The Actuarial Standards Board (ASB) is responsible for setting standards for actuarial practice in the United States and they accomplish that objective through the development of Actuarial Standards of Practice (ASOPs). One such standard, ASOP No. 4 addresses “measuring pension obligations and determining pension plan costs or contributions”. This guideline is not specific to either FASB or GASB, so this standard should be applied by all actuaries when performing the following tasks:

Measurement of pension obligations, funded status, solvency risk, and the pricing of benefits. There are several other areas of focus, but the assessment of a Low-Default-Risk Obligation Measure was the one that grabbed our attention. Section 3.11 of ASOP No. 4 states that “when performing a funding valuation, the actuary should calculate and disclose a low-default-risk obligation measure of the benefits earned or costs accrued as of the measurement date”. When calculating this measure, the actuary should select a discount rate derived from low-default-risk fixed income securities whose cash flows are reasonably consistent with the pattern of benefits to be paid in the future. Sounds like cash flow matching to us. Examples of permitted discount rates include, US Treasury yields, rates implicit in the settlement of pension obligations, yields on corporate bonds of the two highest ratings given by recognized rating agencies, multiemployer current liability rates, and non-stabilized ERISA funding rates for a single employer plan. Notice that the return on asset assumption (ROA) is not one of the approved rates.

The actuary should provide commentary to help plan sponsors AND participants understand the significance of the low-default-risk obligation measure with respect to the funded status of the plan, future contributions, and importantly, the security of participant benefits. It is up to the actuary to use their professional judgement when producing the commentary. This measurement is not intended to highlight one discount rate as being the most appropriate. It is intended to provide a more transparent view of the current financial condition of the plan with respect to its future commitments. Final comments on this third draft are due by October 15th.

Ryan ALM is one of the few vendors that provide U.S. Treasury STRIPS and AA corporate zero-coupon (ASC 715 requirement) discount rates. We also created and provide a Custom Liability Index (CLI) as a monthly report that calculates: Future Value (grows and net of contributions), Present Value, Growth Rate, Interest Rate Sensitivity, and Statistical Summary (average YTM, duration, etc.) of the plan’s liabilities.

Most participants in the US pension industry know that the credit rating downgrade trend has been occurring for quite some time, but they may not necessarily appreciate the magnitude. The US bond market has shifted heavily toward BBB from AA and A rated bonds as nearly 70% of new issuance has been BBB (see chart below).

At the conclusion of 1990 roughly 11% of the corporate bond market was rated AAA. Today, there are exactly 2 corporate bonds – Microsoft and Johnson & Johnson – that maintain a AAA rating. Incidentally, this rating remains one notch higher than the US government, which has had a AA+ rating from S&P since 2011. The BBB segment of the US bond market was roughly 25% of the investment grade (IG) universe in 1990. Today, more than 50% of the IG universe is BBB and there doesn’t seem to be any let up at this time, as cheap financing has led to this borrowing craze.

Fortunately, default rates have remained incredibly low since the Great Financial Crisis for all credit ratings within the IG universe. We, at Ryan ALM, have taken full advantage of the growing BBB segment within our cash flow matching portfolios providing our clients with a terrific yield advantage relative to the pricing of their plan’s liabilities (ASC 715 AA corporate bond yield curve discount rates). Also, it should be pointed out that credit spreads for AA bonds have tightened significantly relative to BBB bonds elevating credit spread duration risk for that segment of the IG universe.

According to the Department of Labor, the median wage in the US in 2002 was $38,655 (adjusted for inflation). In 2019, the median wage had “rocketed” all the way to $39,101! Amazingly, we have ONLY seen inflation adjusted wages grow by $546 since 2002. Oh, my! During that nearly two decades we’ve witnessed further deterioration in the use of defined benefit plans (DB) and the greater emphasis on defined contribution plans (DC) that require individuals to fund, manage, and then disburse a retirement benefit. Do you really think that this is feasible given the modest growth in wages? Furthermore, we have seen housing costs (both purchase and rent), educational costs (look at student loan debt), healthcare, and health insurance premiums explode with each outpacing the CPI. This experiment will end in catastrophe.

Regrettably, many Americans don’t have access to an employer sponsored retirement benefit of any kind. We know from studies that most Americans don’t save outside of their employer-sponsored plan. For those that do have an employer capable of providing their employees with a plan, only about 70% of the employees take advantage of the savings vehicle. Furthermore, most aren’t coming close to maximizing their full deduction, and who can blame them given the meager wages. It costs a certain amount to provide for oneself and many Americans aren’t earning enough to meet that threshold. Why do we think that saving for a future retirement is even possible – it isn’t!

Why have we allowed this development to occur? Why have we determined that it is okay for DB plans to be frozen and terminated in favor of DC offerings that don’t come close to providing individuals with the necessary assets to enjoy a retirement, let alone one that is dignified. This social experiment will be a failure! I don’t think that we really need more time to see that insignificant DC balances will be adequate to keep Americans from falling onto the social safety net of our federal government. It is time to embrace the use of state-sponsored defined benefit plans. If corporate America doesn’t want to own the pension liability – fine! But they should at least be mandated to make a contribution on behalf of an employee into a state run defined benefit plan that is professionally managed, low cost, and one that provides a monthly annuity upon retirement.

As a young man growing up in Palisades Park, NJ, I loved the folk duo Simon and Garfunkel, and one of my absolute favorite songs was “Bridge Over Troubled Water” (released in January 1970). Much to the chagrin of my family, I will still belt out that song when I hear it. However, until yesterday I would not have thought that I’d use this song as a metaphor for potential issues in the pension/investment industry, but Ryan ALM’s Head Trader, Steve DeVito, provided us with the following chart and title that is just perfect for what we try to do for DB pension plans.

As the graph highlights, the decade of the ’00s was tragic for pension America. As we recently reported, the decade of the ’90s ended with most pension plans fully-funded if not in surplus funded status. But those funded ratios soon plummeted as the result of two incredible drawdowns in the S&P 500 (8/20 – 9/02 and 10/07 – 2/09). Had pension America engaged in a de-risking strategy when pension plans were fully funded in the 1990s, such as cash flow matching that would have protected what had been earned, the impact of those two major market declines would have been somewhat muted. First, DB plans would have maintained a greater allocation to fixed income, which performed superbly during that decade when equities truly suffered, while importantly matching the growth rate of the plan’s liabilities. Second, a cash flow matching bond strategy buys time for the alpha assets (non-fixed income) to grow unencumbered. Why is that important? The graph below highlights the fact that it took thirteen years for the S&P 500 to recover it’s $ value as of 1999.

By permitting the assets to grow without being a source of liquidity, equities benefit from the reinvestment of dividends. Studies have shown that more than 50% of the S&P 500’s return over 20+ rolling year periods is from dividend reinvestment. Furthermore, by establishing a cash flow matching program that provides for the payment of benefits and expenses, a plan is not forced to raise liquidity from equities when valuations have already been driven lower. Lastly, it also protects plans from making improper asset allocation decisions during periods of distress.

Pension America has benefited from an amazing period of performance since the Great Financial Crisis ended in early 2009. Funded ratios have improved for all DB plan types. It would be sinful to see this improved funding wasted as a result of inaction. It is time to secure the plan’s cash flow needs, funded ratio, and contribution expenses. A pension plan should covert the current fixed income allocation from a return seeking instrument to one that focuses on a bond’s cash flows. In a rising interest-rate environment such as the one that we might be experiencing, traditional fixed income strategies will likely generate negative total returns with as little as a 30 basis point move upward in rates. That could happen very easily. However, in a cash flow matching strategy, where we carefully match maturing principal and income cash flows with benefits and expenses, we are ensuring that the plan’s liquidity needs are being met and that interest rate risk is being eliminated, as future values are NOT interest rate sensitive.

Defined benefit plans need to be protected and preserved for the millions of plan participants who are counting on that promised benefit. Let’s not give those supporting these plans ammunition to seek their destruction. Risk reduction and the securing of benefits should be at the top of every plan’s working agenda. I’m not smart enough to know when the equity markets (perhaps bonds, too) will crater. I just know that history DOES repeat itself in the pension industry.

At the end of 1999, the average US public pension plan had a funded ratio >100%. Yes, just a couple of short decades ago the average public pension plan was overfunded thanks to great equity returns during most of the 1990s. Wow! During the 1990s asset allocation models reduced their allocations to bonds as interest rates kept going down so by 1999 they had the lowest allocation to bonds in modern history.  Why? Well, when the yield on bonds went below the ROA target (8.0%+) starting in 1989, it was perceived that any exposure to fixed income would jeopardize a plan’s ability to achieve the ROA. If only a plan’s liabilities, and not its ROA, were top of mind in 1999 we wouldn’t have the pension issues that we do for many state and municipal plans.

According to several actuarial firms that track the funded status for public DB plans, the average funded ratio for a public fund is now in the low 70% range, when applying GASB accounting rules, which means that the discounting of liabilities uses the ROA rate instead of FASB that calls for a AA corporate bond rate to be used. The current yield on the 10-year US Treasury note is at 27% of the 5.65% (12/31/99 US Treasury note) yield that was deemed too low to be meaningful. Had plans focused on the liabilities by driving asset allocation through a liability lens, plans would have defeased their Retired Lives liabilities through cash flow matching when they were fully funded thereby securing benefits and low contribution costs. That exposure should have been used to defease the Retired Lives Liability. This action would have stabilized the plan’s funded status and contribution expenses, while also buying time for the alpha assets to work through some very challenging times, such as the Dot-Com bubble burst and the Great Financial Crisis.

As we discussed in a recent blog post, US public pension plans do have exposure to fixed income, primarily to provide the cash necessary to fund benefits and expenses. However, in a rising rate environment, traditional fixed income programs will see the value of their assets decline, producing a likely negative return for the plan. It is far better to cash flow match bonds with the plan’s liabilities ensuring that the cash necessary to meet the promised benefits will be kept. Furthermore, future values of promised benefits are not interest rate sensitive.

Instead of driving asset allocation decisions through a ROA lens, let’s adopt a return to traditional pension management that views the plan’s liabilities as the most important variable in the asset allocation decision tree. It makes no sense that a plan that is funded at 60% should have the same asset allocation as one funded at 90%, but this happens all the time, as these plans are focused on achieving the same 7.25% ROA. Given the improved funding that we’ve witnessed, it is time to focus on securing the promised benefits at low cost and with prudent risk. 

Remember when Alan Greenspan uttered this famous phrase? He spoke these two words at an American Enterprise Institute event in the 1990s. It was a reference to the stock market’s valuation during the Dot-Com go-go era. It was interpreted as a warning to investors that things had gotten too overheated. He was ultimately proven correct!

We think that pension plan sponsors, as well as any other type of investor, should heed this warning once again, as Irrational Exuberance seems to be everywhere today.

Stock market – Historically high multiples based on any fundamental analysis.

Bond market – 39-year bull market dating to July 1982

Single family homes – The median cost for a single-family detached house last month was $391,250, compared with $307,220 a year before (+27.4%)

Cryptocurrencies – What is it? It isn’t a currency. So, let’s pay $42,866.40 for one bitcoin that has no underlying value.

Also, let us not forget meme stocks, which are stocks that have seen an increase in volume NOT because of the company’s performance, but rather because of hype on social media. Now there’s an investment strategy for you!

Any one of these might give you pause, but all of them at the same time – oh, my! As we’ve stated on many occasions, after a successful run at a Vegas casino one should take some risk off the table. Pension plans would be wise to follow the same course of action. There is little from that list above that is suggesting to us that pension systems will be able to generate the types of returns that we’ve witnessed since the Great Financial Crisis and that they are banking on to reduce contribution expenses.

Now is the time to cash in those gains while simultaneously protecting the improved funded status/funded ratios. Defease your plan’s Retired Lives Liability as far out as possible providing your plan the opportunity to wade through potentially troubling markets in the foreseeable future. It would be a shame to see this funding progress wasted through complacency, or worse, neglect.

The US Federal Reserve has just released a report stating that inflation is running “hotter” than expected. That probably won’t come as a surprise to anyone buying nearly anything today. So, what happens to your fixed-income portfolio should we get continuing inflation that ultimately leads to higher rates? Well, if your pension plan is invested in a traditional fixed income product managed to a generic index, your bond portfolio’s principal will decline in value by 1% for every one-year of duration and every 1% increase in yields. Invested in a 5-year duration strategy, your portfolio will decline by 5% should interest rates back up 1%. Given where interest rates are your fund’s total return isn’t going to be protected much through income. We’ve been in a protracted bull market environment for US bonds since roughly July 1982. Fixed income managers and their clients have benefited tremendously from this tailwind. Is the bond party nearing its conclusion?

Plan sponsors of pension plans need fixed income if for no other reason than to have the cash necessary to meet monthly benefit and expense needs. Is there an alternative to sitting in a portfolio that will likely suffer principal and total return losses? There sure is! A portfolio of investment-grade corporate fixed income cash flow matched to your plan’s liabilities and expenses will provide significant protection from interest rate risk, as both the assets and liabilities will move in lock-step with one another. Actuarial projected benefits and expenses are future values which are not interest rate sensitive. By cash flow matching liabilities with bonds, you have eliminated interest rate risk which is by far the dominant risk in bonds.The Ryan ALM cash flow matching model (Liability Beta Portfolio™) is a corporate bond portfolio skewed to A/BBB+ securities. This LBP will outyield liabilities when discounted using ASC 715 rates of AA corporate bonds. This will produce some Alpha by the difference in yield (+/- 50 bps).

Furthermore, the cash flow matching portfolio (CDI) provides additional benefits. Importantly, because your cash flow needs are now taken care of for some period of time – we recommend 10-years – the non-bond assets (alpha assets) can now grow unencumbered, as they are no longer a source of liquidity. Studies have shown that the reinvestment of dividends is a major contributor to the S&P 500’s return over time. In fact, some studies that I’ve seen allocate 50% to 60% of the return coming from dividend reinvestment over periods greater than 20 years. In addition, both the funded status and contribution expenses should be more stable given this approach.

A pension plan’s asset allocation should be dynamic. It should be driven by the plan’s funded status and projected liabilities and not the return on asset assumption (ROA). There has been terrific progress made by many pension systems as a result of out-sized performance during the period since the Great Financial Crisis. It would be truly devastating to have those wonderful gains lost because we remained complacent thinking that yesterday’s great results were likely to happen once again. Now is the time to convert your fixed-income exposure from an allocation that will work against your fund should rates rise to one that insulates your portfolio against this great risk. Oh, and as rates rise, the CDI investment strategy gets to reinvest excess income at higher interest rates. That’s another benefit to adopting this approach. Call us. We’ve written the book or at least the chapter on CDI (Frank Fabozzi’s latest book).

It is common in our pension industry to fit every product/strategy into an asset class box. I understand the thought process, but it doesn’t work for ALM strategies, especially when discussing products that are designed to meet a client’s specific pension liabilities. As a reminder, no two liability cash flows are the same given different labor forces, salaries, mortality, and plan assumptions. This requires that every ALM mandate be tailored to meet the specific requirements of that fund. Thus, these unique ALM fixed income solutions can’t and shouldn’t be compared to a generic fixed income index. Such generic benchmarks are inappropriate objectives and are not a good fit.

In order to assist the asset consulting community and their clients, we at Ryan ALM created a Custom Liability Index ((CLI) trademarked in 1991) to provide the appropriate index for cash flow matching assignments (CDI) and any LDI strategy. When asked to provide CDI, we are usually asked to defease roughly 10-years of the Retired Lives Liabilities, but in several cases our mandates are for periods both shorter and longer. How would comparing these assignments inform anyone of our skill relative to say the long corporate index? Clearly, it wouldn’t. However, the Ryan ALM CLI produces the information absolutely necessary to determine if our fixed income skills were in place to match and fund each benefit and expense during the period that we are asked to cover. All that matters in these mandates is that we have secured and fully funded benefits at low cost, and with prudent risk.

If a pension plan were to hire a small cap core manager with the goal to beat the R2000 then placing that manager in a small cap box might make sense because they aren’t providing a unique solution since the objective is the same for 100s of managers. But asking a fixed income manager to create a cash flow matching strategy designed to fully fund a plan’s specific liabilities is as unique a solution as there is. Don’t try to put CDI or any custom LDI in an asset class box. The true value added and acid test of any CDI asset manager is the cost savings to defease the liabilities that have been targeted. It doesn’t matter how they perform versus the long corporate index or any other generic fixed income comparison. To help consultants and plan sponsors with return performance, Ryan ALM provides a CLI that calculates the growth rate (return) of liabilities and a Performance Attribution Report (PAR) that calculates 14 different risk/reward measurements of assets versus liabilities.

We’ve reported previously on the results of the Natixis Global Retirement Study. 2021’s results are out and the United States has fallen one spot to #17. Not much to be proud about given that ranking. Sure, we are one place ahead of the United Kingdom, but we trail the likes of Slovenia and the Czech Republic. We have 100,000s of well-intentioned individuals feverishly working on behalf of current and future retirees, but that effort isn’t creating the outcomes that our workers and retirees obviously need and want.

According to the study, the index “incorporates 18 performance indicators, grouped into four thematic sub-indices, which have been calculated on the basis of reliable data from a range of international organizations and academic sources. It takes into account the particular characteristics of the older demographic retiree group in order to assess and compare the level of retirement security in different countries around the world.” Those thematic sub-indices are Health, Quality of Life, Material Well-being, and Finances in Retirement. Regrettably, the U.S. doesn’t score in the top 10 in any of these categories. Shockingly, it scores in 34th place for life expectancy, which craters the overall Health ranking despite scoring well in 2 of the 3 main sections.

Importantly:

80% of individuals (including 77% of business owners in our survey) believe companies should be responsible for helping them achieve a secure retirement. In addition, 80% of individuals say they would be more inclined to work for a company that offered matching contributions to their retirement savings plan. That’s fine and dandy, but we’ve seen companies quickly eliminate or slash matches in DC plans when economic times get challenging.

If our goal is to provide a dignified retirement to our participants, then we as an industry need to do a much better job. Retirees need a monthly annuity that they can count on. Asking untrained individuals to fund, manage, and then disburse a “retirement” benefit with little skill to do this is a ridiculous exercise. Trying to manage a retirement portfolio in this low-interest rate environment is incredibly challenging and forces participants to chase more aggressive/risky strategies. I’m a huge fan of traditional defined benefit plans, but the private sector has abandoned them, and individual workers are less interested in working for one company anymore. I just read this morning that the average worker will have 12 employers during their career.

Lastly, too many American workers aren’t earning nearly enough to provide for their needs today let alone allocate a percentage of their incomes to a retirement benefit years away. Sure, I’ve read many an article about how people had wished they’d saved more for retirement, but you can’t get blood from a stone.

I suspect that most of us have no idea that today, September 10, 2021, is National 401(k) Day. This day is recognized every year on the Friday following Labor Day. The day is supposed to be an opportunity for retirement saving education and for companies to inform their employees about their ability to invest in company sponsored 401(k)s. Did you get your update today?

401(k) plans are defined contribution plans (DC). This plan type was created in the late 1970s as a “supplemental” benefit. Corporate America liked the idea of a DC offering because it helped them recruit middle and senior management types who wouldn’t accrue enough time in the company’s traditional pension plan. Again, the benefit was supplemental to the traditional monthly pension payment and not in lieu of it!

I think that defined contribution plans are fine as long as they remain supplemental to a DB plan. Asking untrained individuals to fund, manage, and then disburse a retirement benefit is a ridiculous exercise. Why do we think that 99.9% of Americans have this ability? Unfortunately, we have a significant percentage of our population living within 200% of the poverty line. Do you think that they have any discretionary income that would permit them to fund a retirement benefit when housing, health insurance, food, education, and transportation costs eat up most of an individual’s take home pay? Remember, these plans are predicated on what is contributed. Sure, there may be a company match of some kind, but we witnessed what can happen during difficult economic times. That employer contribution suddenly vanishes.

Defined benefit plans are the gold standard of retirement vehicles. They once covered more than 40% of the private sector workforce, most union employees, and roughly 85% of public sector workers. What happened? Did we lose focus on the primary objective in managing a DB plan which is to SECURE the promised benefits in a cost effective manner with prudent risk? Did our industry’s focus on the return on asset assumption (ROA) create an untenable environment? Yes, we got more volatility, but did we get the commensurate return? It was this volatility that impacted the financial statements and led to the decision to freeze and terminate a significant percentage of private DB plans. It is a tragic outcome.

What we have today is a growing economic divide among the haves and haves-not. This schism continues to grow, and the lack of retirement security is only making matters worse. DB plans can be managed effectively where excess volatility is not tolerated, where the focus is on the promised benefit and not some made up ROA and where decisions that are made relative to investment structure and asset allocation are predicated on the financial health of the plan and the funded status. We need DB plans more than ever and ONLY a return to pension basics will help us in this quest. Forget about all the new-fangled investment products being sold. Replacing one strategy for another is no better than shifting deck chairs on the Titanic. We need improved governance and a renewed focus on why pensions were provided in the first place.