Rethinking POBs – A Webinar on 2/10

I am pleased to be participating in this important IFEBP sponsored event. I will be presenting on the history of Pension Obligation Bonds (POBs), the strategies used to date, the risks, and most importantly a unique approach that might just up end the “common wisdom”.

From IFEBP: Pension Obligation Bonds (POBs) are generating renewed interest; register now for this upcoming webcast on February 10 to learn more about what public sector pension plans may gain by issuing a POB.

Hopefully, I’ll have the opportunity to share ideas with you.

Today’s Question Of The Day

Question: What is the purpose of a Pension Obligation Bond?

Possible answers:

  1. A POB is intended to take advantage of potential arbitrage opportunities by investing in higher return asset classes that should outperform the cost of the bond? or
  2. A POB is intended to secure the promised benefits and improve the plan’s funded status by investing the POB bonds proceeds in a cash flow matching strategy (bonds) that match and fund the pension plan’s liabilities from next month’s payment out as far as the POB proceeds permits?

For decades, most plans have said that 1 was the correct answer. It’s all about the arbitrage, especially with interest rates being at “historic lows”. But as multiple studies have shown, issuing a POB and hoping that the proceeds are invested in instruments that outperform the plan’s ROA over time is little better than screaming red when the roulette wheel spins. Given the low interest rates and stretched valuations for equities, is there a great probability that the plan will produce a total fund return that exceeds the cost of the POB during the next 10 years?

At Ryan ALM, we would unequivocally state that the true objective of a POB is to SECURE the promised benefits by cash flow matching the POB proceeds against the plan’s projected benefit payments and expenses. By doing so, the plan has bought time for the current alpha assets to grow unencumbered, improved liquidity, removed interest rate risk, and stabilized both the funded status and contribution expenses.

Remember, we have gone through several major corrections during the last two decades that would sabotage a POB strategy reliant on generating 6+% returns and capturing the arbitrage. Why take the risk? POBs are a great tool provided that they are implemented appropriately. Reach out to us at Ryan ALM to discuss our game changing strategy.

Not The Same!

Yesterday, we reported that Congressman Neal (D, MA) had introduced pension reform legislation titled Emergency Pension Plan Relief Act of 2021 (EPPRA) on January 21st. We were also led to believe that the legislation bore similarities to the Butch Lewis Act (BLA). Having gone through the 37 pages of legislation several times, I’m sorry to inform you that it doesn’t. Not even close. In fact, apples and oranges have more in common.

Believe me, I am pleased that Congress is once again taking up pension reform, as millions of Americans are at risk of losing their promised benefits, but I would have hoped that a long-term fix was going to be part of any plan, especially since we already had terrific legislation passed by the House in July 2019 (BLA). I’m afraid that isn’t the case with this legislation. Don’t get me wrong, there are elements worth fighting for as participants that had benefits previously cut will be made whole, which is wonderful news. DB plans struggling to fund orphan participants will be able to partition (offload) those obligations to the PBGC and the maximum multiemployer benefit covered by the PBGC, which is now $12,870, will be enhanced. All good! But many of the current Critical and Declining plans are not going to return to health just through partitioning.

Why is it that the BLA isn’t the legislation of choice? The BLA would secure benefits for All Retired Lives. Instead of starting over by filing new proposed legislation in the House, why not push for the BLA to be taken up in the Senate? Both chambers of Congress are controlled by the Democrats, who passed the BLA in the first place. You would think that they would exert a little muscle and try to get their preferred legislation enacted.

We will continue to provide updates on this developing story. Stay tuned.

Hey, Now! Could We Actually Get Some Pension Legislation?

House Ways and Means Committee Chairman Richard Neal (D-MA) introduced the Emergency Pension Plan Relief Act of 2021(EPPRA) on January 21, 2021. EPPRA represents the latest legislative attempt to address the well-documented multiemployer pension crisis. We are told that there are similar elements in this legislation to those which were included in the Butch Lewis Act (BLA), but it is not a clone. For example, we do not see the Federal loan that was the central point of the BLA that defeased and secured Retired Lives. We, at Ryan ALM, thought that the BLA was an excellent piece of legislation. Let’s hope that a proposed bill (BLA or EPPRA) actually sees the light of day in the Senate, as time is getting short for both troubled plans and the participants who continue to count on their promised benefits. We will get back to our blog followers with more details as they become known to us.

Ryan ALM’s Q4’20 Newsletter

We are pleased to share with you Ryan ALM’s latest insights related to how pension assets and liabilities performed in 2020. As you will note, despite a very strong rally in equities during the final 8 months of the year, liability growth (under FASB accounting rules) outpaced asset growth once again.

In addition to our views on pension liabilities, there are numerous blog posts and research ideas contained in this newsletter covering other topics of interest. As always, please don’t hesitate to reach out to us with any questions and/or comments. We welcome your feedback.

Fundamentals Can Become Disconnected

There are multiple examples throughout time when the price of an “investible” item has gotten tremendously out of whack from the underlying fundamentals. There are examples of prices rising well beyond what the underlying story would justify and examples of when prices have collapsed in anticipation of a changing fundamental landscape. We likely have a couple of such stories developing today – perhaps Bitcoin and some of our technology stocks on the upside and many value stocks that have been pummeled representing attractive opportunities to explore on the downside.

One opportunity that presented itself early in 2020 reversed course so quickly that one would have to have been in the positions already and hung on or an investor would have to have been so agile to move quickly to take advantage of the opportunity. For most U.S. pension systems that dynamic capability just doesn’t exist. As the chart below indicates, yield spreads for U.S. corporate bonds blew out versus comparable maturity U.S. Treasuries in March of 2020. The sell-off in those bonds and the subsequent widening of yield spreads occurred nearly overnight. However, the rally and tightening of yield spreads has been nearly as rapid.

Investment grade corporate yields currently sit at just under 100 bps of spread versus Treasuries. This is about as tight as they’ve been in the past decade or so. However, that yield advantage still provides a very nice cushion should a rare default occur. In addition, that premium yield compounds each year of any bond’s existence. As you may recall, Ryan ALM uses corporate bonds almost exclusively in implementing our cash flow matched portfolios of assets versus pension liabilities. We were recently retained by a corporate plan to provide a cash flow matching portfolio for a vertical slice of the plan’s liabilities (about 12% of projected liabilities over 80 years). Because of our yield advantage we were able to create an incredible 30%+ funding cost savings on the future value of the plan’s liabilities.

The U.S. investment-grade corporate bond market has changed dramatically over the years. Long gone are the days of multiple AAA rated securities. Today we have nearly 70% of new issuance being BBB, and that has led to an investment-grade universe with more than 50% in BBBs at this time. Fortunately, defaults remain rare, but that doesn’t mean that strong credit research isn’t imperative – it absolutely is. Given that bond yields in general are near historic lows, bonds should not be viewed as performance generating instruments in this environment. They should be used for the cash flow that they generate through coupon, reinvestment of the coupon, and maturity. Now’s the time to adjust your asset allocation to reflect this reality and use cash flow matching with investment grade bonds as the liquidity core portfolio. Call us – we’ll help you think through an appropriate strategy.

Is There A Correlation?

Who needs cellular tracking when you have United Van Lines? The U.S.’s largest moving company keeps track of moving patterns and produces the results in an annual survey each January called the National Movers Study. Anyone who keeps up on the news will have a general idea of where people are going to and leaving from, and for a variety of reasons, but this study lays it all out there for everyone to see. For instance, is it surprising to read that Idaho led the country this year in inbound migration given some of the issues facing their neighbors to the West?

I got excited for a moment when I read that New Jersey was ranked only 48th until I realized that Alaska and Hawaii were not included in the study. Vermont wasn’t included either because of the small sample size, and they were replaced by the District of Columbia. So, NJ is in fact last in this category. Oh, it is good to be king!

Because I am always focused on pensions and pension-related issues, I began to wonder if there might be a correlation between the funded status of each state’s public pension system and their rank in the inbound/outbound tables. The funded status data that I was able to gather is through December 31, 2018. There does seem to be a pattern, but it may just be coincidental. For instance, the top 10 inbound destinations had an average funded ratio of 52.9% while the bottom 10 (includes #39 Maryland) had an average funded ratio of just 41.6%. If you eliminate from each data set one state that seems not to belong (NY at 60% from the outbound list and SC at 34% from the inbound list) you get a difference that grows to 15.4% (55% versus 39.6%).

In reality, how many citizens are staying up on pension deficits and the impact that those might have on current and future tax policy? Then again, they may have already been feeling the effects of higher taxes (sales, income, property, etc.) from escalating contribution rates in places like NJ, CT, IL, etc. As you know, I am a huge fan of DB pension systems, but that doesn’t mean that I don’t think that there shouldn’t be changes in how they are managed on a day-to-day basis, especially when it comes to asset allocation decisions. By focusing more attention on the plan’s promise (liabilities) to their participants, asset allocation can be more responsive to changes in the asset/liability relationship. By bifurcating plan assets into both beta (bonds) and alpha (everything else) buckets, a plan can improve liquidity, eliminate interest rate risk, extend the investing horizon for the alpha assets, and use bonds more appropriately for their cash flows, while also stabilizing the funded status and contribution expenses.

There are no guarantees, of course, but a little change in the funded status of your state’s public pension plan may just encourage your residents to stay, while attracting others from around the U.S. Why not give it a try?

Please, Please DON’T

I read something recently that had me shaking. Someone was suggesting that the recent run-up in the price of a Bitcoin was being driven by demand from pension plans. Please tell me that isn’t the case. The US pension system is in difficult enough straits from a funding stand-point. We don’t need to be gambling on Bitcoin’s price movement or any other cryptocurrency for that matter. Oh, and by the way, Bitcoin’s recent ascent to $42,000 per coin over the weekend was short-lived as the price this morning (10:15 am EST) is $34,557 for a quick 18% loss in just a couple of days. Please also remember that we’ve seen this roller-coaster ride before, as Bitcoin rose to >$19,000 only to fall rather quickly back to earth and settle at <$3,200 within 12-months ending December 2018.

6 in 10 – Outrageous!

According to a new Kiplinger survey, nearly 6 in 10 Americans withdrew or borrowed money from their 401(k) “retirement” funds. Of that 60%, 58% withdrew or borrowed from $50,000 to $100,000. These are shocking statistics! I’ve claimed for years that the transition that occurred in our retirement industry from company sponsored defined benefit plans to defined contribution plans was going to create a huge crisis, and here is the proof! Defined contribution plans are nothing more than glorified savings accounts masking as retirement plans. They were never intended to be anyone’s primary retirement vehicle, as they were designed to be supplemental to a traditional pension plan.

Not only did Americans withdraw huge sums from these plans, but many companies ceased contributing matching funds once the pandemic hit. This double whammy has about 1/3 of respondents to the Kiplinger survey contemplating staying in the labor force longer. In fact, 55% now expect to work beyond 65-years-old. However, according to AARP (2/19) only 20% of Americans 65-years-old or older are actually working or looking for work at this time, which is double from 1985. What is the likelihood that 55% of older Americans would be able to secure work to help supplement their retirement income?

Of further concern regarding the management of defined contribution plans is the fact that roughly 70% of those surveyed indicated that they had a least 20-years left of work until retirement. Yet the average asset allocation to stocks/equities was only 35.7%. Unfortunately, cash was the second largest allocation at 23.8% and bonds third at 17.3%. Federal Reserve policy has certainly crushed cash and bonds from providing meaningful returns. Furthermore, 41% of those polled changed their allocation to stocks during the pandemic, with only a small percentage indicating that they had increased exposure after the significant sell-off in March. Why should we expect any other outcome? Why do we think that these participants are going to be able to fund, manage, and then disburse this “retirement” benefit with limited education and experience in this subject?

At the same time that retirement dreams of those stuck with a DC plan are being dashed because of Covid-19 and the impact that has had on our economy and labor force, we have Congress neglecting to address the pension crisis within multiemployer plans, despite the fact that outstanding legislation passed through the House of Representatives in July 2019. What a mess. If you think that income inequality between the haves and have-nots is great today. Just wait to you see what it looks like when there are no longer any DB plans – public or private – and the only way to potentially retire is through a DC offering. Can it get any uglier?

Another in the Series of Ryan ALM’s, “Believe It Or Not!”

The graph above compares major asset class index benchmarks versus the Ryan U.S. Treasury STRIPS indexes as a yield curve of 30 distinct indexes. This analysis provides a picture (more than 1,000 words in my humble opinion) of the relative risk/reward of each asset class versus the risk-free Treasury STRIPS yield curve. Since liabilities are to be priced as zero-coupon bonds, the Ryan Treasury STRIPS yield curve indexes are a good proxy for the economic risk/reward behavior of pension liabilities. Importantly, please note there are no equity index benchmarks that have outperformed liabilities for the same relative volatility (i.e. risk) for the last 20-years through December 31, 2020.  Foreign equity exposure, as measured by EAFE, has dramatically underperformed during this time.

The only indexes to outperform STRIPS during this 20-year period are fixed income related. But, here’s the rub: most plan sponsors have been reducing their exposure to fixed income during this lengthy period of falling interest rates fearing that lower bond yields would create lower future returns and become a drag on the total pension fund’s ability to achieve the return on asset assumption (ROA). The primary reason to own bonds, despite a 20-year period of outperformance, is for their cash flows. Separating the plan assets into Beta (bonds) and Alpha (non bonds) assets helps pension plans to improve and designate liquidity to meet the promised benefits, eliminate interest rate risk, buy time for the alpha assets to perform (and they may need 20+ years, as we see from above), and stabilize the funded status. That is a strong array of benefits from a minor tweak in strategy.

Given where equity valuations are at this time, does it really make sense to continue to look at the asset allocation as a single bucket? Separate your assets Beta (liquidity) and Alpha (growth) and buy time for your portfolio to potentially recover from periods of underperformance. The last thing anyone wants to do is force liquidity into the portfolio to meet benefit payments when asset prices are falling. That strategy failed miserably in 2000 – ’02 and certainly 2008. It won’t do any better during the next major correction.