As mentioned earlier this week in a previous blog post, Norwich, CT sought support from town residents to approve a $145 million Pension Obligation Bond (POB). I’m happy to report that the community supported this initiative. Now the challenging part begins. How will they invest the proceeds? Will they inject the new contribution into the existing asset allocation and subject those funds to the whims of the markets or will they try to secure the promised benefits by defeasing the Retired Lives liability as far out as the allocation permits? As a reminder, we believe that the primary objective in managing a defined benefit plan is to SECURE the benefits at a low cost and with prudent risk. Defeasing the plan’s liabilities accomplishes this objective! It will be interesting to watch this story unfold. This one and the other 90+ municipalities that have issued >$10 billion in pension debt in 2021.
I can’t tell you how many times I’ve read articles about underfunded pension systems that are “on track” to be fully funded in x # of years. The most recent one claims that the fund will be stable in 22-years. However, what they fail to discuss are the actions required to achieving a fully funded status. First, the plan sponsor must make all annual actuarially determined contributions, which usually increase every year. Second, the assets must earn the actuarially determined ROA consistently for the next 22 years. But those are big ifs, especially when one looks at the fact that we are at historic lows in US interest rates and at historic highs in equity markets on basically any valuation tool.
What is the probability that the ROA will be achieved? Furthermore, the sequencing of returns can play a meaningful role in whether the return objective is met, especially since this is a closed plan that will have greater outflows tomorrow than 20 years from now. What this plan needs to do is to secure the promised benefits for the next 10 years or so. This action will insulate the plan from adverse market conditions that would harm the plan’s alpha assets. Buying time for these growth assets permits them to grow unencumbered, as they are no longer a source of liquidity.
Buying time would enhance the probabililty of achieving the actual ROA of these growth assets since they are not diluted to make benefit payments. The history of the S&P 500 tells us that dividends reinvested account for 48% of the total return on a rolling 10-year horizon since 1940 and it is even greater for 20-year periods.
Actuaries do a terrific job despite all of the uncertainty in forecasting benefit payments and expenses far into the future. But they aren’t magicians. There should be an expectation built into their forecast that not all of the inputs will be achieved as predicted. We’ve seen this situation play out time and time again. Given this understanding, perhaps a greater emphasis should be placed on the contributions, which reduces the reliance on markets thus improving the likelihood of success. Just a thought!
Norwich, CT residents (population 40,000) are going to the polls today to vote on a Pension Obligation Bond (POB) of $145 million. The pension system currently has a 59% funded ratio (under GASB accounting). The “need” to issue a POB is based on the fact that retirement costs have nearly tripled in the last decade. The city is proposing this issuance given the historically low interest-rate environment. City officials believe that they will be able to complete the sale of the bonds at a roughly 3% yield.
The issuance of POB debt in 2021 is near historic levels. In fact, 93 municipalities have issued debt year-to-date surpassing the total in every year since data was first kept in 1999. The $11.4 billion raised is eclipsed by only 2003’s total debt, which included Illinois’s $10 billion POB. We, at Ryan ALM, agree that the current rate environment makes POB issuance particularly attractive, but only if the proceeds are used to defease the Retired Lives liability. Historically, POB proceeds have been injected into the plan’s current asset allocation subjecting these new assets to the whims of the market. We have never liked this strategy and are particularly concerned at this point given US equity valuations, which are stretched no matter what metric is used.
The primary object of a defined benefit pension plan should be to secure the promised benefits at low cost and with prudent risk. It is not to take a flier on the markets HOPING to achieve an arbitrage between the bond’s cost and the targeted ROA, which in Norwich’s case is 7.25%. The drafters of the original Butch Lewis Act understood this concept that mandated that the loan provisions should be used solely to defease pension liabilities for as far out as the allocation would permit. We think that this is a prudent approach that minimizes the risk to the pension system, its participants, and the municipality’s taxpayers. We would be happy to provide interested readers with our turnkey system on how this is accomplished.
We’ve talked about Bitcoin in previous posts. We’ve wondered what this instrument is in terms of an asset category because we think that the volatility in pricing would suggest that it isn’t a currency. Unlike the US $ and other fiat currencies, there is no willingness from these countries to accept Bitcoin as a payment of taxes due. Is it a commodity? I suspect that many supporters of Bitcoin and other cryptocurrencies would suggest that it is new age gold, but is it? What is the underlying value of a Bitcoin? At least gold has a use in the manufacturing of jewelry and in electronics. What can you do with a Bitcoin?
I bring this subject up once more because it has been announced that a public pension plan has invested $25 million in Bitcoin and Ethereum. The allocation to each has not been disclosed. The CIO believes that there will be long-term value-add from an investment in this cryptocurrency and believes that it does a better job of providing an inflation hedge than other asset categories. Bitcoin has been around for roughly 11 years. It has gone through a number of boom and bust cycles, but it hasn’t “lived” through an inflationary environment. I’m not sure how one can make a determination that it is the best inflation hedge let alone an adequate one.
Given the fact that there is no underlying value to a Bitcoin or any other cryptocurrency, the “investing” of $25 million is a purely speculative investment. But advocates would claim that Bitcoin has a limited issuance. That is true, but there are dozens and dozens of cryptocurrencies with no barriers to entry keeping others from being issued. Just look at Dogecoin for how easy it is to issue a crypto. So, cryptocurrencies in their entirety are hardly rare and limited.
Should pension plans be permitted to invest in purely speculative investments? Will this plan’s willingness to dive into the crypto pool open the floodgates to others following suit? We’ve recently seen the first Bitcoin ETF launched (the ProShares Bitcoin Strategy ETF) with great market fanfare. However, this vehicle isn’t buying Bitcoin, but derivatives that are designed to closely track the price movement. What’s next? As a reminder, the primary objective for a pension plan should be to secure the promised benefits at a low cost and at reasonable risk. Does investing in this instrument fit that objective?
We, at Ryan ALM, are pleased to share with you the Ryan ALM Q3’21 Newsletter. In keeping with past newsletters, we provide the reader with a unique perspective on pension liabilities and how they have performed relative to pension assets. As a reminder, the primary objective in managing a defined benefit plan is to secure the promised benefits at low cost and with prudent risk. Having a frequent understanding of a plan’s liabilities is the ONLY way to accomplish the securing of benefits. In addition to several exhibits focused on liability performance during the quarter, we provide the reader with links to both recent research and pension-related blog posts. We hope that you find our thoughts insightful.
Are you thinking that another major equity market decline isn’t possible? That we are once again entering into a new paradigm (remember 1999) casting all previous ideas on market fundamentals out the window? If yes, I implore you to think again! Market fundamentals still matter. Sure, value is always in the eye of the beholder, but eventually value does in fact matter. It is difficult to identify today any asset class exhibiting cheapness or fair value when looking at the landscape of potential investments for pension plan sponsors and their advisors. Please don’t forget the significant damage that was inflicted on pension plans and E&F’s during the Tech Bubble bear and the Great Financial Crisis when the bull markets went poof! Market declines of roughly -48% and -52%, respectively, were generated.
We recently pointed out the fact that in both of those bear markets the S&P 500 registered a low at the bottom of the bear markets near 760. Given the S&P 500s current value, a -50% decline would bring the S&P 500 to a price of 2,265. Should a retest of the lows of the last 20-years be in the cards, the return would be roughly -83.1%. Come on, Russ, when have we seen declines of that magnitude? Well, students of the markets don’t have to go back too far to remember that the NASDAQ declined -76% when the tech bubble burst. Also, as the chart below highlights, the S&P 500 fell nearly -85% in 1932. I can just hear the roar from the crowd chanting the mantra once again that “it is different this time”. Maybe, but maybe this will prove once again to be another chapter in the normal cycles of equity market performance.
I bring this concern to your attention because pension America – private, public, and multiemployer – have benefited tremendously from the equity market rally since the bottom achieved on March 9, 2009. Please don’t continue to subject this wonderful improvement in funding to the whims of the markets. I have no clue when the next correction will come, but I do know that one will come. Based on the market’s current valuations, I don’t think that the impact will be tamer than the usual bear market experience, which has produced an average -37% correction in the previous 20 bear markets! Ouch! Take risk off the table, ensure that you have the proper liquidity necessary to meet benefits/expenses during the downdraft by building a cash flow matching portfolio to meet those projected outflows, as traditional bonds will not preserve capital in a potentially rising interest rate environment. This strategy will allow your equities and other risk assets the time necessary to work through any turbulent market environment.
House Ways and Means Social Security Subcommittee Chairman John Larson, D-Conn., plans to introduce Wednesday a new bill called Social Security 2100: A Sacred Trust. Importantly, the bill will include a change in the inflation rate index from the CPI-W to the CPI-E. As a reminder to our regular readers, I’ve been encouraging our legislators to make this change for years (7 blog posts, including the most recent on 6/14/21). This inflation rate has a greater weight assigned to healthcare related spending, which continues to be one of the most critical expenditures for our Senior population. In addition, the bill would tax incomes >$400,000. The Social Security payroll tax is not presently applied to wages greater than $142,800. The new payroll tax will be applied to those wages up to the current maximum and for wages earned over $400,000, which presently impacts about 0.4% of our workforce. 2021 could be very exciting for our SS recipients given the nearly historic COLA announced recently and a possible shift in the inflation index.
As the chart below depicts, there has been a massive shift in the asset allocation of DB plans since the mid-50s from mostly fixed income allocations to significant exposure to risk assets.I suspect that most of the motivation has been driven by the plan sponsors desire/need to achieve a target return or hurdle rate (ROA). The idea is if the ROA is achieved then contribution costs remain as projected…but has this goal been achieved?
Actuaries do a wonderful job (very difficult task) of forecasting the plan’s liabilities despite ever changing inputs, such as life expectancy, which fortunately has expanded leaps and bounds since the 1950s. I often say that my crystal ball is no better than anyone else’s if not worse. Actuaries can’t afford to have a crystal ball that is foggy. Their forecasts of future benefit costs are amazingly accurate despite the many inputs that drive their calculations. Given the reliability of their data and the importance of meeting those future expenditures, why aren’t plan sponsors and their consultants using these insights to drive asset allocation and investment structure decisions?
Most DB plans were well overfunded in 1999. They had the opportunity to remove substantial risk from their portfolios by defeasing the plan’s Retired Lives Liabilities and securing the funded status. To achieve the ROA, asset allocation models did the opposite! As a result, their increased equity exposure got crushed when significant market corrections occurred in 2000-02 and again in 2007-09. Did we learn anything? It doesn’t appear that we did, as equity exposures continue to ratchet higher despite the appearance of dramatic overvaluation. Could it be that fixed income, after an historic 39-year bull market, scares plan sponsors and their consultants to a greater extent? Could be. However, as we’ve stated on several occasions, bonds should not be viewed as performance or Alpha assets in this environment. They should be used exclusively for the certainty of cash flows that they generate as liquidity assets or Beta assets.
We believe that a cash flow matching implementation that defeases a plan’s net benefit payments chronologically from next month’s needs to as far out as the allocation will permit will provide many benefits, including: 1) improved liquidity, 2) elimination of interest rate risk on the bonds that are used to defease liabilities, 3) buys time for all of the equity exposure now in DB plans, and 4) allow the alpha assets (non-bonds) to grow unencumbered, as the re-investment of dividends is critical to the long-term success of investments, such as the S&P 500.
Increasing equity exposure in the hope that a greater return will reduce the need for future contributions hasn’t yet proven to be true. It has ensured that total expenses (management fees) have gone up, as well as the overall volatility of the funded status, but success hasn’t been guaranteed. Given where valuations currently reside, either dramatically reduce the equity exposure or reconfigure your fixed income exposure from a total return seeking mandate to a cash flow matching implementation that now allows time for the alpha assets to recover after the next equity market correction. There will be one.
Each quarter, Ryan ALM produces the “Pension Monitor” to reflect how pension liabilities are behaving versus plan assets. We believe that pension plan liabilities need to be measured and monitored regularly. Without knowledge of plan liabilities, the allocation of plan assets cannot be done appropriately.
The funded ratio/status of pension plans are present value calculations. Each type of plan is governed by accounting rules and actuarial practices, which determine the discount rate used to calculate the present value of liabilities. Single employer corporate plans are under ASC 715 (FASB) discount rates (AA corporate zero-coupon yield curve); multiemployer plans and public plans use the ROA (return on asset assumption) as the liability discount rate. The difference in liability growth between these plans can be quite significant, which will affect funded status and contribution levels.
Although the third quarter of 2021 saw funded ratios decline marginally, the strong rebound in markets following the onset of Covid-19, has enabled a plan’s total assets to outperform liabilities during the last 18 months. Whether the plan is a public, corporate, or multiemployer plan, assets have been aided by strong global equity markets and liability growth has been tempered by rising interest rates. This combination has been great for pensions that have witnessed strengthening funded ratios and improved funded status, especially for corporate plans that utilize a discount rate more reflective of the current market environment. We believe that the time is right for plan sponsors to take some risk out of their pension plans.
Please don’t hesitate to reach out to us if we can answer any questions related to asset/liability management.
The Social Security Administration has just announced that SS recipients would see the greatest annual increase in 40 years. As we reported back in June, the COLA is based on the inflation rate during the three Summer months. It was just announce that the increase will be 5.9% for 2022. The average recipient will see a monthly increase of $92 for a total of $1,657 per month or $19,884 per year. Let’s hope that inflation does prove transitory providing our senior citizens and those receiving disability benefits the opportunity to get ahead just a little bit.