Another Arrow in Their Quiver

The Illinois State Assembly has passed HB0417, a piece of legislation designed to provide funding flexibility in support of the Chicago Park District pension fund. According to the brief explanation of the bill, the legislation “amends the Chicago Park District Act and authorizes the Chicago Park District to issue bonds in the principal amount of $250,000,000 for the purpose of making contributions to the Chicago Park District Pension Fund”. There are other provisions within this legislation, but the ability to raise funds through bonding is the critical element.

We continue to live in a nearly historically low-interest-rate environment. As we’ve discussed previously, it is quite prudent to take advantage of these low rates to stabilize defined benefit plans that will not achieve full funding through investment returns alone. An investment of $250 million through a pension obligation bond (POB) will dramatically improve the plan’s funded status and help stabilize annual contribution expenses.

Now that this legislation has passed, the fund and its advisors need to consider how the proceeds will be invested. Historically, POB proceeds have been injected into the plan’s existing asset allocation. This has proven to be a mistake in many cases and is very much dependent on the “timing” of the investments. POB proceeds should be invested in a way that ensures that the liabilities (promised benefits) are secured through a cash flow matching strategy (CDI) that will match and fund each monthly liability (and expense) chronologically until the POBs assets are exhausted. This strategy is NOT dependent on future market returns, as the assets and liabilities are matched no matter what happens with interest rates, as there is no interest rate sensitivity since we dealing with future values.

Furthermore, the current assets and future contributions can be managed more aggressively and unencumbered, as they are no longer a source of liquidity to fund benefits. Buying time for the alpha bucket improves the probability that the fund will achieve its return on asset (ROA) objective. The S&P 500 dividends alone account for over 50% of its growth in the last 40 years. This cash flow matching strategy is a return to pension basics. It is also how insurance companies and lotteries work, and quite successfully I might add. Why pension America ever departed from this approach escapes me. But let’s not focus on past mistakes. It is time to use all the tools in our toolbox or arrows in our quiver to help stabilize these critically important retirement vehicles. America’s workers are counting on pension systems to deliver on their promises.

What Disposable Income?

US males have seen their median lifetime earnings collapse relative to those entering the workforce in the late 1960s and early 1970s despite the tremendous cost increases related to housing, post-secondary education, healthcare, etc. One needs not to look any further than the chart below to understand why there is such discontent in the US at this time.

When I entered the workforce in 1981, it wasn’t unusual that your employer had a defined benefit plan, paid all or a significant portion of one’s medical insurance, and may have even supported education by paying for a class or two each semester. Wow have things changed. Today, you hardly find any examples of these being offered. Worse, we now have on-call workforces with little to no benefit of being a “full-time” employee.

Incredibly, lifetime earnings began to retrace at just about the same time that DB plans were supposed to be protected by ERISA. The demise of the private sector DB plan has put significantly more pressure on American workers to fund their own retirement benefits. But how? As the chart above reflects, compensation hasn’t come close to keeping pace with the tremendous growth in living expenses. There is a basic level of income necessary just to just “live” and for a significant percentage of the American workforce, they are not even getting to that level let alone have the disposable income to fund a defined contribution plan.

As I reported last week, it is forecast that 22% of the American adult population will be >65-years-old by 2050. While it is wonderful that we are living longer, not having a retirement benefit means that our golden years will not be so golden. It also means that a significant percentage of our population won’t likely continue to be active participants in the economy, as the average Social Security benefit is only $1,543/month.

There is a huge economic divide in our country. This crisis shows little sign of abating. The lack of a company funded retirement program is not helping.

History Does Repeat itself

Just this morning, I read an article from Bloomberg that highlighted the narrowing spreads available on high yield debt. In fact, they are so narrow that we are at historic lows! Here is a chart reflecting that fact:

Yes, the economy is once again opening up as Covid-19 becomes less of an impact and yes, this will positively impact businesses, but how much of the “good” news is already reflected in the prices? Are you really getting compensated for the additional risk?

Then I read a WSJ article, titled “Issuance of Bundles of Risky Loans Jumps to 16-year High”, which referred to CLOs (collateralized loan obligations) seeing a significant renaissance. These securities “buy up loans to companies with junk credit ratings and package them into securities, totaled over $59 billion as of May 20, according to data from S&P Global Market Intelligence’s LCD.” This is a record amount since data was first kept in 2005. The CLO market is now $760 billion. Market participants, BofA and Citigroup, anticipate CLO sales to be anywhere from $290 billion to $360 billion this year, which if realized, would shatter previous annual sales records.

I don’t know what the future will bring for either high yield or CLOs, but I do know that history repeats itself and after 40 years in this business, I’ve seen a lot of history. It isn’t always pretty. Haven’t we lived through previous blow-ups in both high yield and leveraged loans?

Last thought: anytime I hear someone talk about a new paradigm, I cringe, as I remember the late-90s being the start of a “new paradigm” reflecting the dawn of technology and the death of value investing. Oh, yeah, and then there is this beauty of a quote in that WSJ article: “The default environment has been very benign and will be (my emphasis) because the capital markets are open to companies that may be struggling a little bit”. Caveat emptor!

Let’s Talk Pensions

I am really pleased to once again be participating in a CAIA sponsored event. We will be sharing our thoughts on a variety of pension-related issues on June 1st. Please plan to join us.

Let’s talk #pensions. In CAIA’s upcoming webcast, leading experts will have a candid discussion on the #investment repercussions of the recently passed Butch Lewis Emergency Pension Plan Relief Act of 2021 and the American Rescue Plan Act of 2021.

Join the CAIA InfoSeries webcast co-hosted with CAIA SoCal to listen in and learn: https://bit.ly/3fujt8X

Panelists include:
Russell Kamp, Managing Director, Ryan ALM
Brian Kwan, CFA, CAIA, Senior Consultant, Verus Investments
Kate Pizzi, CFA, ASA, Senior Investment Consultant, Fiducient Advisors
Andrew Spence, CEO, Spence Strategic Consulting Group

Moderator:
Zack Ellison,MBA,MS,CFA,CAIA, Managing General Partner & CIO, Applied Real Intelligence LLC (“A.R.I.”​)

#CAIA #pensionfund #pensioninvestment #investments #riskmanagement

Why it is Better NOT to Wait

We are working with a public fund prospect on a cash flow matching project to secure benefit payments as far out as the current fixed income allocation will permit. In our normal implementation we would cash flow match each monthly benefit payment (and expenses, if desired) chronologically. This particular project is unique in that this plan is cash flow positive through 2028. The current allocation to fixed income would allow for the matching of benefits from 2029 to 2033. Given the positive cash flow situation we were asked why the plan sponsor should implement the strategy now as opposed to waiting until they become cash flow negative. Good question. Here, I hope, is a better answer.

Ron Ryan, CEO, Ryan ALM, preaches to me and others that the longer the bond, the lower the cost. In addition, the higher the yield, the lower the cost. By implementing our CDI approach in 2021 instead of waiting until 2028, we are able to save substantially more for that four year period then we would if we waited. In fact, by investing in bonds with maturities of 8-12 years, as opposed to 0-4 years, we are getting substantially more yield resulting in cost savings equal to 24.5% on the future benefit payments. A current 4-year implementation beginning one-month out would result in “savings” of only 3-5% given the historically low-interest rates in the 0-4 year range. It is important to note that the savings is realized upfront allowing for the savings to be invested in alpha assets.

Speaking of alpha assets, the plan sponsor can now extend the investing horizon 12-years for the non-bond assets to grow unencumbered. This lengthening of the investment horizon allows for the greater use of less liquid assets since they are no longer a source of cash flow. It should also result in a higher probability of success in achieving the required return on asset assumption (ROA) since bonds will be used exclusively for their cash flows and not as a source of performance.

Cash flow driven investing approaches have been around for many decades. They are the backbone of many insurance products and lottery systems, and once were the dominant strategy to ensure that the promised pension benefit was funded with little to no risk. Unfortunately, we as an industry moved away from this effective strategy and began to focus more on return than low cost and low risk. We believe that CDI strategies work in every market environment, but we believe that they are especially important in today’s low-interest-rate environment in which bonds are not performance drivers.

LOGIC: Uncertainty is risk. It is always more prudent to be able to budget expenses now than to wait for a better opportunity to come along, which just might not. 

A Review Worth Doing!

US Senators Patty Murray and Bobby Scott have written to the Government Accountability Office (GAO) requesting that they conduct a review of target Date funds (TDFs), as they have grown to more than $1.5 trillion in AUM within 401(k)s and other defined contribution plans. The GAO last conducted a study on these investment strategies in 2011. Murray and Scott are concerned about the potential deviation in performance, fees, risk management, and asset allocation among the various providers that can dramatically impact participants, especially as they near retirement. I personally think that this is a critical issue that needs to be thoroughly vetted, especially since TDFs are now the QDIA for most DC plans.

According to a recent NY Times article, “many of the major target-date funds tailored for people retiring in 2020, for example, had roughly 50 to 55 percent of their investments in stock funds.” One 2020 TDF, which has over $16 billion in assets, is reportedly 60 percent invested in stocks. Furthermore, dynamic adjustments in asset allocation are rarely witnessed. Is a conservative (heavier bond exposure) implementation really conservative in this environment of near-historic low-interest-rates?

The review consists of having the GAO respond to 10 questions. I’m particularly interested in eventually reading the response to question 6: What percentage of plan sponsors (and their consultants) select off-the-shelf TDFs? What percentage of plan sponsors select custom TDFs? Is there a material difference in the performance of off-the-shelf versus custom TDFs?

Like many asset categories in our industry, the biggest, not necessarily the best, firms seem to attract the most assets. There seems to be a similar bias among TDF selections. As mentioned previously, the GAO has been asked to evaluate this space out of concern for the wide variances in performance and other important characteristics. As the chart below reflects, they should be alarmed that near-term retirees could be impacted so harshly. In 2008, many 401(k)s became 201(k)s. That isn’t acceptable under any circumstance, but it is outright criminal for the 2009 retiree.

Let’s hope that the GAO’s review leads to some important action regarding defined contribution plans and TDFs. If we don’t have the ability as an industry to sustain defined benefit plans, let’s at least make DC plans more palatable.

Not Performance Instruments

Bonds have enjoyed an incredible bull market run since 1982. Is the rally finally done? Unfortunately, my crystal ball is no better than anyone else’s so I don’t know when bonds will finally enter a bear market, but I can surmise that we are much closer to that happening than at any time in the last 30+ years, as inflation is beginning to present itself throughout our economy. In fact, the WSJ is reporting this morning that consumer prices surged 4.2% in April from one year ago to the highest level since 2008. In addition, we have the chart below from the BLS highlighting the fact that significant segments of our economy have seen huge spikes in cost since 2000, and given the significant stimulus, 2021 continues to fuel these trends.

https://media-exp1.licdn.com/dms/image/C4E12AQF5cjp-QbyzRw/article-cover_image-shrink_720_1280/0/1620819328710?e=1626307200&v=beta&t=ehc6DOo1RMOLFTcqQqjQrBhFg_vWjlQpOutvxgEoPx4

Given where U.S. interest rates are today, traditional core fixed income programs are NOT sources of return (performance). Exposure to bonds will likely weigh on pension plan sponsors and their asset consultants in their pursuit of an asset allocation strategy that will help them achieve the desired return on assets (ROA), as yields hover far below the median ROA objective. What should pension plans do? They should use their bonds (fixed income exposure) as a source of cash flow, as bonds are the only assets with a known cash flow AND terminal value. Plan sponsors should take advantage of these positive attributes to build a cash flow matching strategy (CDI) to defease pension liabilities, improve liquidity, eliminate interest rate risk, and extend the investing horizon for the non-bond assets (alpha assets). Another benefit here is that if interest rates rise as a trend, a CDI strategy can reinvest at lower cost and earn more income while fixed income performance strategies suffer especially on long bonds. 

A CDI approach will also allow for less fixed income exposure than a typical asset allocation strategy, while achieving the benefits highlighted above. With less dependence on traditional fixed income approaches, more of the plan’s assets can be invested in products/assets designed to generate greater returns. A CDI strategy also buys time since it defeases liabilities chronologically. By extending the investing horizon, these higher octane products can grow unencumbered as they are no longer a source of liquidity to meet benefit payments and plan expenses. History tells us that given time the S&P 500 performs better and better. Moreover, dividends reinvested represent over 50% of the S&P 500 growth since 1980. Thus, a CDI implementation creates a much more efficient asset allocation for the plan sponsor.

The Bloomberg Barclays Aggregate index declined -2.6% on a year-to-date basis through April 30th, even with a 0.8% “rally” in April. Long-bonds (>10-years) produced at least a -10% return for the four months. It could get really ugly, and fast! Rising rates will not negatively impact a CDI’s efficacy, as both assets and liabilities will move in lock-step. This is certainly more palatable than witnessing significant underperformance from a traditional fixed income strategy.

A Step in The Right Direction, but Not Quite There.

I read with interest about a public pension system approving the issuance of a pension obligation bond (POB) to sure up their plan’s poor funding (this is not unusual in today’s environment). I applaud them for doing so, as the historically low-interest rates are providing a unique opportunity. However, the proposed implementation leaves a lot to be desired in my humble opinion.

As we’ve written before, POBs that have failed have done so because they have not captured the potential arbitrage that existed between the plan’s return on assets assumption (ROA) and the interest rate on the POB. That failure has led to increased costs when both the bond’s interest and the loss on the bond’s proceeds have to be paid. We believe that this failure has been caused by injecting the POB’s proceeds into the plan’s existing asset allocation subjecting those assets to the whims of the markets. Given the current fundamentals for both stocks and bonds, the risk of the markets working against this asset allocation is greater than it is being supportive.

The plan that I’m referencing recognized this issue and they plan to invest 1/6th of the assets each quarter hoping that dollar-cost averaging will smooth the returns and reduce the risk that they are injecting a significant sum of money at the peak of the market’s cycle. I’m glad to see that someone is thinking outside the box, but this strategy comes with the potential for significant opportunity cost, as the POB’s non-invested proceeds will be kept in very short-term instruments. This will clearly have an impact on the plan’s ability to achieve the ROA during the next couple of years.

We, at Ryan ALM, would suggest that the POB’s proceeds be used to cash flow match or defease the plan’s benefits and expenses for the next 10-years or more through cash flow matching with investment-grade bonds. This is where the bond allocation belongs, as a liquidity strategy. This strategy would provide for an enhanced yield relative to cash (cash flow match through a corporate bond portfolio) while securing the benefits and reducing the cost of future benefits through the defeasement. Furthermore, it is likely that only a modest portion of the POB’s proceeds would be needed to accomplish this objective. The remainder of the assets (we call alpha or growth assets) would then be used in concert with the existing corpus and future contributions to meet the plan’s future liabilities. Importantly, the cash flow matching creates an extended investing horizon for the growth assets to grow unencumbered, as they are no longer a source of liquidity. These Alpha assets can be managed more aggressively in strategies without bonds that provide a liquidity premium.

The longer the investment horizon the greater the probability of success. The S&P 500 doesn’t outperform bonds in every 10-year period, but they do so more than 80% of the time. Creating that extended horizon and removing the bond allocation improves the odds that the ROA will be achieved longer-term, if not enhanced. Furthermore, being able to secure the plan’s benefits and expenses for the next 10-years reduces the volatility of both the funded status and contribution expense. To repeat, our strategy secures benefits and expenses, reduces the future cost of these benefits through the defeasement, extends the investing horizon improving the odds that the ROA will be achieved while reducing the volatility of the funded status and contributions. Seems almost too good to be true: but it isn’t!

If You Are Going to Duration Match – Consider…

Ryan ALM has produced a position brief on various ALM strategies, including cash flow matching (CDI) and duration matching, but with a twist.

The purpose of duration matching is an attempt to match the interest rate risk sensitivity of assets to liabilities.  The objective is to have the market value or present value (PV) changes (growth rate) in the bond portfolio match the market value or PV changes (growth rate) in liabilities for a given change in interest rates. But duration matching is only accurate for small parallel shifts in the yield curve.  However, the yield curve rarely moves an equal number of basis points at every point along the curve. For more info, Ron Ryan wrote a research paper “The Seven Flaws of Duration” while he was the head of Ryan Labs.

Fortunately, bond management evolved to remedy these flaws by using Key Rate Durations, which attempt to match the duration of multiple points along the yield curve. Key Rate Duration is an improvement over using a single average duration, but it still has several deficiencies, including the fact that duration is a present value calculation requiring pricing each projected benefit with a discount rate yield curve (i.e., ASC 715 discount rates). As a result, 30 annual benefit payments require 30 separate discount rates.

Further evolution within fixed income has brought us to Dollar Duration Matching (DDM). DDM matches the Dollar Value change per basis point change in yield for assets with the Dollar Value change per basis point change in yield for liabilities. When the Dollar Duration of assets is matched to the Dollar Duration of liabilities for every year in the term structure of liabilities, then DDM is the most precise form of Key Rate duration matching because it matches the Key Rate durations at every point along the liabilities yield cure or benefits payment schedule (30 years = 30 key rate durations).

The Ryan ALM DDM approach greatly improves the accuracy of Key Rate duration matching by matching the Dollar Value changes in liabilities with the Dollar Value changes in assets across the term structure and yield curve for both assets and liabilities. The liabilities are represented by using a Custom Liability Index (CLI) to more precisely measure and monitor the dollar value movement in liabilities given any movement in interest rates.

Pension plans need to pay more attention to their plan’s specific liabilities. Using either CDI or DDM is a step in the right direction to securing the promised benefits, while reducing cost. Please don’t hesitate to reach out to Ryan ALM with any questions that you might have on either of these disciplines that we bring to asset/liability management.

Ryan ALM Q1’21 Newsletter

We are pleased to share with you the Ryan ALM quarterly newsletter for Q1’21. As you will read, a terrific quarter was logged for both private and public pension systems that benefited from rising rates (liabilities down) and strong markets (assets up). The combination lead to improved funded ratios and funded status. We hope that you find our insights beneficial. As always, please don’t hesitate to reach out to us at (561) 656-2014 or visit us at ryanalm.com or kampconsultingblog.com. Thank you for your on-going support.