A Record Year in the Making?

According to analysts at Goldman Sachs, 2019 is shaping up to be a very challenging year for the high yield market, as the three-month trailing annualized default rate is running at nearly a 5% clip up from a low of 1.3% achieved in 2018. There have been $36 billion of defaulted “junk bonds” in the first 8 months. The post-financial crisis high was $43 billion in 2016. The Energy sector is where many of the problems are occurring, but given the slowing global growth, there remains concern that the Energy contagion (which is secular in nature), could spread to other challenged sectors through a cyclical shift in economic prosperity.

According to Michiel Tukker, Oxford Economics’ global strategist in a note Friday, 18% of high yield companies have recently reported negative quarterly earnings, which is the highest post-crisis level outside of the Energy sector collapse in 2014-15.

Although the high yield market is showing signs of deterioration, few if any, expect U.S. defaults to reach the level of 14% achieved during the GFC, unless there is a full-blown recession.  Given the U.S. government’s incredible stimulus (deficits >$1 trillion) a deep recession is highly unlikely.

However, as yields on HY bonds continue to compress, profit-taking from that segment of your portfolio may be the correct strategy in this environment.

The World Of Multiemployer Benefit Funds Podcast

I had the great pleasure of speaking with Traci Dority-Shanklin last week about the multiemployer pension environment generally and more specifically about the Butch Lewis Act (H.R. 397). It was a great conversation because Traci had a firm grip on the issues confronting multiemployer plans and the plan participants.  The retirement crisis that is unfolding for participants in the more than 120 Critical and Declining plans is speeding forward and it will impact everyone (all taxpayers) if we allow these plans to fail, thus pushing them onto the PBGC.

Hopefully, you’ll find my insights beneficial. Please don’t hesitate to reach out to me if I can be a resource for you in the struggle to rescue these critically important pension systems.

Generics Don’t Work

Now, before everyone gets upset, I am not referring to generic drugs. I am specifically speaking about generic indexes to replicate liability streams for pension benefits, which seem to be all the rage these days.  Corporate America has been derisking their pension systems for years and many use generic indexes to approximate duration. Unfortunately, duration strategies are never going to be able to match precisely any liability stream, as durations change daily with changes in rates.

Furthermore, a generic index couldn’t possibly work for more than one company in matching needed benefit cash flows unless those two companies have the exact same labor force characteristics. They would have to have the same benefit formula for their plan, and the employees would have to be the same age, started in their jobs on the same day, made the same wages, etc. I think that you get the picture. But, unfortunately, plans are still engaging in their use despite the potential for a significant margin of error.

The only way to properly de-risk a pension system is through a cash flow matching approach in which net liabilities (after contributions) are matched precisely with cash flows from a bond portfolio. Future values don’t change daily, which allows for the precise matching of cash flows with net liability payments. We believe that Pension America should be engaged in the derisking of their portfolios in order to meet near-term Retired Lives benefit payments for a variety of reasons.  In order to accomplish this objective, a Custom Liability Index, no generics please, must be created to model that plan’s specific net liability cash flows. We’d be happy to do that modeling for you.

Are You Prepared?

I found an article in The Hill this morning, titled “If A Recession Is Coming, Pension Managers Need To Prepare”, and I got excited that the writer, might actually discuss strategy. Unfortunately, that wasn’t to be the case. He did highlight the fact that in recessions it is easy to find excuses not to fully fund the plan through the annual required contribution, which is important, but not preparing your portfolio for a recession and its likely impact on the plan’s performance because of the asset allocation is much more critical.

As Ron Ryan and I have been espousing for years, asset allocation predicated on the return on asset assumption (ROA) places the plan on the asset allocation roller coaster from hell. Your plan will ride up and down through the various markets until eventually the fund, like the roller coaster, ends up broken. We’ve seen it too many times before, and after this protracted run of very good equity and bond market returns are you prepared to see your plan’s funded status get crushed once more?

Another one of the biggest problems facing plan sponsors during the last significant and protracted bear market was liquidity risk. Many plans that had invested heavily in equities and alternatives were forcing liquidity where it wasn’t naturally found thus compounding the downward spiral for these assets.

As a result of these events, contributions ratcheted significantly higher. Ryan ALM estimates that most public pension systems have seen contributions increase by 5 to 10 times what they were in 2000. We are aware of at least one fund that has seen their contributions increase from $68 million to more than $3 billion, a >38Xs increase in the last 18 years. Incredible, outrageous, abominable – pick your adjective of choice!

However, there is an easy way to mitigate these risks, but it will force you to take a different path. Let’s all embrace Robert Frost, who “took the one less traveled by, and that has made all the difference”. What we are talking about is bifurcating your asset allocation and adopting a new objective for your plan, which should have been the objective all along. We believe that managing a pension plan should be about meeting the promised benefits at both reasonable cost and risk. By bifurcating your asset allocation to focus on Retired Lives in the near-term and Active Lives longer-term, we can insulate the portfolio from the ups and downs associated with the market and economic moves.

Unfortunately, most plans have dramatically reduced the fixed income exposure because of their fear that the ROA would not be achievable given these low level of interest rates. However, through a combination of a cash flow matching strategy (beta) using corporate bonds to meet Retired Lives and a growth (alpha) strategy heavily dependent on equities and alternatives, the combination will accomplish many objectives, including reducing interest rate risk, enhancing liquidity, and extending the investing horizon for the growth assets to capture the liquidity premium that is associated with these assets.

If in 2006 you weren’t preparing for the possibility of a major market crash you likely got crushed.  Well, it is 2019 and we are now 10+ years into a bull market for equities, the yield curve has recently inverted, and global growth is waning. If you aren’t preparing your portfolio for the inevitable market decline then please be prepared for the consequences of a falling funded status and escalating contribution costs. Act now before it is too late.

 

Talk About Sobering

Annie Lowery, a staff writer at The Atlantic, has written an article that throws substantial cold water on the argument that Millennials are participating to the same extent economically as did Boomers and Gen Xers. Her article, titled “The Next Recession Will Destroy Millennials” is about as subtle as a Mack truck playing on the offensive line for your football team.

Regrettably, Millennials are already struggling from the dual burden of debt and non-existent savings. Unlike those that came before, they are likely to be the first generation in modern economic history that doesn’t end up better off than their parents. Why? First, many were entering the workforce at the time of the Great Financial Crisis (GFC) and the impact on their wages was not temporary by any stretch of the imagination.  According to the article, Millennial men were making the same wage as Gen Xers when they were the same age and roughly 10% less than Boomers when they were at that age, too, despite a substantially larger and more “prosperous” U.S. economy. Wow! In addition to finding quality jobs with quality wages almost as difficult as finding the Loch Ness Monster, these younger adults were burdened by student loan debt the likes we’ve never seen before.

About 75% of Gen Xers were able to get through college and any post-graduate work with no student loan debt, while 50% of Millennials needed student loans at twice the amount of Gen Xers to achieve the same level of education. Is it not surprising then that Millennials are not buying homes, marrying, and having children until much later in life? I find it particularly shocking that the average age of a homebuyer today is 46! That represents the oldest first-time buyer since data was recorded. Furthermore, they aren’t saving for retirement, but how can they? With the impact of low wages, ever-increasing rents, and significant student loan debt, there is little, if any, disposable income left to fund the basics let alone a retirement plan whose need seems so far into the future.

This is where the use of defined contribution plans instead of defined benefit plans is crippling the financial futures of so many people. Even more sobering than what is happening to Millennials is the fact that Gen Zers may have it even worse. UGH!

 

Is It Really The Fed’s Fault?

There appeared an article in Seeking Alpha (8/26) titled, “Blame The Fed For The Coming Pension Fund Crisis” that railed against the impact that lower U.S. interest rates are having on Pension America that has witnessed, on average, a 27.5% decline in the fund status for all U.S. pensions since 2001 from 100% to today’s 72.5%. Ironically, they weren’t even focused on the liability side of the ledger, which certainly would show a great escalation in the value of future promises if plans used a mark-to-market valuation approach (but, alas, they don’t), thus driving the average funded ratio further into the hole.

They correctly pointed out that the lower interest rates of the last 2-3 decades have forced pension systems to seek greater exposure to equities and alternatives, as the potential return associated with both cash and bonds had become less compelling. The result has been the injection of greater risk into the asset allocation process and more uncertainty as to whether or not future benefit payments would, in fact, be met.

However, this article with all of its charts from various providers, including Bloomberg, Wilshire, Pew Charitable Trust, NASRA, etc., failed to highlight the fact that the continuing focus on the return on asset assumption (ROA) to drive pension returns has directly lead to this funding crisis. Had Pension America continued to engage in defeasance strategies for their promises (liabilities), as they had for much of the 50s to 70s, and managed these plans as if they were lottery systems, pension America wouldn’t be facing the ever-increasing pension expenses to meet these future promises. Furthermore, the plan participants, such as those in critical and declining multiemployer pension plans, wouldn’t be gnawing their fingers to the bones, as one plan after another files for benefit relief under MPRA and more plan participants see dramatic cuts to their monthly checks.

When will we learn? Will it take the third major stock market crash in the last 2+ decades to finally wake up folks to the fact that the up and down asset allocation rollercoaster is not appropriate and eventually collapses? There was another article today in The Atlantic that stated that the next recession will “destroy millennials” (how comforting). Do we really want generation after generation of Americans struggling to survive?

But, Is It The Smartest Beta?

It seems that Smart Beta strategies are all the rage these days. What used to be alpha factors (momentum, size, quality, low-vol, etc.) are now being isolated as smart beta factors leading to indexes being reweighted to take advantage of these exposures. But, in reweighting the index exposures are they not engaging in active strategies? One should be asking if these factor exposures always outperform, and of course, the answer is an unequivocal NO! Furthermore, what is the capacity of some of these exposures?

If one wants to truly engage in a beta exercise, shouldn’t they identify the “smartest beta” portfolio, which is the portfolio that best matches and achieves the true client objective with the least amount of risk and cost? Risk is best measured as the uncertainty of achieving the objective. Cost is the amount required to fund the objective. The true objective of most institutions and even individuals is some type of liability (annuities, banks, insurance, lotteries, NDT, OPEB, pensions, etc.). The absolute level of volatility of returns is not risk given a liability objective.

The most appropriate and smartest beta portfolio is the one that matches the liabilities cash flow.  In essence, the smartest beta portfolio is a custom liability index fund. Such a portfolio should be the core portfolio for any liability objective.  By matching the liability term structure the uncertainty of matching liabilities is eliminated and interest rate sensitivity is neutralized. By matching the liability term structure with bonds that have higher yields and lower present values (price) than the discount rates used will lead to cost savings. Since the accounting rules (ASC 715, IASB, and PPA) use AA zero-coupon discount rates then a liability beta portfolio of As and BBBs will produce higher yields and lower costs that will lead to cost savings of approximately 10% to 15%. Thus, the smartest beta portfolio is a liability cash flow matched portfolio!