Pension risk management

I just had the opportunity to speak at the Opal/LATEC conference in New Orleans on the topic of pension risk management. For many plan sponsors and their consultants, “risk management” is focused on the asset side of the equation, but managing a DB pension plan is much more than just assessing the risks associated with plan assets. We, at Ryan ALM, espouse a risk management approach that focuses first and foremost on the plan’s liabilities.  Liability-driven investing (LDI) is a refocusing of the management of the plan’s pension assets away from an “asset only” approach to an approach that considers both the assets and the pension plan’s specific liabilities. The objectives are two fold: 1) secure the promised benefits, and 2) maximize the cost efficiency of the plan’s asset allocation.

There is more than one way to de-risk a plan within the broad Liability-driven investing category:  pension risk transfers, duration matching, and cash flow matching are three of the most common approaches. At Ryan ALM we utilize cash flow driven investing (CDI) as the preferred implementation for we believe that it is the most precise and least expensive de-risking strategy.  However, many corporate plans, and some public funds and multiemployer plans, have used duration matching strategies to accomplish their goal of neutralizing interest rate risks (not necessarily securing the benefits) with a combination of target duration LDI, Treasury STRIPS, long government/credit, and in some cases derivatives to construct a portfolio suited to meet an individual plan sponsor’s liability hedging goals.

Plan sponsors that have used long credit maturities and longer duration STRIPS to duration match their plan’s liabilities may want to reassess the composition of their fixed income program at this time.  U.S. interest-rates continue to plummet, as both the 10-year (1.33%) and 30-year U.S. Treasury (1.82%) rates are at historic lows. By selling the long-term credits/STRIPS, plan sponsors can lock in significant gains from these assets and then use the proceeds to cash flow match near-term Retired Lives liabilities (1-10-years) chronologically in order to finally secure those promised benefits, while significantly reducing the interest-rate sensitivity of their holdings since CDI matches and funds future values (benefit payments) which are not interest rate sensitive.

Obviously, no one knows where U.S. rates are headed, but at these incredibly low levels the probability of seeing interest rates remain flat to rising is greater than rates continuing to fall much further from here. We encourage you to use this unique opportunity to restructure your LDI program away from duration matching and refocus on cash flow matching 1-10 year Retired Lives using shorter maturity bonds to truly secure the benefits that have been promised to your plan participants. We’d be pleased to help guide you in this process.

Last July, American workers in failing multiemployer pension plans, also know as Critical and Declining (C&D) plans, got bi-partisan support from the House of Representatives when they approved H.R. 397. The bill went to the Senate at that time where it continues to reside. Is it on life-support? Melanie Waddell reported for ThinkAdvisor on a recent interview with Congressman Richard Neal (D, MA) in which the Congressman states, “Improving Americans’ retirement security remains a top priority of mine in 2020.” Neal also stated, “Last year, the House passed my Rehabilitation for Multiemployer Pensions Act — also known as the Butch Lewis Act — and I intend to do all I can to make sure the Senate passes that critical bill during this Congress as well.”

Let’s hope that he can get this done and sooner rather than later. As we reported earlier this year, the folks at Cheiron have estimated that each monthly delay increases the cost to “fix” this problem by $750 million! The Grassley and Alexander counter proposal to the Butch Lewis Act (BLA) , which was floated in November 2019, is too draconian (in my humble opinion) to even be considered by organized labor. Regrettably, the BLA does not currently have support from Senate Republicans to move this critical legislation forward.

We would prefer to see a legislative proposal that keeps these critically important DB plans alive and not be left to fail only to then have the PBGC step in to “save” a percentage of the promised benefits after their collapse. One criticism of the BLA is that some of the C&D plans receiving low-interest loans from the proposed Pension Rehabilitation Administration (PRA) would not be able to pay back the loan in thirty years. Why is that a problem? By providing the loans to these troubled plans, participants would get another 30-years of the promised benefits that would further help local economies and produce tax revenue at the state and federal levels that dwarfs the estimated cost of the program. Furthermore, aren’t debts renegotiated all the time? Why should these borrowers be treated any differently?

Corporate America continues to use different discount rate methodologies to measure and fund their pension plan’s liabilities. According to Russell Investments, the use of smoothing techniques (90%/110% corridor and 25 years) would create a discount rate of roughly 5.5% today, while a true marked-to-market discount rate would be about 2.5%. Plans claiming to be “fully funded” using smoothing are likely much worse off. The folks at Russell estimated that a plan claiming to be fully funded when using smoothing, would actually be only about 76% if the plan had a duration of about 12 years. A plan at 90% funded with an average duration of liabilities at 16 years might be truly funded at only 64%. Wow!

This certainly has implications for future contributions, PBGC premiums, the ability to engage in risk transfers, and other pension matters. Oh, and by the way, according to Russell “barring future changes to pension law, sponsors ought to be mindful of the coming phase-out of funding relief. With the ongoing decline in the 25-year average determined by the IRS, and the 90%/110% corridor expanding from 2021, the effects of funding relief will increasingly wear away. Contribution requirements will increase for many plans, bringing marked-to-market liabilities into economic reality.”

I saw the above chart in a MarketWatch article and it really struck home. We are living during a period of nearly unprecedented gains for the U.S. stock market, yet many Americans are being left behind. According to MarketWatch, “the rate of credit card balances that are 30 days or more delinquent at the 4,500 or so commercial banks that are smaller than the top 100 banks spiked to 7.05% in the fourth quarter, the highest delinquency rate in the data going back to the 1980s.

The need to borrow for many American workers doesn’t come from the fact that they are being frivolous with their money. It has everything to do with the fact that basic needs for items such as healthcare, education, housing, food, etc. are outpacing the earnings potential and incomes for many workers. A significant percentage of Americans now live paycheck to paycheck. So while it is great for the “Haves” that equity markets and home prices are rising, for many of America’s “Havenots” that reality is nothing more than a fairytale.

Given this fact, does it really seem logical to ask them to fund a defined contribution retirement program? Do you really believe that they have the disposable income to adequately prepare for a dignified retirement? The answer is, of course not. This is another reason why DB plans are so necessary for a great swath of our workers.

Ryan ALM is a leading voice in the trying to rescue and preserve DB pension plans. We were established in June 2004 with the mission to try to preserve these incredibly important social and economic tools by focusing greater attention to the promise that was given to the plan’s employees. We believe that everyone should be entitled to a dignified retirement, but the demise of the DB plan and the greater, almost exclusive use of the DC plan (within the private sector), is undermining this important effort.

Regrettably, we’ve seen DB plans nearly wiped out in the private sector.  However, a significant majority of public employees (estimated at about 85%) still enjoy the benefits of a traditional pension plan.  But for how much longer will they?  As I mentioned at the Opal/LATEC conference in New Orleans just yesterday, there is a perception among public plan participants and sponsors that these plans are perpetual. However, since the Great financial crisis most, if not all, public plans have taken action to reduce the future liability by asking employees to contribute more, extend vesting periods, reduce benefits for new hires, eliminate COLAs, etc.

This doesn’t signal to us that everything is honky dory! In fact, employer contributions have rocketed higher in the last couple of decades.  There are many examples of annual contribution rates being 25% to more than 40% of salary. At what level of contribution do these “perpetual” plans become unsustainable?  For many states and municipalities, the pension contribution is but one element of a social safety net that must be funded.  As the contribution rate escalates for DB plans, it naturally squeezes out other necessary programs unless there is no restriction on the taxing authority’s ability to raise revenue.

Given the pension envy that exists among those taxpayers in the private sector that aren’t participants in a DB plan (most), it is doubtful that they would be supportive of any administration that attempts to substantially raise taxes in this economic environment to fund someone else’s retirement benefit.

DB plans can be saved, but plan sponsors and their consultants need to begin to think outside the box. Focusing on the return on asset assumption (ROA), as if it were the Holy Grail, has lead to greater volatility and little reward to show for it! DB plans need to focus on the promise that they have made, use their funded status to adjust asset allocation, and de-risk plans as they see improved funding.  We missed the boat to de-risk at the end of the 1990s.  Let’s not blow it again!

As much of Pension America struggles to meet the promised benefits, significant work has been done to address the benefits through various tiers and changes to benefit formulas. There has also been a concerted effort to address the investment side with a significant shift from traditional asset classes, such as bonds and equities, to much greater emphasis on private markets, but at what cost, and is this move actually going to help plan sponsors and their consultants achieve the desired results?

Actuaries are fond to remind us of the pension equation:

C + I = B + E

Where C is contributions, I is the investment return, B is benefits paid and E is expenses, a big part of which are investment fees paid to managers.

Andrew Vo, CFA, Founder and CEO, Aidos, has penned an excellent article titled, “Venture Capitalists Are Getting Rich Off The Management Fees”, in which he discusses the concept of asset gatherers versus performance generators. He specifically focuses on VCs for his series of articles, but the same case can be made for hedge fund managers, too. The mega funds generate so much in management fees (2% in many cases), that a $1 billion AUM fund would generate $20 million per year and $200 million during the life of the fund (assuming the fund has a 10-year life) before the investors earn $1.

As mentioned above, Pension America is struggling in many cases to meet the promised benefits, and the move to private markets may not be the right course of action if at the end of the day these funds with these extraordinary fees don’t produce net results that exceed traditional asset classes, such as equities (private equity) or bonds (hedge funds). At the same time that plan sponsors are asking their employees (average Americans) to fork over a greater percentage of their salaries to help fund their retirement benefit, these same plan sponsors are rewarding the general partners of these funds with greater compensation packages. According to Mr. Vo, “many of these average Americans are government employees who rely on, and indirectly self-fund, their public pension plan, the same public pension that often misallocates capital to Venture Capitalists who earn 85X the salary of the government employees who partly funded them.”

If asset consultants and their clients continue to believe that investing in private markets – both equity and fixed – makes sense for the long-term viability of Pension America then let’s align all of the interested parties. Let’s adopt a new framework in which management fees of this magnitude disappear for good and a greater percentage of the outperformance is provided to the GPs of these funds, such as 30%. What do you think?

We are pleased to share with you Ryan ALM’s latest research paper, “Pension De-risking, Cash Flow Matching versus Duration Matching”. You can view the full white paper here.

Many defined benefit systems, especially within the private sector, have been engaged in de-risking activities for some time now. The prevailing methodology has been to use duration matching, but is that really the most effective way to secure the promised benefits at the lowest cost and reasonable risk? We believe that Cash Flow Driven Investing (CDI) is the more effective process to ensure that the cash flows will be available to meet the benefits as they come due. This piece will explain why we’ve come to that conclusion.

We hope that you find our thoughts insightful, and we look forward to receiving your feedback whether in the form of questions, comments and/or concerns. Don’t hesitate.

In our continuing focus on why DB as opposed to DC or anything else resembling a retirement program, the U.S. economy is leaving a significant percentage of our workers behind. The following information is taken from an article, “Trump’s Economy Isn’t So Great” written by the leading retirement voice, Teresa Ghilarducci, Professor of Economics at the New School, who wants us to make sure that we aren’t confusing the economy with the stock market’s performance.

Teresa writes, “A Brookings Institution report found that low-wage earners—those who earn two-thirds median wage in the region—make up over 53 million workers or 44% of all workers ages 18 to 64. More than 40% are raising children, and over half are in their prime working years. 

And low-wage workers are unsettled and insecure. Another Brookings report, based on extensive interviews, found that “despite the rosy headlines, workers described feeling uncertain and uneasy about their future.” They live paycheck to paycheck, have inadequate or no health insurance, can’t see how their children could afford college, lack access to retirement plans and in many regions have trouble finding affordable housing. 

Even with low unemployment, low-wage workers are suffering what journalist Annie Lowery calls the Great Affordability Crisis: “Fully one in three households is classified as financially fragile,” lacking even $400 in emergency savings, so that “a surprise furnace-repair bill, parking ticket, court fee or medical expense remains ruinous for so many American families, despite all the wealth this country has generated.””

Yes, the stock market is booming, but according to Teresa, the stock market “barely touches the lives of most Americans”, as the median retirement balance for “All Near Retirees” is only $15,000. Social Security and one’s home provide most of the wealth for this cohort.

For those 53 million Americans age 18-64 who may or may not have access to an employer-sponsored retirement program, the paycheck to paycheck subsistence creates a profound impediment to funding a retirement plan. These folks need a DB plan. Without that the federal social safety net may be their only choice later in life.

Opponents of the Butch Lewis Act (H.R. 397) talk about this legislation as nothing more than another federal bailout that will further negatively impact the U.S. taxpayer. I say hogwash! If the taxpayer truly understood what the pension benefits actually do for not only the plan participant, but also both the local and national economies, I suspect that they would be fully supportive of having the federal government provide the low-interest loans called for in the BLA.

The following paragraph is from Michael Scott, Executive Director, NCCMP, from his December 6, 2019, letter to Senate Chairmen Grassley and Alexander.

“The Multiemployer system is an incredible economic engine for the U.S. Government and the American economy. In 2015 alone, the Multiemployer system and the job creating employers of America and labor that jointly sponsor these plans paid more than $158 billion in taxes to the U.S. Government and $82 billion to state and local governments. They also provided $41 billion in Pension income to our retirees and paid more than $203 billion in wages to our 3.8 million active workers. Combined, the pension and wage income supported 13.6 million American jobs and generated $1 trillion in GDP”!

Yes, that was $1 trillion in GDP and $41 billion in pension income – incredible! The BLA calls for less than $40 billion to be provided in loans that the actuaries from Cheiron estimate that 111 of the 114 critical and declining pension plans (the number has increased to roughly 125 plans) reviewed would be able to repay in full. It seems like the failure to provide lifelines to these struggling plans would result in a far greater loss of economic activity than anything close to the total cost of implementation. Talk about penny wise and pound-foolish! Instead of allowing the critics to label this program as just another bailout, let’s redefine the argument and suggest that the government is merely providing a rebate to the multiemployer system for their on-going significant contributions to our economy.

President Trump’s proposed budget for fiscal year 2020-2021 has two new premiums to help sure up the Pension Benefit Guaranty Corporation’s (PBGC) multiemployer insurance pool. The White House’s Office of Management and Budget estimates that the current PBGC multiemployer pool is short by $65 billion, with only $2.9 billion in assets at this time. The PBGC estimates that their multiemployer program will become insolvent by 2025, at which time participants in failing plans will likely receive 10% or less of their promised benefit.

The first premium adjustment is a variable premium to be paid by the individual plans per participant, both active and retired, and based on the funding status of the plan. The worst the funded status the more you pay per participant. The second proposed premium is described as an exit premium that will be “equal to 10 times the variable-rate premium cap – to be assessed on employers that withdraw from a multiemployer plan to compensate the multiemployer program for the additional risk imposed on it when employers exit” (ASPPA).

This proposed premium adjustment was part of the Grassley/Alexander proposal that has been floated. Unfortunately, it does nothing to keep these plans viable, but does provide a greater safety net should a plan fail. As we’ve discussed many times, there are roughly 125 multiemployer plans that have been designated as Critical and Declining, which means that they are <65% funded and will likely become insolvent in the next 15 years.

These plans are so cash flow negative that it is highly probable that they will all fail during that period. Raising the cost per head (as much as $80 from $29) isn’t going to help with the cash flow necessary to meet the promised benefits. Also, creating an exit premium (in lieu of withdrawal liability or in addition to?) will likely lead many of these plans to seek an alternative or hybrid retirement program.

The only legislation that keeps these plans alive is the Bill passed by the House of Representatives in July (H.R. 397), which provides critical loans to these failing plans. The plans receiving loans must defease their current Retired Lives Liability thus guaranteeing that the promised benefits will be paid in full, while extending the life of these plans by 30-years. Despite passing the House in July, this legislation continues to sit within the Senate as no action has been taken. It appears that Senate Republicans have no interest in providing a lifeline to these pension plans.

Why let these important retirement vehicles die? Wouldn’t it make more sense to keep these pension funds as on-going concerns so that current and future employees could also benefit from having a DB plan? Funding the PBGC and not these cash-starved plans is like allowing the patient to die, but giving them a nicer funeral! I don’t want to see these plans die!