We are pleased to share with you the latest research from Ryan ALM – Buy Time. One of the most important benefits of utilizing a cash flow matching strategy is that less liquid assets (the alpha portfolio) have time to perform and capture the liquidity premium that exists. We hope that you enjoy the insights. Please don’t hesitate to reach out to us if you have any questions/comments.
The WSJ is reporting in today’s edition that public pension plans suffered a -13.2% average return for the quarter ending March 31, 2020. This information was obtained from the Wilshire Trust Universe Comparison Service (TUCS) data. The first quarter return eclipsed 2008’s fourth quarter as the worst on record in the 40-years that the TUCS universe has been reported. This shouldn’t be surprising, but it may actually be an understated return, as alternative investments in private equity, real estate, infrastructure, etc. often come with a one-quarter lag. Oh, boy!
We’ve been anticipating that the first quarter was devastating for the funded status of public pension plans, as well as those in the private sector – both corporate and multiemployer plans. The hit to plan asset bases was somewhat soothed by April’s strong market returns, but not nearly enough to maintain contribution levels. Unfortunately, state and municipal governments are also being harmed by significant reductions in revenues as the economy slowly reopens. The ability to meet increased funding requirements may not be possible in this environment.
We are huge fans of DB plans and they must be preserved, but states such as NJ, IL, KY, CT, etc. cannot overcome their significant negative cash flow requirements through “better” investment returns. The only way to make up for this shortfall, without further burdening their tax base, is to have the Federal government provide low-interest rate loans to these struggling plans. The proceeds from the loans must be used to defease the retired lives liability out 10-15 years, so that the residual assets now have time to grow unencumbered. The extending of the investment horizon (buying time) will allow for a more aggressive risk profile since these assets are no longer a source of liquidity.
While the loan is outstanding, states and municipalities would be forced to make the annual required contribution, something that NJ hasn’t done since Washington slept there. They would also have to maintain current benefit levels. If this sounds familiar, this strategy is contemplated in the legislation that passed the House of Representatives last July (H.R. 397 – the Butch Lewis Act).
I’ve enjoyed producing nearly 780 blog posts during the last 4-5 years or so on a variety of pension-related issues. We often get comments and/or questions from the public regarding what’s been produced. I respect people who are willing to share their views, while in many cases challenging our thoughts. It is certainly a great way for me to continue to learn and hopefully the audience does, too.
As an example, I received this comment yesterday. Russ, “promises” i.e. pensions would have been much less under CDI. This individual clearly understands that we at Ryan ALM espouse using a cash flow driven investing (CDI) approach to meeting near-term benefit payments. I have to believe that this individual feels that our bond exposure would somehow reduce the pension plan’s ability to achieve the return on asset assumption (ROA). That isn’t necessarily true, as most pension plans have exposure to fixed income and cash. According to P&I’s annual asset allocation survey, corporate, public, and multiemployer plans had fixed income exposure as of September 30, 2019 of 47.5%, 21.1%, and 35.5%, respectively.
What we suggest is converting the current bond exposure that is highly interest-rate sensitive to a CDI portfolio that matches and funds (secures) benefit payments chronologically from next month’s to ideally ten years out. This CDI portfolio, which we call a Liability Beta Portfolio (LBP), is invested in investment grade corporate bonds, as opposed to a diversified bond portfolio geared to the Barclays Agg. Our portfolio currently has a yield of roughly 3.5% versus the Agg’s yield at 1.5%. This significant yield advantage actually improves the plan’s ability to meet the ROA objective, although we believe that securing the benefits should be the primary objective in managing a plan. If a plan’s investment policy statement (IPS) provides for exposure to high yield, these bonds can be used in support of the LBP, too, which further enhances the portfolio’s yield advantage and ability to achieve the ROA.
Thanks for the comment, and please keep them coming!
Everyone knows that first quarter performance results were ugly. It will not come as any surprise then that funded status and contribution expenses were significantly negatively impacted. But, even before Covid-19 struck, assets were struggling to keep up with the growth in pension liabilities, as the chart above reflects (data through December 31, 2019).
Different accounting rules (IASB, FASB, GASB) permit different discount rates to be used to measure pension liabilities, but the only TRUE measure of pension liabilities is a risk-free rate. The liability index above (red line) uses the Ryan ALM STRIPS index (maturities 1-30 years). The performance of the STRIPS index for the 20-years ending 12/31/19 dwarfs the risk-adjusted returns for many of the major indexes that would represent exposure to the assets in most pension systems.
I mention this because most non-corporate plans continue to focus nearly exclusively on the return on asset (ROA) assumption, and as a result, fail to include liabilities in the analysis when it comes to determining an appropriate asset allocation and investment structure. Clearly, paying heed to plan liabilities would NOT have negatively impacted America’s pensions during the 20-years ending December 19. Furthermore, understanding and managing to pension liabilities would absolutely not have hurt during the first quarter of 2020.
When will out industry wake up to the fact that you can’t manage a pension plan without understanding the promise that you made to the plan’s participants? Can you imagine playing a football game and not knowing what the score was as you entered the fourth quarter? In that case, you wouldn’t know what offense or defense to run. It is the same thing in managing a pension system. The only way to know the “score” is to measure, monitor, and manage to the plan’s liabilities.
We’ve all seen the headlines this morning about the unprecedented 20.5 million American jobs that were lost in April leading to an unemployment rate of 14.7%. The economic consequences related to the virus are beginning to pile up. According to a Bankrate survey, most consumers that have a mortgage or auto loan fear that they will miss a payment in the next 3 months. 54% of American consumers with a mortgage and/or auto loan are at least somewhat concerned about their ability to pay.
Not surprisingly, the ability to pay differs by age group, as only 43% of Baby Boomers are concerned, while 56% of Gen Xers, 65% of older Millennials, and 79% of those 30 and younger are in a precarious position at this time. I fear that this situation will cause many American savers to forgo contributions into their retirement accounts, or worse, force those with retirement accounts to take loans or premature withdrawals.
These actions could profoundly impact their ability later in life to retire. It once again highlights for me why it is important for American workers to participate in a traditional DB plan as opposed to a mostly self-funded (many companies have already suspended contributions), self-managed “retirement” vehicle such as a 401(k).
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?