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!

Out of Sight, but certainly not out of mind!

The Butch Lewis Act that passed the U.S. House of Representatives with bipartisan support in July 2019, continues to languish within the U.S. Senate more than 12 months later. While our august Senators fiddle, the pensions of nearly 1.4 million Americans burn. The nearly 130 Critical and Declining pension systems for these Americans were already teetering on the brink of insolvency, but their lifelines have grown shorter as the impact of Covid-19 has destabilized the economy and markets.

Not much has been reported recently with regard to getting the Butch Lewis Act through the Republican controlled Senate, but it is safe to say that there isn’t any sense of urgency, as members of Congress have begun yet another recess despite many outstanding and critically important issues remaining open, including pension reform, unemployment benefits, aid to states/municipalities, etc. Unless the current logjam in negotiations is eased, we won’t see our representatives back in Washington DC before September 8th.

Despite the fact that progress related to pension reform remains painfully slow, there are many in our industry that continue to fight for the American worker. I found this article written by Donnie Blatt (US Steel) on the website Cleveland.com. Blatt argues that workers in these troubled plans are on the verge of losing everything that they were promised (and worked for) despite having nothing to do with the current funding crisis. He reminds us that they often deferred raises in order to make larger contributions into their retirement plans.

Anyone who follows this blog knows that we frequently highlight the economic benefit that monthly pension checks provide to the communities in which these participants live. The US government has the ability to provide these low-interest loans as a lifeline for these struggling plans. Let’s stop playing with people’s lives and livelihoods for the sake of political gamesmanship.

Those Differences Matter

At the end of each fiscal year, corporate pension plan sponsors must select a discount rate to use in valuing the liabilities of their pension plan for GAAP accounting purposes. As a result, the choice of discount rates will affect the balance sheet and credit rating.

When FAS 158 became effective December 15, 2006, Ryan ALM created a series of discount rates in conformity to then FAS 158 (now ASC 715). Ryan ALM provides four distinct discount rate yield curves that best conform to GAAP requirements.

We believe our discount rates consistently provide higher rates that are in conformity with ASC 715, well documented, and validated by auditors. Because our ASC 715 rates are usually higher than other discount rates, it should enhance financial statements and credit ratings. Ryan ALM has produced a white paper that highlights our discount rates and why they stand apart from other industry offerings.

The Ryan ALM ASC 715 discount rates consistently demonstrate a higher yield than most other discount rates. Historically, the yield difference is as follows: Top 1/3 = 21 to 84 basis points, Above Median = 11 to 62 basis points, and the Full Curve = -1 to 27 basis points.

Based on Above Median discount rates, for every $1 billion in projected liability benefit payments the reduction in present value could be $11 million to $62 million. That isn’t chump change! Let us help you save precious financial resources during these challenging times.

Not nearly enough!

Like you, I read as many articles related to pensions, retirement, and savings as I can. As our retirement industry has moved from defined benefit pensions where the monthly benefit is explicit, to a defined contribution plan where the payout is anyone’s guess, more and more articles have appeared proclaiming a certain $ threshold is necessary in order to achieve a “dignified” retirement. According to a recent Schwab survey, the average worker “expects” to need roughly $1.9 million to retire comfortably. For Millennials and Generation X, the number is $2 million, while Baby Boom generation members need about $1.6 million. Really? This expectation is based on what?

For many Americans, the dream of accumulating $1 million in a retirement account was considered to be enough to bring you to the promised land of a quality retirement. In years past, and really not too long ago, a $1 million retirement balance could produce a $50,000 annual income through a combination of bond interest and stock dividends. That in combination with a Social Security average monthly payout ($1,461 in 2019) and you could have a retirement that allows you to stay in your home while still being able to meet future expenditures related to aging.

Regrettably, the Federal Reserve policy action of the last several years has made the $1 million account target basically useless. In an environment where the Bloomberg Barclays Aggregate Index is yielding only 1.04% (6/30/20), it would take nearly $5 million to produce the same $50,000 that $1 million used to generate. Given that the average retirement account balance is a mere fraction of the original goal, most Americans will NEVER achieve the dignified retirement that they desire.

As a result of those plunging US interest rates, retirees are forced to stretch for yield through investments that they don’t understand and can’t afford to see fail, as they have little recourse to make up for a substantial hit to their principal balance. It truly is shameful what we’ve done to retirees and near-retirees.

The loss of DB pension incomes in the private sector will create an economic drag that will become exacerbated when many of those age 50 and up are forced into early retirement through the economic disruption caused by the Covid-19 crisis, which has disproportionately impacted lower wage earners. In fact, I recently read that American workers making $40,000 or less had a 40% chance of losing their job in the last 4 months! Anyone think that they are in a position to fund a retirement program?

The creation of an on-call workforce has further destabilized the promise of a meaningful retirement, as most of those employment opportunities don’t come with benefits. As we all know, Americans don’t save outside of an employer-sponsored retirement program. Do you really think that there isn’t a retirement crisis, as some in our industry would have you believe?

If You Don’t Like The Outcome, Switch The Objective.

I don’t like that public pension systems use the return on assets objective (ROA) to value their liabilities, but it is the accounting rules under GASB that dictate that requirement. I also don’t like that public pension systems continue to have such lofty ROA targets (7.22% based on a NASRA 2/20 brief). The higher the ROA target the lower the annual contributions required to fund the plan. For those plans that have failed to achieve the ROA, the combination of weaker performance and smaller than necessary contributions is an unaffordable double whammy that destroys the funded status of these plans longer-term.

If that isn’t bad enough, I was reading an investment annual report for 2019 for a large state plan (yes, I have a thrilling life) that showed performance for the fiscal year 2019 (June 30th fiscal year-end), and for 3-, 5-, 10-, and 20-year time frames ending June 30, 2019. The performance comparison was for the total fund versus the total fund benchmark (benchmark is a weighted composite of index returns in each asset class). The 2019 and 3- and 5-year comparisons were below that benchmark, while the 10- and 20-year performance revealed above benchmark returns. So what!

In the case of the 20-year period, the pension plan in question had generated only a 5.7% return while the total fund benchmark was up 5.3%. Does it really matter that this plan topped it’s total fund objective by 40 basis points when it failed to achieve the ROA by 1.8% per year for 20 years? Remember that annual contributions are determined based on the assumption that the ROA will be achieved. The fact that this system underperformed so badly should be the story. Let’s stop coming up with new ways to measure “success” when really the only thing that matters is if the plan can secure the promised benefits or at the very least, achieve the ROA. Oh, the games people play.

No Need For The Volatility

The following graph highlights the fiscal year returns for the Mississippi Public Employees Retirement System. I would hazard a guess that this pattern differs only marginally from the “average” public pension system, since most plans continue to focus on the ROA as the primary objective and they all tend to be 7% and greater. This volatility is neither necessary nor helpful, as it leads to big swings in both the funded status and contribution expenses.

The chart begins with the year that equity investing was first permitted. I have no issue with plans investing in a variety of asset classes and products provided that the primary objective is to secure the pension plan’s promised benefits. To that end, we recommend that you don’t have all of your assets as alpha generating assets. It is imperative that the near-term pension liabilities be defeased allowing for a longer investing horizon for the true alpha assets to generate excess returns versus future liability growth.

As we demonstrated in a recent post, the volatility associated with short time frames is difficult to manage (see above chart), but by extending the investing horizon to 10-year time frames the probability of success is greatly enhanced.

Also, in the article where I came across the fiscal year returns for Mississippi PERS they mentioned that the plan’s funded ratio was only 60%. I realize that there are many factors that go into why a plan’s funded status may be a certain level – contributions, benefits changes, returns, expenses, etc. – but I always find it interesting when an annualized return over some long period reveals outperformance versus the ROA objective only to have the plan’s funded status be so poor. It just highlights that achieving the ROA is not the answer to solving the DB pension problem.

No Time To Celebrate

The WSJ has published an article today that highlights Wilshire’s TUCS universe performance for public pension systems. The gist of the article is that public pension systems established a 22-year record for positive performance during the second quarter – great – but there is no time to celebrate. Yes, the median public pension generated a whopping 11.2% return for the 3-months ending June 30, 2020, but the 12-months through the second quarter produced only a 3.2% return for the same universe of plans, which dramatically undershoots their target return of roughly 7.2%.

Once again we find these plans riding the asset allocation roller coaster to ruin. Despite the terrific second quarter result, plan sponsors are still facing massive funding shortfalls that will continue to grow, as many states and municipalities deal with the consequences of falling revenues and escalating costs associated with the Covid-19 crisis making the full payment of this year’s ARC nearly impossible. Sure, no one saw this coming, but then again, do we ever see Black Swan events before they’re thrust upon us?

Adopting a different approach to asset allocation is imperative at this time. We would highly recommend splitting the assets between beta (cash flow matching retired lives liabilities) and alpha (growth assets to meet future liabilities) enabling the plan to maximize the efficiency of the asset allocation. We’ve discussed this subject in previous blogs and in Ryan ALM research that can be found at RyanALM.com.

We remain huge fans of the traditional defined benefit plan, but have never been fans of the focus on the return on assets assumption (ROA) as the primary pension objective. Public pension systems cannot afford the volatility that the current approach produces, especially in this environment. Adopt this strategy that was once the only game in town and you will improve liquidity to meet benefit payments, eliminate interest rate risk, reduce the volatility of the funded status and contribution expenses, while extending the investing horizon for all of the alternative assets that have been injected into these plans.

Let’s stop riding that asset allocation roller coaster before we are all wet. Oh, as I sit at my desk in New Jersey today, I am reminded that the picture above was from Super Storm Sandy (October 2012). Ironically, we are under a tropical storm warning from Isaias. Stay safe, everyone.

We Can and MUST do Better!

On January 11, 2017 I penned a blog post titled “Perpetual Doesn’t Mean Sustainable”, which addressed my concerns about the fact that the idea that public pension systems were perpetual might just be a fallacy. In fact, the funding status for public pension DB plans was deteriorating and I was questioning their sustainability. Little has changed since that January day. I was attending an Opal conference in Arizona when I wrote the post so I can’t lay claim to a cold January day.

Recently, a friend from our industry shared with me the output from the Melbourne Mercer Global Pension Index (MMGPI) to showcase which countries are best equipped to support their older citizens, and which ones aren’t. Why older citizens? According to the study, one-sixth of the world’s population will be over 65-years-old by 2050 making the soundness of a country’s pension system so critically important.

The analysis uses a number of factors, which are then put into three sub-indexes:

  1. Adequacy – the base-level of income
  2. Sustainability – The state pension age, the level of advanced funding from government, and the level of government debt.
  3. Integrity – Regulations and governance put in place to protect plan members

These certainly seem to be reasonable. These measures were used to evaluate the pension systems for 37 countries (including the US) covering more than 60% of the world’s population. The Netherlands ranked highest with a combined score of 81, while Thailand ranked poorest at 39. Regrettably, the US ranks 17th in this global index placing behind Malaysia and only slightly ahead of France, Peru, and Columbia, which complete the top 20.

While each of the 3 sub categories is important, Sustainability is likely the most important given the aging trends that we are witnessing globally. As I wrote several years ago, perpetual doesn’t mean sustainable, and if we don’t change our approach to managing public pension systems, we will truly be challenging the premise that these entities are in fact sustainable.

DB plans are too important to the US plan participant to see them fail. A pay-as-you-go pension system is not sustainable, yet that is exactly what we have for a number of US states at this time. The Covid-19 crisis has impacted state revenues to such an extent that contributing the annual required contribution in 2020 is likely a pipe dream for many systems further destabilizing these plans.

Pension systems were much better funded years ago when the focus was on the plan’s liabilities. As plans began to focus more attention on the return on asset assumption (ROA) as the primary goal greater volatility in the funded status and contribution expense was realized. It is time to get back to basics before it is too late.

The Cost of a PRT is Rising

During June, the estimated cost to transfer retiree pension risk to an insurer rose 70 basis points, from 103.9% of a plan’s total liabilities to 104.6% of those liabilities according to the Milliman Pension Buyout Index (MPBI). The historically low interest rate environment for annuities is fueling this cost increase. Milliman’s MPBI uses the FTSE Above Median AA Curve, along with annuity purchase composite interest rates from insurers, to estimate the average cost of a PRT annuity de-risking strategy.

“Since April, accounting discount rates have dropped approximately 30%,” says Mary Leong, a consulting actuary with Milliman. There are many factors that go into the pricing of pension risk transfers (PRT) including the size of the potential transaction, the composition of the retiree base, the complexity of the deal, and the competitiveness of the market.

DB pension systems might be better off keeping the liability on their books by exploring the use of a cash flow matching strategy to defease the retired lives liability. Analysis performed by Ryan ALM estimates that cost savings of 15% to 20% are highly likely when compared to a PRT.