Recognizing Reality is a Good Thing!

Headline: Kentucky Teachers Retirement System adds $3 billion in unfunded liabilities to their books basically overnight. In actuality, they really didn’t. What they did do was to reduce a high discount of 7.5% to a more reasonable assumption of 7.1%. Do we hear 6.5%? In addition, they adjusted the assumptions for annual salary increases from 3.5% to 2.75% and extended longevity for the average participant. These are all very reasonable. Yes, on paper it looks as if Kentucky’s taxpayers are on the hook for more (roughly $200 million per year), but in actuality, they were already on the hook for much more than that! These moves are just more in line with reality! Good for them. The fact that accounting rules and actuarial practices allow public pension plans to discount their liabilities at the return on asset assumption (ROA) distorts economic reality, especially in an historically low interest rate environment. Economic reality and greater transparency would actually reveal a funded status that is not 54%, but something dramatically lower.

The argument in using the ROA to discount a plan’s liabilities has been that public pension plans are perpetual – baloney! We’ve seen a number of situations over the years that had public fund DB plans being shuttered and hybrid or DC plans being offered in their place to new employees. Furthermore, even without freezing and terminating, the use of multiple tiers reflects the reality that the original promise wasn’t going to be met for the entirety of the plan’s participants. Adopting a truer, more realistic, discount rate for the pricing of liabilities will help keep these plans better funded, as annual contributions will be greater. Please note that corporate pensions use market value discount rates and are much better funded. It also means that asset allocations can be less risky. Given current extreme valuations for both equities and bonds, this might just be a very good time to act. We congratulate KY on taking these steps and hope that other public pension systems follow a similar course.

When will they become a focus?

Summer is here. It officially started at 11:30 pm (DST) on Sunday, June 20th (Happy Father’s Day). Maybe that is why I’m feeling restless today and perhaps a little rambunctious. That said, I need to get something off my chest! I recently had the opportunity to view a quarterly report for a major public pension system. The report by the asset consultant was massive (thank God I didn’t drop it on my foot!), as it contained 282 pages and every conceivable metric to evaluate an investment manager’s performance. Despite the 282 pages, there was not a single reference to the pension plan’s liabilities – not one! A comparison of the plan’s total assets to total liabilities should be on the first page. There is nothing more important! It doesn’t matter how assets do versus the plan’s return on assets (ROA) assumption or some hybrid index. It the total assets fail to beat liability growth the plan loses. As a reminder, these plans only exist because a promise was made to a plan participant. It is that promise (the liability) that must be funded.

At Ryan ALM we believe that the primary pension objective in managing a defined benefit plan is to SECURE the promised benefits in a cost-efficient manner with prudent risk. The ONLY way that this objective is met is to measure and monitor the plan’s liabilities on a regular basis. Since most actuaries only produce annual reports on the plan’s liabilities, it behooves plan trustees to find an alternative source for this information. The plan’s liabilities must be used to drive investment structure and asset allocation. I’ve written plenty on this subject in many different blog posts that can be found at Kampconsultingblog.com, so I won’t repeat myself now.

But where are trustees getting the knowledge necessary to focus on plan liabilities to make these critically important asset allocation decisions? I’ve been very pleased during the last several decades to see the effort put forward to educate public pension trustees through organizations such as FPPTA, IPPFA, MACRS, TexPERS, and many more. They have invested many $s and hours into making sure that plan trustees know everything about the asset-side of the pension equation, but how much time do they spend on liabilities? If you were to take a look at the tests that trustees need to take in order to get a certificate, what percentage of that test would be on plan liabilities? Unfortunately, I would guess very little to none. This needs to change.

As I shared the other day, tremendous asset growth has been achieved during the fiscal year 2021. As Moody’s has suggested, it is time to take some risk off the table so that plans don’t continue to risk these gains or worse. But a plan sponsor will need to know the liability side of the pension equation to make the necessary decisions. Waiting until the next actuarial report is produced is not an option.

Public DB Plans Should Heed Their Advice

Moody’s has recently published a very balanced analysis on the current state of public pension systems. Most of the article discusses the outstanding, perhaps historic, performance results achieved during fiscal year-to-date 2020-2021. Let’s hope that the last couple of weeks in this fiscal year don’t bring any surprises. As a result of the terrific performance and slightly higher interest rates, most DB plans have witnessed improvement in the plan’s funded status. There weren’t many people in our industry who would have expected this performance turnaround when we were living through the depths of uncertainty brought on by the Covid-19 pandemic during 2020’s first quarter.

Despite the rosy performance picture, Moody’s does remind us that “unless US public pension systems move to significantly de-risk their investment portfolios, the potential downside to government credit quality from their reach-for-yield strategies will remain” even after these recent outsized returns. Given the heavy exposure to both equities and alternatives, the average public pension fund’s asset allocation “carries significant volatility risk”. Whether these pension plans de-risk remains quite uncertain. But according to Moody’s, given the 7% target return, the average asset allocation has a one-in-six chance of producing a -5% return or worse annual result. They also suggest that these mature systems, with their large benefit payouts, could see funding gains evaporated and funded status fall to June 2020 levels should the poor performance results occur.

When we at Ryan ALM discuss de-risking DB plans, we are not encouraging a UK-like process. According to John Authors, Bloomberg, the average UK pension plan has reduced equity exposure from 61% to 20% during the last 15 years, as UK regulators encouraged DB pension systems to de-risk. We believe that costs will be dramatically increased if the US were to adopt a similar approach. At Ryan ALM, we suggest that DB pension plans convert their current fixed income exposure from a return-seeking focus to a cash flow matching mandate that enhances liquidity, removes interest rate risk, secures the promised benefits, while also extending the investing horizon for the alpha portfolio that will have a significant exposure to equities and alternatives.

Letting your winnings ride in Las Vegas may occasionally prove fruitful, but it shouldn’t be the approach used to manage DB pension plans. After this incredible performance year, plans would be wise to take some chips off the table and finally begin to manage their plan’s assets versus plan liabilities. Everyone will sleep better at night knowing that the promised benefits have been secured.

Plan Sponsors Need All The Info

We have been doing an analysis on a fairly good sized municipality’s pension system using our Custom Liability Index (CLI). The fund appears to have a roughly 35% funded ratio when using standard accounting rules and actuarial practices. However, when you include projected future contributions (provided by the actuary), the plan is well over-funded. It begs the question, why aren’t contributions part of the funded ratio calculation? Does it make sense to have future liabilities in the equation but not future contributions? As a result of this inconsistency, plan sponsors are forced to make important decisions related to benefits, COLAs, ROA targets, asset allocation, etc. without having the full economic picture.

In this case, future contributions are massive and dramatically overstated. In our analysis we were able to suggest a reduction in annual contributions of $5 million/year for a savings of nearly $100 million during the evaluation period and the plan would still be fully funded. This is a tremendous savings that can now be used to support the other important programs within this city’s social safety net. Furthermore, the fund only needs a very modest return (i.e. 3%), far smaller than the current return on asset assumption (7.25%), to maintain a healthy funded status. Without this insight, the plan sponsor and their advisors would continue to manage a much more aggressive asset allocation injecting unnecessary risk into the process and jeopardizing the current funded status.

There are a lot of things that don’t make sense in our industry. Why do we have two accounting standards – GASB (public funds) and FASB (private plans)? Why don’t we account for future contributions (as assets) while including future liabilities? Why do pension systems focus on the ROA and not the promise (projected benefits) that has been made to the plan participants which is the only reason that these plans exist in the first place? Finally, how can a plan be managed when only focusing on the asset side of the equation? This would be like playing a football game and only knowing how many points you’ve scored. Every pension plan should have an x-ray (asset/liability review) taken quarterly that demonstrates the health of the pension system. Without this review, you could end up throwing a “Hail Mary” when 3 yards and a cloud of dust is all that is necessary.

There’s a Long Time until October

Inflation is on everyone’s mind these days, and for most of the investment community higher inflation is not welcomed! But there is a group that might just benefit a little from a bit of inflation. I am specifically referring to Social Security recipients. Every October the Social Security Administration announces the COLA for the next year. Unfortunately, COLA increases have been running at 1.92% for the last four years, bringing with them annual increases of roughly $20/month to $39/month for a recipient who gets the “average” monthly payout. Clearly not enough to be life changing.

We’ve reported on these developments in the past, and have discussed using the CPI-E instead of the standard CPI-U, as the CPI-E measures the inflationary impact on senior citizens. The CPI-E has run about 0.2% higher than the CPI-U since it was first reported. That change has not been adopted yet. The Bureau of Labor Statistics recently released the inflation number for May, which showed a 0.6% increase following April’s 0.8% surge.

“In May, The Senior Citizens League (TSCL) released its first forecast of the 2022 COLA after analyzing the April CPI data and had it pegged at 4.7%.”(401(K)Specialist) Given May’s continuing inflationary upward trend, it is not inconceivable that the forecast for 2022’s COLA could rise further. If the COLA ends up being anywhere near the 4.7% increase or greater, it will represent a >3Xs increase on 2021’s 1.3% allocation. Again, the annual COLA is intended to help recipients stay one step ahead of inflation but given the use of the CPI-U instead of the CPI-E, our seniors may still be falling behind.

A Potential 401(k) “Investment”

I just read this morning that ForUsAll Inc., a 401(k) provider to roughly 400 plans (total AUM of $1.7 billion) has entered into agreement with a division of Coinbase Global to offer access to cryptocurrencies – bitcoin, ether, litecoin, etc. – through the workers’ 401(k). The potential investment is limited to 5%. Do we really want unsophisticated employees making an investment in these instruments given the extreme volatility we are witnessing? There are on-going efforts within the 401(k) community to provide participants with access to private/alternative investments, but in nearly every other example, there is an underlying fundamental story or balance sheet supporting the product.

The WSJ article did not mention the cost of investing in cryptos, but they did highlight the fact that ForUsAll would notify the participant when their exposure neared or exceeded 5% so that they could rebalance their exposure. Are they going to inform the participant when the original investment has been cut in 1/2 or more?

Massive Rotation?

A Bank of America research note published recently suggests that the significant improvement in corporate pension plan funding (Milliman calculates the collective funded status at >98%) will likely lead to a “massive rotation” from equities into corporate bonds. We absolutely agree that it should. Many private sector pension systems have frozen and terminated their pensions during the last 4 decades, but many 1,000s still exist. For those that haven’t yet terminated or frozen their plan, engaging in a de-risking strategy at these funding levels makes absolute sense. Why wait? Market timing, predicting equity markets and interest rates, shouldn’t be driving this decision. For instance, the US Treasury 10-year note has rallied despite inflationary expectations and the yield sits at 1.47% this morning down from 1.75% on March 31, 2021. Most market participants were expecting rates to continue to climb.

“I think this becomes a pretty big story, and it becomes a support for credit spreads in the back end of the curve
especially,” Hans Mikkelsen, BofA’s head of high-grade credit strategy, said in an interview. We agree that it likely supports credit spreads, which have tightened, but we disagree that it particularly supports the back-end of the curve. Engaging in asset liability management (ALM) is NOT about buying long corporate bonds. Effectively managing assets versus plan liabilities calls for the cash flow matching of assets along a liability yield curve of projected annual benefit payments, with the next month’s benefit payment being the most important. Sitting with a bunch of long corporate bonds and thinking that you have somehow “immunized” the  assets to match liabilities is just wrong, while opening the plan to significant interest rate risk.

There are only two ways to secure benefits – insurance buyout annuities (IBA) and cash flow matching (CDI). Doing a pension risk transfer through an IBA can be very expensive, especially relative to managing the plan’s liabilities through a cash flow matching strategy. Our experience and analysis suggest that a CDI approach can save the plan about 30% on the future costs of the benefit relative to engaging in an IBA. Furthermore, if a plan is focused on eventually doing a pension risk transfer a cash flow matching portfolio is the perfect vehicle to meet this objective as the insurance company will likely be happy to do a portfolio transfer-in-kind. Go to RyanALM.com to see multiple research pieces on this subject.

Will there be enough money?

There is much chatter and speculation on social media regarding ARPA’s funding and ability to meet all the promises. There is growing fear among some circles that somehow the “pool of resources” will fall short of meeting the objective to fund ALL the benefits (and expenses) for the next 30-years for those plans filing for financial assistance. Please remember that no specific $ amount has been allocated and no estimate of the final cost was in the legislation. Sure, there was an estimate by the OMB that suggested that the ultimate price tag would be $86 billion, but that is only an estimate. Furthermore, the amount of Special Financial Assistance (SFA) will be predicated on multiple inputs yet to be decided. These inputs include the discount rate used to determine the present value (PV) of the liability and whether or not the current assets, future contributions, and projected return on the assets are included in the SFA calculation. Hopefully, we’ll get answers to these critical variables when the PBGC publishes their guidelines around July 10th.

Importantly, the legislation does specifically state that “there is appropriated from the general fund such amounts as are necessary for the costs of providing financial assistance under section 4262 and necessary administrative and operating expenses of the corporation. The eighth fund established under this subsection shall be credited with amounts from time to time as the Secretary of the Treasury, in conjunction with the Director of the Pension Benefit Guaranty Corporation, determines appropriate, from the general fund of the Treasury.”

The only possible fly in the ointment is the following: “but in no case shall such transfers occur after September 30, 2030. Given this restriction, the powers that be better get the discount rate and calculation of the SFA correct, or there could be significant shortfalls during the next 30-years in the amount of assets needed to meet those promised benefits!

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.