signatory plan. The Pension Benefit Guaranty Corporation (PBGC) announced on Thursday, December 23rd that it had approved the plan application for the Idaho Signatory Employers-Laborers Pension Plan (Idaho Signatory) in Portland, Ore. The plan covers 682 participants in the construction industry and will receive $13.9 million in special financial assistance (SFA), including interest to the expected date of payment to the plan.
The plan, like the other 19 that have filed for the SFA in tier one, was expected to run out of money in 2022. In their announcement, the PBGC indicated that as a result of this grant the benefits paid to participants would average about 15% more than the PBGC “guarantee” had the application been denied and the plan been absorbed by the PBGC’s insurance pool. This accepted application is the second to be approved in the last week. Hopefully, we’ll continue to see grants approved for all the plans filing for this absolutely necessary support.
In yesterday’s post, we speculated that we might hear something by the end of the day regarding the acceptance or rejection of Local 138’s ARPA application for Special Financial Assistance (SFA). I’m thrilled to report that the PBGC sent out a press release yesterday afternoon announcing that Local 138’s application had been supported. According to the release the “Local 138 Pension Plan based in Baldwin, N.Y., which covers 1,723 participants in the transportation industry, will receive $112.6 million in special financial assistance, including interest to the expected date of payment to the plan.”
As we also mentioned in recent posts, “Final, Final Rules” on how to invest the proceeds have not been announced. In their release, the PBGC stated that they are reviewing the feedback received following the release of the “Interim Final Rules” in July and that the Final Rules “MAY” reflect some of the input. What seems apparent to me is the fact that the discount rate won’t be adjusted given that the SFA that has been approved for Local 138 would reflect the current discount rate of the 3rd Segment (PPA) plus 200 basis points. That is truly unfortunate, as the use of this rate dramatically reduces the potential SFA payment.
Any assistance that these struggling multiemployer plans get is terrific, but the thought that 30-years of future benefit payments would be secured is nothing but a pipe dream at this time. Let’s hope that those plans receiving the SFA can secure the benefit payments for the next 8-10 years, which would buy time for not only the legacy assets to grow unencumbered but perhaps a few tweaks to the current legislation should the PBGC’s “Final Rules” not meaningfully change. The next plan up is Idaho Signatory Employers-Laborers Pension Plan. More to come!
As we recently reported, Local 138’s ARPA application reaches its 120th day under review at the PBGC today (December 21st). No news is good news with regard to this Special Financial Assistance (SFA) application, as the PBGC is required to notify a plan only if the application has been rejected for one of a plethora of reasons. The fact that 138 has not been notified suggests to me that their application has been accepted despite the fact that the PBGC’s website still says that the application is under review. Perhaps will see an update later today.
Now the waiting to receive the SFA funds begins. Unfortunately, I sometimes feel as if the multiemployer pension system is playing a massive game of red light, green light that you and I played as kids, except that there is too much at stake for the participants in these plans. According to the ARPA legislation, the “Special financial assistance issued by the corporation shall be effective on a date determined by the corporation, but no later than 1-year after a plan’s special financial assistance application is approved by the corporation or deemed approved.” Why one year? It doesn’t seem possible that it would take one year from the time that the SFA application has been approved to the point that a single lump-sum payment can be wired to the plan’s custodian.
Here’s my greatest concern: markets (equity) are near or at historic levels. A traditional asset allocation will have significant exposure to equities and equity-like asset classes. Negative cash flow from these Critical and Declining pension systems on a monthly basis is difficult to manage. Not getting the SFA proceeds for a year opens these plans to unnecessary liquidity risk. Why? If SFA assets were received promptly the proceeds would be invested in investment-grade bonds per the legislation’s mandate and the SFA assets would be used to meet the monthly benefit payments. We would prefer that the SFA assets be used to defease (cash flow match or CDI) the current Retired Lives Liability as far out as possible (likely around 8-10 years depending on the plan). This action ensures that the plan has the liquidity necessary to meet those monthly flows without having to force liquidity from the equity managers that might be under stress as the markets turn. Furthermore, should the US equity markets experience another major decline, the availability of SFA assets to meet benefit payments means that the investment horizon has been extended for equities allowing for them to grow unencumbered while allowing for recovery of those potential losses.
There are enough documented issues with regard to this ARPA rescue plan. Imposing unnecessary delays on pension plans that have gotten approval for their SFA applications is just further salt in the wounds inflicted by previous failed attempts at improving the soundness of these struggling multiemployer systems. Get the SFA money to these plans ASAP. They can then secure the promised benefits for at least some period of time despite the fact that the 30-year “guarantee” is nowhere close to being a reality.
The ARPA legislation states the following: DETERMINATIONS ON APPLICATIONS.—A plan’s application for special financial assistance under this section that is timely filed in accordance with the regulations or guidance issued under subsection (c) shall be deemed approved unless the corporation notifies the plan within 120 days of the filing of the application that the application is incomplete, any proposed change or assumption is unreasonable, or the plan is not eligible under this section. Such notice shall specify the reasons the plan is ineligible for special financial assistance, any proposed change or assumption is unreasonable, or information is needed to complete the application. If a plan is denied assistance under this subsection, the plan may submit a revised application under this section. Any revised application for special financial assistance submitted by a plan shall be deemed approved unless the corporation notifies the plan within 120 days of the filing of the revised application that the application is incomplete, any proposed change or assumption is unreasonable, or the plan is not eligible under this section.
Given the above wording, we are now within days of having the first applications either approved or rejected. Local 138 Pension Trust Fund filed their application on August 23rd, which means that their 120 days are up on December 20th. Furthermore, “Special financial assistance issued by the corporation shall be effective on a date determined by the corporation, but no later than 1 year after a plan’s special financial assistance application is approved by the corporation or deemed approved.” There are several other plans that filed their initial application in September meaning that January is going to be a fairly busy time for the PBGC, which also has the second priority tier eligible plans filing their initial applications, too.
Unfortunately, these plans may be receiving their Special Financial Assistance (SFA) without knowledge of the PBGC’s “Final Final Rules”. As you may recall, the PBGC published its “Initial Final Rules” in July. Many plans and their asset consultants/actuaries are waiting to see if any changes will be made that would impact the size of the government grant or how the SFA assets may be invested. As of now, the SFA assets must be segregated from the plan’s legacy assets and be invested only in investment-grade bonds. There is a provision allowing for a 5% bucket of high yield bonds, but only if they are “Fallen Angels”.
For plan participants in Critical and Declining plans that were granted “relief” under MPRA, the waiting is particularly burdensome. Many of these participants have been struggling with financial hardship due to the draconian cuts to their earned benefits. The expectation was that benefits would be restored to previous levels once the legislation passed. But the waiting continues. Will the PBGC take the full 1-year to provide the grant? I sure hope not! Stay tuned.
March 2021 was an exciting time for many multiemployer pension plans and their participants with news that the American Rescue Plan Act (ARPA) had been signed into law and a “rescue” of some roughly 130 struggling multiemployer pension systems was right around the corner. But was it? Following the March passage, we all waited for the PBGC to produce their interim “final” rules, which they did in early July. Those guidelines laid out a schedule – a priority pecking order – for funds that qualify for the Special Financial Assistance (grant).
According to the PBGC’s website, there have been 20 applications for the Special Financial Assistance (SFA) filed to date, with one plan, Road Carriers Local 707 Pension Plan, submitting their first application on August 13th and a revised application on November 12th. To date, no applications have either been approved or rejected. The PBGC has 120 days from receipt of the application to either approve the SFA request or send it back to the plan for an amended application. Furthermore, we continue to wait for the PBGC’s “Final, Final Rules”.
As a reminder, roughly 100 letters were received by the PBGC following the publication of the Interim Final Rules in July. These comments covered various aspects of the legislation and represented feedback from individual participants, pension systems, actuaries, asset consultants, money managers, and more. It is anyone’s guess at this point whether the PBGC will, in fact, listen to the industry participants and amend any of their initial guidance. The key request by industry participants is to change the discount rate used to calculate the SFA grant from a PPA 3rd segment rate + 200 basis points to the PPA three segment rates currently used. The higher discount rate required by the legislation significantly reduces the SFA grant. I am not confident that they will further amend their guidelines, despite the fact that several leading voices in Congress are not pleased with how the legislation was interpreted.
It remains to be seen whether the goal to secure the next 30-years of benefits and expenses will be achieved, but initial analysis suggests that few if any, plans will, in fact, be able to secure the promised benefits, reinstitute cuts that had previously been made to benefits (18 plans under MPRA), and maintain sufficient assets to meet future benefits. Despite the possible shortfall, what we should be focused on is the fact that these struggling plans are getting a grant, and in some cases, a substantial one, to help improve funding, at least in the near term. Importantly, the SFA assets received should be used to secure the promised benefits as far out into the future as possible. This action will buy time for the current assets to grow unencumbered, and if necessary, allow for future amendments to this legislation to be enacted. Actions that don’t secure the promised benefits only act to increase the likelihood that assets received through ARPA will not be sufficient to meet the promises that are supposed to be secured until 2051. More to come.
The market action over the last week or so has been so crazy that many participants are likely suffering from seasickness. It has given me the feeling that I’ve been on a monstrous roller coaster of just ups and downs with no extended straightaways. How about you? There are so many inputs that need to be factored into the decision to buy or sell the US equity market, but have things really changed that significantly since Thanksgiving let alone every day? Sure, we have the new Covid-19 strain called Omicron, but as of today we really don’t know how much we will be impacted by it. Yet, with each piece of “information”, the markets rapidly adjust (overreact). Is it rational behavior? Given underlying valuations for US stocks… are holders of equities just looking for a reason to sell or are we seeing long-term investors using every opportunity to buy dips? I guess that only time will tell.
However, if your head is spinning and you aren’t sure about the near-term direction of your equity exposure I would encourage you to look to your Investment Policy Statement (IPS) for guidance. Take advantage of the tremendous gains created during the last 18 months to rebalance your pension asset allocation back to policy normal targets. It is never a bad time to take profits! Furthermore, if you believe, as we do, that US interest rates need to eventually reflect the current economic environment, you may also want to change the composition of your fixed-income allocation.
A rising US interest rate environment will create significant headwinds for your total return-oriented manager. It doesn’t take much of an interest rate move upward to create a negative annual return for your manager. In fact, at these low-interest rates, only a 30 basis point move up in rates would have a 7-year duration portfolio producing a negative annual return for your bond manager. That can happen in a week or less! Consider adopting a cash flow matching fixed income (CDI) implementation that matches asset cash flows from bonds (interest and principal) with liability cash flows. A CDI strategy will ensure that your plan’s liquidity is enhanced, interest rate risk on that portion of the portfolio is mitigated, and importantly, the investing horizon for your growth assets is extended allowing for those assets to grow unencumbered.
Adopting this approach will likely reduce the seasickness that you may be experiencing at this time. Securing the plan’s liabilities (the promise to participants) should be the primary objective, which can be accomplished at a reasonable cost and with prudent risk. Save the ups and downs for your next visit to Six Flags.
Remember… trends don’t wait for the end of the year to happen!