Are These Really the Reasons?

By Russ Kamp, Managing Director, Ryan ALM, Inc.

There was an article in today’s WSJ that addressed the issue of transparency among hedge funds, private equity, and private debt offerings. There are a plethora of institutional entities imploring the SEC to require greater disclosure. Not surprising that this objective is being met with harsh criticism from the targeted investment firms. I’m all for more transparency and disclosures and the idea that performance is going to be hurt by enhanced reporting doesn’t carry water in my opinion.

That said, I am much more interested in the following paragraph that was embedded in the article: “Many pension plans are having a hard time meeting their payout obligations to members, the result of decades of underfunding, benefit overpromises, and unrealistic demands from unions. This year’s simultaneous decline in stocks and bonds has only made matters worse. To compensate, many pension plans are increasingly putting their money into private-market investments like hedge funds, private-equity funds, and private debt funds.” Do we really believe those are the primary reasons for poor pension funding where it exists? Furthermore, do we really believe that investing greater and greater sums of money into HFs, PE, and PD will be the Holy Grail to full-funding success? I certainly don’t!

Sure, there have been some entities that haven’t fully funded that annual required contribution, but many funds have met those obligations. Aren’t benefits, as well as other plan provisions, part of a negotiation process? Since when do unions make demands on their own without a counterparty involved in the process? No, the biggest contributor to poor funding among some pension systems has to do with not having the right objective in place. Our industry is enamored with the idea that achieving a target return solves all problems. It doesn’t. Given this unhealthy pursuit, it isn’t surprising that plans and their advisors are allocating more money to these private alternatives. Just remember that too much money into any asset class can significantly diminish future returns.

If generating a return is not the primary objective then what is? It is the SECURING of the promise that has been made to a plan participant that guarantees a certain payout each and every month in retirement until death. Meeting that objective is the only reason why that plan exists. Given that reality, it becomes obvious why that promise needs to be secured in such a fashion as to significantly reduce funding volatility. There is no reason to blame the size of the benefit or the union’s demands. Once that benefit has been agreed to the process becomes very simple as B+E=C+I, where contributions (C) and investment gains (I) and the existing corpus must be sufficient to meet the promised benefits (B) plus the expenses (E) necessary to meet those benefit payments.

With greater and greater emphasis on investments to drive success, we get potentially greater variability in a plan’s funded status as markets and market returns are not linear. Pension systems need to spend more time understanding their plan’s specific liabilities and then managing plan assets versus those promises and not some generic asset-based index. The roller-coaster gyrations that traditional asset allocations follow lead to significant volatility in contribution expenses. Get off that roller-coaster. Put in place a bifurcated approach to pension asset allocation that will enhance liquidity to meet the promises while buying time for all the private investments to which plans have flocked. Bonds are NOT going to be return generators in a rising interest rate environment. I have no idea how high rates will go, but I do know that their trajectory is higher – the Fed told me and everyone else. Use your plan’s fixed-income cash flows to meet your plan’s liability cash flows. Securing the promised benefits for the next 10-years or so buys ample time for your alpha assets (non-bonds) to achieve their expected outcomes.

Pension plans are much too important to rely solely on markets to create success. Put in place an objective to secure the promised benefits that elevates the probability of success!

ARPA Update Through June 3, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There was modest activity last week as it relates to the ARPA pension legislation, as only one plan, Mid-Jersey Trucking Industry and Teamsters Local 701 Pension and Annuity Fund, received approval from the PBGC on their application for Special Financial Assistance. This fund will receive $142.2 million to help stabilize and secure the promised benefits for 1,623 plan participants. To date, $6.7 billion in SFA support has been approved by the PBGC and of that total, $6.45 billion has been disbursed including three more funds last week. There were no new applications submitted among Priority Group 1, 2, and 3 plans. Priority Group 4 candidates may begin filing their applications on July 1, 2022.

All attention continues to be focused on the Office of Management and Budget (OMB) which received the PBGC’s Final, Final Rules about two weeks ago. We should be hearing something soon from them. Have a great week, and as always, don’t hesitate to reach out to us if we can be of any assistance to you.

SFA Discount Rates – Part II

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

What do you do on a rainy day? If you are in NJ, you may just decide to read through 38 ARPA/SFA applications residing on the PBGC’s website. Sounds like fun, right?

Today’s blog is a follow-up to yesterday’s post when we discussed the importance of the discount rate used for the SFA calculation. We specifically mentioned that smaller is better, and I wanted to get a sense of how many plans were submitting applications with discount rates lower than the 3rd segment (PPA) plus 200 bps that is embedded in the legislation. Well, it turns out to be quite a few – fortunately!

For instance, 25 Priority Group 1 applications have been filed. This group consists of plans that are already insolvent or were projected to become insolvent before 3/11/2022. Their actuaries did a fine job lowering the discount rate to reflect the poor (critical) funded status. In fact, all but 7 of the 25 had a discount rate lower than the 3rd segment plus 200 bps rate. The average discount rate for the 25 applications was only 3.94% and they ranged from 0% to 5.38%.

On the other hand, of the 12 Priority Group 2 plans, those plans that are expected to be insolvent within one year of the date the plan’s application is filed or those that Implemented MPRA benefit suspensions before 3/11/2021, only 1 plan had a discount rate lower than the legislation’s rate – Freight Drivers and Helpers Local Union No. 557 Pension Plan. That fund’s discount rate was a very conservative 4%. There remains only 1 Priority Group 3 submission (Central States) and given their extremely poor funded status it shouldn’t come as a surprise that they are using a 3% discount rate for SFA purposes.

Again, the lower the discount rate the greater the present value (PV) cost of those future benefits and expenses and the greater the gap when netting out current assets, future contributions, and investment earnings. I can’t imagine that these plans and their actuaries knew this legislation was forthcoming. The fact that they used such conservative discount rates is a testament to their professionalism. I suspect that most of the plans yet to file will have discount rates at or above the 3rd segment plus 200 bps rate, but I’ve been surprised before. We’ll keep you updated as additional applications are submitted. We are about to enter Summer in NJ where afternoon storms are not rare. I’ll need something to do!

The Size of the SFA Very Dependent on the Discount Rate

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

We’ve had the opportunity to produce Custom Liability Indexes (CLIs) for several multiemployer plans going through the ARPA/SFA process. In all but one case, the SFA grant received or likely to be received falls far short of the goal to secure 30-years of benefits through 2051. Why? More than anything, it really comes down to the discount rate used by the multiemployer plan. The ARPA legislation allows a plan’s actuary to use the lower of either ARPA’s 3rd segment (PPA) plus 200 bps rate (roughly 5.5%) or the plan’s current discount rate. Most plans have been using a discount rate equal to the return on asset assumption (ROA) or one quite similar (>7%). The one case where our CLI shows full 30-year coverage of pension liabilities net of forecasted contributions is for a plan that adopted a 4% discount rate given its severe funding challenges.

As a reminder, the size of the SFA is determined through multiple factors, such as the size of the current legacy assets, the discount rate used to determine the present value of the plan’s future liabilities, future “earnings”, and forecasted/estimated contributions. A discount rate much greater than the ARPA rate will significantly reduce the future value of the benefit payments. We’ve encouraged the PBGC through our outreach to use all three segments and not just the 3rd segment rate while eliminating the kicker of 200 bps. It is inconsistent and unfair to use the third segment rate (20+ years) since benefits are paid chronologically and the SFA grant may only be able to fund less than the next 20 years of benefits. Although the PBGC hasn’t released its Final Final Rules (as they are still being reviewed by the OMB), it is highly unlikely that the discount rate formula will be amended given the potentially dramatic increase in the cost of the legislation currently estimated at about $95 billion.

I mentioned above that the plan using the 4% discount rate could defease net pension liabilities through 2051. How comforting would that be to plan participants? If the pension plan were to use the contributions to support the current legacy assets, the SFA assets alone would defease 15-years and 9 months of benefit payments – still very attractive! My question to our readers, would you rather use contributions to support a full defeasement through 2051, as the legislation intended, or use future contributions (which are truly unknown) to support the legacy assets with the hope that future returns on those contributions would be outsized relative to the return generated by the cash flow matching strategy (CDI)? Please remember that plans receiving SFA assets cannot increase benefit payments prior to 2051’s conclusion. The higher potential return on future contributions would have to be used to beef up the number of assets to meet pension promises after 2051. If risk is best defined as the uncertainty of achieving the objective, wouldn’t it be most risk-averse to use contributions and the SFA grant to fund benefits as far out as possible through a cash flow matching strategy?

Like future contributions, future returns are not guaranteed either. A plan striving for a 7% annual return may have a two standard deviation (95% of observations) volatility in the return pattern of +/- 24% to 30%. One way to reduce some of the uncertainty would be to include only those contributions that have been fully negotiated in the net calculation of future benefit payments. If a plan has a 3- or 5-year negotiated rate for their contributions, only use those contributions in the cash flow matching strategy which would extend the life of the CDI program beyond the 15+ years. Again, how comforting it is for both sponsor and participant to know that the promised benefits have been absolutely secured for that length of time.

ARPA Update as of May 27, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Before getting into the most recent update regarding the ARPA legislation, I’d like to express my sincere gratitude to the men and women who gave the ultimate sacrifice to defend our nation. God Bless you and your families.

Activity surrounding ARPA/SFA was fairly modest last week following several weeks of intense activity. There were no new applications filed or approved. Fortunately, there were none that were denied. However, there were two plans New York State Teamsters Conference Pension and Retirement Fund and Freight Drivers and Helpers Local Union No. 557 Pension Plan, both Priority Group 2 members, which withdrew their applications. The NYS Teamsters had filed their initial application on 1/28/22, so they were within days of getting their application acted on, while the Freight Drivers submitted their application on March 4, 2022. There have been dozens of applications withdrawn to date, but in every case, a new application was submitted. It shouldn’t be long until we see new applications filed on behalf of these two plans that represent just under 36,000 plan participants.

As we reported last week, the PBGC has sent its Final, Final Rules to the OMB and it shouldn’t be too much longer before we get the update that everyone has been waiting for since the Interim Final Rules were announced last July. Have a great week, and please don’t hesitate to reach out to us with any questions/comments.

“Higher and For Longer”

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

According to the US Federal Reserve’s minutes from early in May, there is a chance that the Fed will have to raise US interest rates “higher and for longer” than originally anticipated. Those four words scare the heck out of me! Yet, the US equity market rallied on the news. Sure, there was no indication that the Fed was contemplating Fed Fund rate increases greater than 50bps at each of the next two meetings, but that isn’t guaranteed. It also isn’t guaranteed that the inputs (war, covid-19, production bottlenecks, etc.) to this inflation crisis will have been eradicated by the end of July 2022.

Perhaps equity market participants feel that interest rates having to rise higher and for longer indicates that a recession isn’t in the near future. Perhaps. But, at some point in the not-to-distant-future bond yields will hit an inflection point that puts real pressure on equities. Remember, pension systems used to have substantial exposure to bonds. Regrettably, that exposure was trimmed quite significantly and consistently as yields fell below the return on asset assumption (ROA) back in 1988. This migration from fixed income to equities and alternatives certainly helped to boost the performance of those asset classes as positive cash flow drives markets higher.

What is likely to happen when holding bonds at attractive yields and with more modest variability starts to impact those fund flows into non-bond asset classes? Could we see significant selling pressure within equities? As pension systems look to de-risk their pension liabilities, they aren’t going to maintain the same level of equity and alternative exposure. At what level of interest rates is that inflection point? We’ve benefited tremendously from a nearly 40-year bond bull market in which plummeting interest rates pushed forward the incredible gains achieved in a variety of markets – real estate, equities, bonds, alternatives, etc. Do you recall how challenging the environment was prior to 1982? It was ugly!

While we sit back and wait for the Federal Reserve to do their thing for potentially longer, US fixed-income investors with a total return focus will get spanked. We’ve already experienced the most challenging performance environment for bonds in the last four decades. If the Fed is true to its pronouncements, total return fixed income programs will continue to see significant losses in principal. Regrettably, the current level of rates (income) isn’t substantial enough to offset much of that principal loss. Now is the time to convert traditional return-seeking strategies to cash flow matched investments that are tailored to meet your plan’s liability cash flows. Importantly, by defeasing benefit payments that are future values, a cash flow matching strategy mitigates interest rate risk. In addition, should we see both equities and bonds sell off, a cash flow matching strategy buys time for the non-bond assets to recover as they are no longer a source of liquidity.

Again, I don’t know about you, but the phrase “higher and for longer” scares me. Given the improved funding that was observed throughout Pension America in 2021 isn’t de-risking the prudent approach as opposed to “guessing” how the Fed will act and more importantly, how the market will respond? Be responsive to today’s environment.

Milliman’s Q1’22 Public Fund Update

By: Russ Kamp, managing Director, Ryan ALM, Inc.

The Milliman organization produces an outstanding report each quarter that covers changes in the funding levels for both corporate as well as public pension systems. The Public Pension Funding Index (PPFI) report was released recently and it covers the top 100 public pension defined benefit plans through March 31, 2022. According to Milliman, the top public pension systems recorded investment losses of roughly 3.4% during those three months resulting in a funded status deterioration of $167 billion. The collective funded ratio declined from 85.5% at the end of 2021 to 82.7% on March 31, 2022.

Public pension systems operate under GASB accounting standards which allow pension liabilities to be valued using the return on asset assumption (ROA) as the discount rate to price liabilities. This discount rate is static and doesn’t reflect changes in the US interest rate environment. The good news for public pension systems is that pension liabilities are like bonds. The present value of those liabilities would fall in a rising rate environment if priced on a market value (economic) basis. Yes, pension assets have struggled so far in 2022, but we believe that the average public pension system’s longer duration liabilities would have struggled more. As a result, the $167 billion estimated loss in funded status may not be correct and may actually have improved on an economic basis despite the struggles in the capital markets. Ryan ALM provides a quarterly Newsletter on pension funding. You can check out our Q1’22 report at ryanalm.com/newsletter. 

ARPA Update through May 20, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Happy to report that there was some more activity related to ARPA and the rescue of struggling multiemployer plans during the last week. As of this writing, there have been 25 ARPA SFA applications approved by the PBGC including two more last week. The newly approved applications were for the Management-Labor Pension Fund Local 1730 ILA and Iron Workers Local 17 Pension Fund which collectively covers 2,378 plan participants. The funds are seeking roughly $110 million in SFA grant money. Since the inception of the ARPA program, 13 funds have received grants totaling just under $2.4 billion.

Two more plans filed their initial SFA applications last week. There are currently 12 applications with the PBGC awaiting action. To date, none of the previous applications that have been filed were rejected. As I reported this morning, it appears that we are getting close to receiving the Final, Final Rules from the PBGC on how this legislation should be enacted. Perhaps news of that development will inspire those Priority groups, 1, 2, and 3 plans that have remained on the sidelines to finally file. More to come! Have a great week.

An Answer from the PBGC – Finally?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Good morning to all my friends in multiemployer pension systems that have filed or will soon file applications with the PBGC to receive Special Financial Assistance (SFA) grants under ARPA. I have just been informed that the PBGC’s Final, Final Rules are with the Office of Management and Budget (OMB). This has always been an important step in the process of getting the final guidelines from the PBGC approved. Let’s hope that this review process can be handled swiftly. Equally important, let’s hope that these final rules don’t create potential harm.

What do I mean by that? I’ve been very consistent in expressing my opinions that the intent of the legislation was to SECURE the promised benefits for as long as possible. The securing of benefits chronologically can only occur through a cash flow matching defeasement strategy, as bonds are the only asset that has a known terminal value (par) and a set of future income cash flows (semi-annual interest). These asset cash flows can be used to match and fund liability cash flows (benefit payments). Let’s not bring uncertainty into this process by expanding the restricted investment list to include stocks, real estate, private equity, etc. These assets don’t do anything to secure the promised benefits. They bring greater volatility and uncertainty, which goes against the legislation’s intent.

This pension legislation is potentially helping millions of Americans gain (regain) more retirement security. It is the first real rescue of the promises made to pension participants in a long time. I am praying that the updated guidelines don’t set this effort backward.

Why is Buying Time so Critical?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

As most investors appreciate, trying to time the markets can prove to be a fool’s game. We know that timing the tops, bottoms, and dips is incredibly challenging and often leads to excessive turnover coupled with transaction costs that can erode potential value-added. As a result, it is best to remain in the equity markets through thick and thin, but does that mean you do nothing? Of course not. The graph below only goes through August 2019, but it dates back to 1970 and clearly demonstrates the impact on the total return to the S&P 500 when missing just a couple of handfuls of trading days.

Do you have the strategy in place to remain patient?

First, the plan’s investment policy statement (IPS) must clearly highlight a targeted allocation for equities (S&P 500 in this case) with an appropriate range above and below that target used for rebalancing purposes (+/- 5%?). The graph above highlights the impact of an all-or-nothing strategy, which pension systems would likely never engage in, but they should bring discipline to the asset allocation process by taking profits when equities have demonstrated enough outperformance relative to other asset classes to have the allocation reach the upper band. Equally important is the realization that stocks will provide value over the long term. Forcing a buy decision at the bottom of an allocation band, although it may not be easy, is the right decision in the long run.

That said, we have a tendency in our industry to seek liquidity wherever it can be found in order to meet the required monthly benefit payments and expenses. This often leads to assets having to be sold when enough liquidity cannot be found. Unfortunately, this may lead to selling equities near the bottom of their market cycle instead of buying them at that point. One way to avoid this unfortunate occurrence is to put in place an asset allocation strategy that divides the assets into liquidity (beta) and growth (alpha) buckets that each have a specific role within the portfolio.

In our model, the liquidity bucket uses investment grade fixed income to meet all of the plan’s cash flow needs. Bonds are the only asset with a known semi-annual cash flow (interest payment) and terminal value at maturity (par) which is why bonds have always been used to defease liabilities (pensions, lotteries, NDTs, OPEBs, and insurance companies). This liquidity bucket will be used to meet all of your ongoing liability cash flows as long as the allocation lasts. We recommend sustaining a 10-year allocation, if possible, by back-filling (rebalancing) the bond cash flow matched portfolio on an annual basis.

Creating a liquidity bucket will permit the alpha assets to grow unencumbered. There will be no forced selling of these assets during periods of challenged liquidity. During market downturns similar to what we are currently experiencing, there will be no temptation to sell, as you’ve built a 10-year horizon for your equities to wade through the troubled waters. Importantly, your fund gets to reinvest the dividends back into the equity market instead of using them as a cash proxy. Studies that we’ve highlighted previously suggest that the S&P 500 derives a significant percentage of its total return from dividends and the reinvestment of those dividends (as much as 48% on a 10-year moving average).

Having all of your eggs (assets) in an asset allocation basket singularly focused on a return on asset (ROA) assumption, as our industry continues to do, has created volatility of returns but no guarantee of success. We believe that the primary objective in managing a DB pension plan is to secure the promised benefits in a cost-efficient manner and with prudent risk. It is not the achieving of the ROA. Split your assets into two buckets. Allow the liquidity bucket to take care of all your funding. Doing so will allow you to sleep better at night knowing that you have the participants’ benefits covered and you’ve now bought time for your equity assets to grow unencumbered. It is a win, win!