I believe that every pension plan should engage in the practice of focusing on plan liabilities to help inform asset allocation and investment structure decisions. This has become common practice for a majority of corporate plans, but they often engage in LDI or duration-matching efforts. If securing the promised benefits is the number one objective in managing a pension system, then utilizing an LDI approach is wrong, as reducing interest rate risk does nothing to ensure that cash is available to meet the next benefit payment.

The only strategy that meets this requirement is cash flow-driven investing (CDI), which utilizes a carefully constructed bond portfolio (we refer to our portfolio as a Liability Beta Portfolio) to meet each and every benefit payment, net of contributions, chronologically from the next monthly payment as far out as the allocation will fund. As the title of this post suggests, cash flow is superior to capital appreciation.

For a plan that is in a net-negative cash flow situation (and what plans aren’t?), having the cash to meet payments when they are due is critically important. Furthermore, it important to control costs, and meeting cash flows through redemptions results in transaction costs and is only possible when the assets are sufficiently liquid. In times of market stress, like now, the cost of trading “liquid” assets can increase dramatically. As plans have moved more of their assets into the alternative bucket, the risk of being a forced seller to meet benefits has increased. Utilizing a CDI approach “buys time” for the non-bond asset to grow unencumbered.

P&I has on the cover of their May 4th edition an article highlighting the fact that the funded status declined for the top 100 corporate plans in 2019 from 90.1% to 87.8% despite generating a 15.7% aggregate return, as the discount rate fell 95 basis points to 3.3%. As a result, liability growth for these large corporate plans grew more than 11%. Wait, liabilities were up 11.3%, while assets were up 15.7% then how is it that funded status declined? This demonstrates that plans with deficits have to work harder and outgrow liability growth in dollars, not percents, to enhance their funded status. Asset growth is not an absolute return target (ROA) but a relative growth rate versus liability growth in dollars.

In the same article, a strategist for Goldman Sachs Asset Management points out that this “paradox reinforces the importance for a liability matched fixed income glide path”. We agree on the need to focus on liabilities but disagree on the strategy of using long bonds in this environment to accomplish the objective. LDI strategies have benefited from a roughly 38-year bond bull market, as interest rates have plummeted.

Given where rates are today, there is a fairly significant probability that rates will rise during the intermediate period creating losses for your portfolio, while not securing the benefits as discussed above. In addition, a CDI approach accomplishes the objective of eliminating interest rate risk, as future values (benefit payments) are not interest-rate sensitive. It is a win-win! We think that CDI approaches work for all pension plans, but if you have any doubts we are here to answer any of your questions.

We’ve been writing about the need for pension reform within the multiemployer space for years by highlighting what failure to act would produce for the critical and declining pension plans and their participants. We’ve questioned how the US government could possibly sanction these draconian cuts through the MPRA (2014 pension “reform”) legislation.

It is easy to focus on the numbers – 130 plans and 1.4 million Americans – but what is happening and what will likely continue to happen to these plan participants needs to be heard through their individual stories. The following link, https://www.youtube.com/…/UCKC1NJczAKwWd2LB3B…/videos…has the stories of 15 brave individuals willing to share their perspective on how these drastic and unacceptable cuts have impacted their remaining years. It is an incredibly sobering reality. In one case, a retiree initially lost 50% of their benefit, only to then lose another 70% of that reduced “benefit”. As his wife indicated, they often deferred raises to support additional contributions being made into their plans to help fund that promise of a dignified retirement.

What the Covid-19 crisis is highlighting is the fact that a majority of Americans are hanging on financially by their fingertips, and pensioners are certainly no different, especially for those that have already seen their benefits slashed and for those in plans that are likely to fail without significant support in the immediate future. Can we really afford to cast them aside?

When Ron Ryan and I first became involved in designing an implementation for the Butch Lewis Act (BLA) legislation, Ron recommended cash flow matching the retired lives liability with the proceeds from the low-interest loans provided to the Critical and Declining status multiemployer plans. This process would require (force) plan sponsors to defease the retired lives liability that would then allow the fund’s current assets and future contributions to meet future plan liabilities, including repayment of the loan and the semi-annual interest payments.

The economic toll from Covid-19 on many states and municipalities will be devastating, as revenue from personal income, corporate business, and sales taxes, motor fuels taxes, casino-related taxes, lottery sales, toll roads, and other fees plummet. As we’ve reported in previous blogs, many states were not prepared for a crisis of this magnitude, and as a result they don’t have the reserves to make up for this significant shortfall in revenue, while also incurring greater expenses in the fight to contain the virus. NJ was actually trying to build a $1.3 billion reserve for 2020, but those plans have recently been scrapped.

There is active debate in Washington, DC as to whether stimulus money should go to these entities. Whether you agree or disagree, public pensions need support. Contribution expenses will continue to rise at the same time that budgets can least afford. Many of these systems will not be able to generate the necessary excess returns to bridge this funding gap. These systems are critical drivers of economic activity through the benefit payments to their participants, as well as the investments that they make, such as infrastructure.

Getting back to the BLA, Ron and I have always felt that the Federal loan program that is contemplated for multiemployer plans would work for public pensions, too. Instead of a bailout that might not be palatable to some, create the Pension Rehabilitation Administration (PRA) as a new agency within the Department of the Treasury to provide BOTH C&D multiemployers and public funds with the assets necessary to defease each plan’s retired lives liability. This will secure the promised benefits, thus maintaining the economic stimulus that is so necessary for these retirees and their communities. It also buys time for the current assets to weather this storm without forcing liquidity in assets that don’t have the natural liquidity to meet monthly payments. This strategy will provide states and municipalities with the necessary resources to maintain (and perhaps expand – unemployment claims) the social safety net that is so critical at this time.

There is a solution! Let’s not permit politics to cloud our judgment. Implementing a low-interest rate Federal loan program that requires a disciplined approach to implementation is the way to go before the economic crisis gets worse.

David Brenner, Senior Vice President and National Director of Multiemployer Consulting at Segal said in an article by Rebecca Moore in PlanSponsor that it is too early to tell what effect the first quarter’s market volatility will have on multiemployer plans in the long term. But, “we do know that those in Critical and Declining (C&D) status will be challenged,” he says. “Even healthy plans will be challenged, but they should be able to recover.”

When David speaks about the C&D plans, he is referring to the roughly 130 plans that have a funded ratio below 65% and are likely to become insolvent within the next 15 years. Many of these were forecast to end up with the PBGC long before the 15-year window expired. Regrettably, many of the funds currently in Critical status will likely be impacted to an extent that will have them fall into the C&D bucket.

The Segal organization has prepared an additional analysis, which considered both investment losses and reductions in contribution income on the multiemployer pension universe. “They found that “depending on the severity and duration of the COVID-19 crisis, we estimate that as many as 180 additional plans could face projected insolvency in the next 20 years. That would bring the total number of plans in critical and declining status to over 300, covering over 2.5 million workers, retirees and beneficiaries.

As we have consistently reported for 2 1/2 years, this crisis is not going to go away on its own. There is no way that these plans can earn enough from their investments to overcome the severity of their negative cash flow status. These plans need the Federal government to inject a significant amount of money to cover existing retired lives while buying time for their current assets to outperform future liability growth. The Butch Lewis Act is the only legislation currently before the Senate, but Republicans are anathema to providing a “bailout” – their description.

While Washington fiddles, the multiemployer pension system is burning. Retirees deserve as much support as that which we are providing to the unemployed, small businesses, states and municipalities, and strategically significant industries. Now is not the time to play politics with the financial future for so many hard working Americans, who were given a promise and who contributed to that promise along the way.

In real estate investing one often hears the saying used by property experts that the three most important factors in determining the desirability of a property are “location, location, location“. For endowments and foundations (and DB plans, too) the key is liquidity, particularly in periods of market stress. In a recent P&I article, Margaret Chen, partner and global head of the endowment and foundations practice at Cambridge, is quoted as saying that “the primary concern of an endowment or foundation CIO is having adequate liquidity to meet operating expenses”, and we would agree. Yet, there seems to be a major disconnect between philosophy and implementation.

NACUBO and TIAA produce an annual study titled, “Asset Allocations for U.S. Higher Education Endowments and Affiliated Foundations”. In the review for 2018’s asset allocation study they highlighted that E&Fs >$1 billion had only 7% in fixed income investments and 32% in public equities (13% in the US), while allocating 58% of the assets for these funds in less liquid alternatives. If liquidity were so key to their success, why would there only be 7% in the only asset class that has a known cash flow? As we reported recently, despite having an absolute-orientation because of their annual spending policies, E&Fs dramatically underperformed corporate pension funds in the Northern Trust universe of large institutional funds, and that’s before we find out the true impact on all the private investments that don’t provide a true market value.

If these plans insist on investing as heavily in alternatives as they currently do, they need to adopt a bifurcated asset allocation that walls off the liquidity needs from the growth part of their portfolio. By implementing a cash flow matching strategy to meet future spending needs, they buy critical time for their alternatives to capture the liquidity premium that exists in these assets. By having so little invested in cash flow producing assets at this time they are forcing liquidity where it doesn’t naturally exist.

Why would you want to be forced to sell public equities at this point or even corporate bonds given the widening that occurred in spreads? These plans may not have a formal liability like a benefit payment in a retirement plan, but these CIOs certainly know what they will generally need in the next 5-10 years to be able to comfortably model that as if it were a benefit payment. Whether we are talking about E&Fs or DB plans, we continue to face the reality that yesterday’s strategies that haven’t worked are not all of a sudden going to work as we move forward. There are time-tested strategies focused on cash flows that should be at the center of any asset allocation strategy.

Milliman, Inc. yesterday released the results of their 2020 Corporate Pension Funding Study (PFS), which analyzes the 100 largest U.S. corporate pension plans. The study highlighted the fact that the aggregate performance (17.3%) for this cohort was the second best annual return recorded during the life of this survey. Only 2003’s 19.5% performance topped 2019’s result.

Despite the significant return achieved last year that was well in excess of the average return on asset assumption (ROA), collective funding for the top 100 plans only modestly improved from 87.1% at 2018 year-end to 87.5% as of December 31, 2019. It once again highlights the fact that a review of asset performance alone only addresses one part of the pension equation. Failure to understand what is happening to plan liabilities often leads to uninformed decisions.

The good news coming from corporate America is their greater use of fixed income within the plans’ asset allocation schemes. According to Northern Trust’s review of their 300 large institutional universe, ERISA plans benefited from a large allocation to fixed income securities. The average plan had 40.4% exposure to fixed income at the end of the first quarter, compared to only 27% for the median public pension system. This additional exposure to fixed income certainly helped to prop up performance for corporate plans in the first quarter. As we highlighted yesterday, the average corporate plan within Northern’s universe outperformed the average public fund by more than 4% during the first 3 months.

Northern Trust has published the aggregate performance results through March 31st for its universe of roughly 300 large institutional pension plans and endowments and foundations. Not surprisingly, performance results (-11.6%) are very weak for the entire universe. What also isn’t surprising to me is that public pension plan performance once again trails that of private sector corporate plans. Corporate DB pension plans had a median performance for the quarter of -8.1%, while public pension systems produced a decline of -12.6%. This comparative result shouldn’t be a surprise to anyone.

Unfortunately, public pension systems operate with the belief that no matter what happens these systems are perpetual. That is absolutely the wrong approach, since perpetual doesn’t mean sustainable. Whereas corporate America pays much more attention to the liability side of the asset/liability equation, public pension systems operate as if they have no plan liabilities, and that is reflected in their asset allocations that have gotten more risky since the GFC.

Maybe it is the accounting rules that keep corporate pension systems more focused on plan liabilities. But, whatever the case, they are less prone to wild swings in plan performance, which means that contribution expenses tend to be less volatile, too. Given the impact that Covid-19 will likely have on sources of revenue for state and municipal budgets, wild contribution hikes are going to create significant financial burdens.

It is stupid that we have multiple accounting rules and regulations on how pension systems value plan liabilities. The use of the ROA to value liabilities under GASB accounting leads to public pension plans being habitually underfunded, as contributions are predicated on a deflated estimate of those liabilities, and it also forces them to inject more risk into their asset allocations, which leads to greater disparity in returns versus their more conservative corporate peers. Assuming more risk hasn’t lead to greater returns either, as corporate plans have done significantly better than public plans for the 3- and 5-year periods ending March 31st producing returns of 5.6% and 4.8% versus 3.0% and 4.1%, respectively.

What did surprise me in the analysis by Northern Trust is just how badly E&Fs performed during the quarter. As a reminder, these funds should have an absolute orientation given that they operate with a positive spending policy each and every year. The fact that they were down -11.6% for the quarter, while also underperforming both corporate and public plans for the 5-year period (3.9%) ending March 31st, is shocking. I guess the move into hedge funds once again proved to be a failed move. When will they learn?

It is time that we get back to basics within our industry. Public pension funds need to be managed more like corporate plans, and all funds need to pay greater heed to their liabilities, whether relative (DB plans) or absolute (E&Fs and HNW). What are we waiting for?

As we’ve been reporting, US states are under significant financial stress that will likely get much worse before it gets better. Debate continues as to what the Federal government might be willing to do to help states bridge their cash flow needs as a result of plummeting tax revenues/receipts. As the following chart indicates, not all state budgets are created equally.

For once, New Jersey is not the worst state, but their rainy day fund might help them get through about two weeks of projected cash flow needs, where as Illinois has the financial wherewithal to make it until 10 am this morning.

It is estimated that US states will incur a roughly $500 billion projected loss in tax revenues from shutting down local economies that needs to be made up somehow. Without a federal bailout, drastic cuts in education and other social safety net requirements will be necessary to close this gap. Unfortunately, these cuts will further derail economic activity creating a further burden on state budgets. The $150 billion that has been earmarked for US states is specifically designated for Covid-19 related expenditures and can’t be used to offset the economic hit that many states are facing. Something needs to be done today. McConnell’s threat of pushing states to use the bankruptcy courts is not helpful or currently legal.

Anyone who has read my blog throughout the years knows that I often rail about decisions taken in NJ with regard to the state’s pension system, but this is one time that I am firmly with NJ and all the other states that have seen their economies wracked by Covid-19-related expenditures.

In yesterday’s post, I mentioned that Senate Majority “Leader” Mitch McConnell and the Republican Senate didn’t appear to be willing to provide assistance to states and municipalities. In fact, McConnell was quoted as saying that he would prefer that states file for bankruptcy rather than receive a Federal bail-out despite the fact that everyone else is getting one at this time. Here is why McConnell’s thinking is so shortsighted. It was reported that another 140,139 New Jerseyans filed for unemployment last week, bringing the tally to an unbelievable 858,000 workers desperate for checks. The state has already dished out $1 billion or so in unemployment benefits. Some perspective: At this time last year, there were just 84,000 residents collecting from the state’s unemployment pool.

As everyone knows, NJ’s economic environment is already challenged by one of the country’s worst out-migration trends that has been brought about through a combination of high state income taxes, excessive property taxes, and out-sized housing costs that make it challenging for a large percentage of the state’s residents. Couple those impediments with a pension system that has a colossal deficit, and not surprisingly, you create a terrible economic environment. Sure, and to be fair, some of this has been brought on by mismanagement, especially when it came to the state’s failure to make the full annual required contribution, which they haven’t done since Washington slept here! But, the unprecedented impact from this virus is crushing NJ’s budget and those of many other states and municipalities.

Does it make any sense to let states collapse? Do we really want to see mass lay-offs in the public sector that would mirror those in the private sector? Isn’t it imperative that we have the tools and resources now to meet this crisis head-on, and not wait for some resolution in the courts to begin to defeat this menace? Governor Murphy said, “come on, man” when reacting to McConnell’s stance. I couldn’t agree more! As a point of reference, I am honored to be an elected official (Councilman) for the town of Midland Park, NJ. In my capacity as a Councilman, I am seeing first hand how state and local budgets are being stretched in ways that we’ve never considered or imagined. Midland Park certainly doesn’t have a rainy day fund of the size necessary to meet these unanticipated burdens. Why should we expect that any state or municipality would?

On the other hand, the US government does benefit from having a fiat currency that can be used at this time to prop up and support our displaced workers and their families, retirees, businesses, AND government entities. It would be foolish to “punish” any one of these important constituencies when we have the economic capacity to provide life saving measures. For once, can we put politics aside and do what is best for our country? If not, then you don’t deserve to “lead” us!

We truly understand and appreciate the funding concerns that all DB plan sponsors are challenged with at this time. However, we are particularly focused on the issues surrounding public pension funds, as they are getting crushed with the doubly whammy of falling asset levels and potentially skyrocketing contribution expenses, in an environment of plummeting sources of revenue, as the closing of the US economy significantly reduces tax and fee revenues.

Senate Majority “Leader” Mitch McConnell and the Republican Senate, don’t appear to be willing to provide assistance to states and municipalities at this time. In fact, McConnell is quoted as saying that he would prefer that states file for bankruptcy rather than receive a Federal bail-out despite the fact that everyone else is getting one at this time. Having US states declare bankruptcy was roundly panned by both Republican and Democratic governors during and after the Great Financial Crisis, as this action would cause disruption to bond markets, while simultaneously driving interest rates higher and raising the cost of borrowing at a time when every dollar matters. Why is it acceptable now?

Given that the financial position of many US states is precarious at best, state and municipal pension systems need time to weather this storm. As we shared during the Opal/Ryan ALM webinars (4/15 and 4/22), one of the significant advantages of using a cash flow matching strategy (CDI) to meet promised benefit payments is that it buys time (extends the investing horizon) for the alpha assets to perform. This extension, which keeps the plan from forcing liquidity where it doesn’t naturally exist, allows the plan’s assets to recover from the significant draw-down experienced year-to-date, but also provides an extended time frame for all of the private assets that have found their way into plans.

The cash flow matching portfolio (beta assets) will be used to meet on-going monthly benefit payments for as long as the current allocation to fixed income can support. With little disruption, a CDI portfolio can be implemented that won’t impact the return on asset assumption (ROA) or the plan’s asset allocation. In fact, it is highly likely that the Ryan ALM CDI portfolio will out-yield the current core fixed income account, thus improving the plan’s ability to achieve the ROA target, at lower cost – management fees and transaction costs. In fact, the conversion from an active, highly interest-rate fixed income portfolio to a CDI approach is quite simple, as the existing portfolio can be transferred-in-kind to us for conversion, saving more money in the process.

It is truly understandable why trustees might be feeling overwhelmed at this time from the negative impact of the Covid-19 virus. They are dealing with falling asset levels, falling interest rates that impact the true liability cost, the likelihood of escalating contribution expenses in an environment of challenged revenue sources, and concern for themselves, family members, and colleagues. It would be enough for anyone to want to go into a bunker. Please don’t. By making this simple (really) conversion from active fixed income to a CDI approach the plan sponsor buys critical time needed to help the plan navigate these troubled waters. But, they also create an enhanced asset allocation process that secures benefits, improves liquidity, eliminates interest rate risk, and likely out-yields the current capability, thus enhancing the ability to achieve the ROA. That is a lot of reward for not a lot of effort. Skeptical? Call us or check us out at RyanALM.com.