Could Rising Rates be THE Antidote?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

As everyone knows, corporate defined benefit (DB) plans have been disappearing like the dinosaur. However, rising US interest rates following a 39-year bond bull market might just prove to be the antidote needed to stem this tide. Milliman’s 2022 Pension Funding Study is out, and as usual, it provides a great overview of the top 100 corporate plans (ranked by plan assets). Corporate funding has improved dramatically in the last several years as investment returns have eclipsed the average plan’s return on asset (ROA) assumptions by a substantial sum. At year-end 2021, corporate pension funding stood at 96.3% compared to 88.1% at year-end 2020. According to the study, only 1 of the 100 plans in this study failed to see improvement in their funded status.

Furthermore, expenses associated with offering a DB plan have fallen substantially. In fact, the aggregate improvement in funding created $18.1 billion in pension earnings (credit) in 2021. There were 53 plans in this study that reported pension earnings in 2021. Importantly, this is the first time that we have had pension earnings since 2001. In addition, and despite the increase in PBGC premiums, total PBGC expenditures fell during fiscal 2021, too. These developments are potentially watershed events.

Despite the struggles year-to-date for both the bond and equity markets, corporate funding has likely continued to improve as the present value impact on plan liabilities from rising US interest rates will have been greater than the losses incurred on the asset side of the pension ledger. Could funded ratios eclipse 100%? If the Federal Reserve is true to its word and given its hyper-focus on inflation, US interest rates could see substantial increases. If such an action occurs, it would not be surprising to once again see aggregate funding achieve fully-funded status. Would this success encourage Corporate America to reduce actions designed to eliminate pensions, such as Pension Risk Transfers (PRT)? We could only hope. Furthermore, the “Great Resignation” that we’ve been witnessing may be tempered with the ongoing support of DB pension systems.

It is also critically important to understand that pension risk transfers are not a panacea. According to Milliman, “PRTs in the form of buyout programs are deemed by plan sponsors to be an effective way to reduce a pension plan’s balance sheet footprint, but generally they have an adverse effect on the plan’s funded status (my emphasis), as assets paid to transfer accrued pension liabilities are higher than the corresponding actuarial liabilities that are extinguished from plans. Much of this incongruity stems from Financial Accounting Standards Board (FASB) pension plan valuation rules, which differ from an insurance company’s underwriting assessment of the same liabilities.” Moreover, we are now witnessing a positive impact on the income statement thru pension income for the first time since the 1990s.

With lower costs, improved funded status, and a need to keep staff during these volatile and challenging times, is it too much to hope that a new day may be dawning for traditional DB pension plans? There are wonderful investment strategies that can be used to lock in the improved funding and secure the promised benefits. We believe that a cash flow matching strategy can secure benefits at a much lower cost than a PRT. We also believe that cash flow matching is the only LDI/ALM strategy that also ensures the necessary liquidity to meet the promised benefits and corresponding expenses. We’d welcome the opportunity to provide assistance to any plan looking for ways to keep its pension plan thriving. Lastly, asking untrained employees to fund, manage, and then disburse a “retirement” benefit through a defined contribution plan is not a good policy. These supplemental plans may also create an unintended consequence given the portability. Let’s go back to the future!

ARPA Update Through April 29, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

A massive Blue Fin Tuna was caught off the coast of Florida a couple of days ago. The 832-pound tuna may prove to be a Florida state record, but it doesn’t compare to the whale of a pension plan that has filed for Special Financial Assistance (SFA) with the PBGC. The Central States, Southeast & Southwest Areas Pension Plan filed the application on April 28th seeking more than $35.1 billion in SFA grant assets to secure the promised benefits for 364,908 plan participants. This plan, if the application is approved, will claim about 35%-38% of the total estimated cost of the ARPA rescue plan assets. The Central States is the first Priority Group 3 plan to file since becoming eligible on April 1st.

In other news, members of the PBGC were quite busy last week approving applications for SFA grants for an additional 7 funds, including three Priority Group 2 applications. The new approvals will help cover the promised benefits for 99,588 participants, as they are expected to receive roughly $3.7 billion in grants. Since last July, 20 plans have had the SFA applications approved covering >117,000 participants with $6.08 billion in grants.

Despite the positive momentum now being witnessed, multiemployer plans (and their advisors) are still waiting for the PBGC’s Final, Final Rules as to how the SFA and legacy assets should be managed. As we’ve discussed, those plans that have already received their assets may have been hurt in this rising rate environment. However, those plans that have yet to receive the approved assets are lucky, as they will now have an opportunity to use the SFA grant assets to defease their plan’s liabilities at higher interest rates, which reduces the economic present value of that future liability payment.

Another Wasted Opportunity?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I published a year-end post (actually December 27, 2021). Here was the concluding paragraph:

So, in conclusion, 2021 was a terrific year for pensions. Now what? Given the improved funding and general expectations for more challenging environments for both equity and bond markets, plan sponsors should seriously consider reducing risk. It would be a travesty to waste all this good news by letting asset allocations remain static and subject to the whims of the markets. Use this unique time to reconfigure your fixed-income exposure to better manage assets versus plan liabilities. This reconfiguration will dramatically improve the plan’s liquidity while eliminating interest rate risk for the portion of the portfolio that will now focus on defeasing liabilities. This action will also buy time for the plan’s alpha assets (non-fixed income) to grow unencumbered, as they are no longer a source of liquidity to meet benefits and expenses. Furthermore, the buying of extra time allows markets to recover should we witness another major market correction. As we conclude 2021 we celebrate the great success enjoyed by Pension America. But, now is not the time to sit on one’s laurels.

Markets are down across the board, the US Federal Reserve is threatening to aggressively pursue a higher rate strategy to thwart inflation, the war in Ukraine continues unabated, and yet little has been done by Pension America to take some risk off the table. What will it take to finally get away from the pursuit of the ROA and focus on securing the promised benefits? There are consequences to maintaining the status quo. Please refer to my February 24, 2022 blog post for a reminder. Such an unnecessary waste!

It Hasn’t been Ideal, But…

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

The start to 2022 hasn’t been great unless you are a long-suffering Mets Fan – great 5-run rally in the 9th to win last night. But I digress. It has been a very challenging environment for our capital markets, which usually means that Pension America is suffering, too. But is that the case this time? The best (most ideal) environment for Pensions is one in which interest rates are rising (liabilities down) and asset levels are flat to up. We haven’t experienced that scenario in quite some time, as we’ve lived through a protracted fall in US interest rates that has harmed pension funding for decades.

Corporate pension sponsors appreciate this fact as FASB mandates a liability discount rate that is market-price based, unlike GASB’s accounting standard that permits public pension systems to utilize the return on asset (ROA) assumption for the discounting of their pension liabilities. This masking of the true level of pension liabilities has been harmful in that decisions related to benefits, contributions, and asset allocation have been made with less than accurate economic information.

Fortunately, in 2022 the US interest rate rise has had a greater impact on a plan’s liabilities than the markets have had on plan assets given the longer average duration of pension liabilities. As we reported in the Ryan ALM Q1’22 Newsletter, plan assets outperformed plan liabilities by roughly 7.2% when using FAS AA Corporate discount rates. We’d already been encouraging plan sponsors to take some risks off the table to preserve the funding gains that had been achieved in 2021 given very strong (unsustainable) market returns. With the continuing improvement in the average plan’s funded status through March 31, 2022, it becomes even more imperative that these gains be preserved.

One easy way to achieve this outcome is to migrate longer maturity fixed income portfolios from a return-seeking mandate to one that cash flow matches pension liabilities chronologically from the next month as far out as the current allocation will permit. This ensures that the fixed income assets will have a shorter duration than the plan’s duration of the liabilities, which is generally somewhere from 10-15 years depending on the maturity of the plan’s workforce. Importantly, a cash flow matching portfolio will ensure that assets and liabilities will move in lockstep with each other stabilizing the funded status for that segment of the portfolio.

If rates continue to rise in a secular trend for many months, long-maturity bonds and pension liabilities will go down in present value significantly. Most total return-focused bond portfolios look like their index benchmark with a sizable amount in maturities longer than 10 years. Cash flow matching is skewed to a much shorter maturity/duration profile which will be much less interest rate sensitive thereby outperforming not only current bond index benchmarks but liabilities as well. We’ve seen the impact of falling rates and falling asset values (’00-’02 and ’07-’09) on pension funding. That combination can be devastating. Fortunately, 2022 hasn’t produced such a combination. Our current scenario of higher rates could be the solution to funding liabilities at lower costs and enhancing the funding status if we transfer from a total return focus on bonds to a cash flow match focus of liabilities chronologically.

Do you know how your plan’s liabilities have performed? If not, call us. We will be happy to provide you with the appropriate insights through our Custom Liability Index (CLI).

We’ve Only Just Begun

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

In 1970, the Carpenters released the song “We’ve Only Just Begun”, as part of the album “Close to You”. I mention this because there are a couple of lines from the song that I believe speak to participants in our current capital market environment. “Sharing horizons that are new to us. Watching the signs along the way.” As I wrote recently, it is a new day for many in our industry who haven’t lived through a protracted rise in US interest rates let alone worked in our industry since the last bond bear market ended in 1981. Everyone is looking for “the sign” that will make their crystal ball a little less foggy. I suspect that they haven’t found it yet given how surprised so many seemed to be when Fed Chairman Powell announced last Wednesday that the next rate move was likely to be 50 bps. We are still so confused by that market reaction since we’ve been regularly writing about the Fed’s intentions.

Want another potential sign? Bank of America strategists are out with a note highlighting the fact that during “the week through April 20, investors pulled $19.6 billion from U.S. large caps, the largest exit since February 2018.” This is in sharp contrast to the fact that nearly $100 billion had been invested into equities so far in 2022 continuing a trend of massive flows into US equities that we previously commented on in 2021. As we reported late last year, BofA had noted that record flows were pouring into US funds outpacing the total of the previous 19-years combined. Our market performance is driven by fund flows. Massive movements in equity fund flows will drive markets up or down, as either the stocks are bought boosting their price, or sold driving prices downward. It is a self-fulfilling prophecy. If we are finally seeing US equity fund flows reversing it could mean big trouble for the broad market. We’ll continue to monitor this trend to see if April’s withdrawals continue into late Spring.

ARPA Update as of April 22, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Another week, and a little more progress. Happy to report that the PBGC approved three additional Priority Group 1 applications last week. The pensions systems receiving approval included, the Retirement Benefit Plan of GCIU Detroit Newspaper Union 13N with Detroit Area Newspaper Publishers (that’s a mouthful), Graphic Communications Union Local 2-C Retirement Benefit Plan, and the Teamsters Local 617 Pension Plan. These plans represent just under 2,000 participants bringing the total number of participants seeing their benefits protected for some period to 17,917. Of the 13 applications that have been approved by the PBGC, seven have received the Special Financial Assistance. One plan, America’s Family Benefit Retirement Plan, withdrew its application. To date, all pension plans that have withdrawn an application have refiled.

As we nearly complete April marking the 9th month of ARPA activity, we still don’t have the Final, Final Rules that are to be provided by the PBGC. Again, I’m told that any changes to the legislation will not result in a clawback of previously paid SFA proceeds. Let us hope! While we wait, significantly rising US interest rates are impacting investment-grade bonds. As I wrote last week, plans that have already received their SFA must hold those assets in IG bonds. If the SFA proceeds had been used to defease plan liabilities, those assets are moving in lockstep with promised benefits, and that relationship is locked in as soon as the portfolio is constructed. Furthermore, the more rates rise, the lower the cost to defease future liabilities.

Plans that used bonds as total return assets, instead of liquidity assets, have suffered significant negative price returns this year. As we’ve witnessed so far in 2022, markets can suffer negative returns. If the list of permissible investments is expanded, the only guarantee is that the segregated SFA assets will have greater volatility, but no greater guarantee of success in securing benefits. I am hoping that the PBGC upholds the intent of the legislation which was to protect and preserve the promised benefits for as long as possible. They should allow for the plan’s legacy assets to be managed as aggressively as the plan would want as the SFA assets will take care of the liquidity for nearly a decade or more.

Would You Invest differently?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

What is the value of time? When it comes to investing, time can be a wonderful tool. When you have a long time horizon, you can seek out investments that have the greatest potential for long-term success. Importantly, you can invest in the knowledge that you can wait out any short-term downturn. Unfortunately, our pension industry has morphed into a “what have you done for me last quarter” mentality. Quarterly reviews measure recent performance differences relative to generic indexes as if they are meaningful. One stock or one bond performing badly can create an underperformance that isn’t reflective of the manager’s long-term capability, yet we scour these performance books each and every quarter as if they were Gospel looking to glean an insight that will provide us with a reason to keep or terminate a manager/strategy. How silly!

As a result, we have created an atmosphere in which a majority of managers have become benchmark huggers, yet they still charge active management fees. What has this wrought? Persistent underperformance on the part of active managers on a net of fees basis. Furthermore, these products ride the rollercoaster of uncertainty given the significant beta exposure to the index benchmark. As we possibly (likely) enter a new investing environment brought about by rising US interest rates, does maintaining a quarterly focus help or hurt pension systems? We’d unequivocally state that having a short-term focus is absolutely the wrong approach.

Don’t despair, for there is a way for Pension America to achieve both short-term (liquidity) and long-term goals. Instead of having ALL of the assets focused on achieving a return on asset (ROA) assumption, bi-furcate your portfolio into liquidity and growth buckets. The liquidity bucket will consist of bonds, and only bonds, whose cash flows of principal, income, and re-invested income, will be used to match net liability cash flows chronologically (after contributions). This “bucket” will provide all of the liquidity necessary to meet benefits and expenses for as far out as the allocation can fund. The good news: as rates rise the cost to fund those benefits gets lower allowing the plan sponsor to either cash flow match more payments or allocate fewer resources to secure the promised benefits.

The remaining growth assets now have an extended time horizon in which to grow unencumbered, as they are no longer a source of liquidity. Furthermore, these assets should be given a wider range from which to operate. Constraining products to narrow benchmarks reduces the efficiency of investing, as the information ratio is a function of the forecasting ability of the strategy and the breadth of the universe from which they are choosing their portfolio holdings. Unconstrained portfolios that now have perhaps as much as 10-years to operate should provide more stable returns as they are no longer tethered to a beta benchmark subject to normal market cycles.

As we have stated many times, defined benefit plans need to be preserved and protected. But approaching the problem in a similar fashion to how we’ve done so for the past 40-years is silly. We’ve all benefited from the significant wind at our backs as interest rates collapsed. Today those winds are blowing directly into our faces and it isn’t a fun feeling. Buying time should permit you the opportunity to invest very differently. If done successfully DB plans should be able to weather this storm.

You Should Believe the Fed

Please don’t tell me that the equity market’s afternoon swoon has to do with Powell indicating that a 50 bps move is on the table (if not locked in). Where have you been hiding if that is the case? Once again, the Fed’s greatest focus right now is on inflation. As Powell has said, “Economies don’t work without price stability.” In order to fight inflation, you need to remove stimulus from the economy. They don’t care what the impact is on markets. That isn’t their role nor should it be.

Is the Credit Rating Stupor About to End?

I warned bond investors just the other day about potential default risk escalating. The WSJ published an article yesterday about the potential impact of rising rates on leverage loans, which financed nearly $1 trillion in acquisitions just in 2021. Quarterly repricing helps investors, but it can damage the borrower. Roughly 15% of the outstanding loans are in companies that have a coverage ratio of <1.5X. The average company is >3X. The rapidity by which the Fed is raising rates may become a heavy burden for many lower quality bonds.

Rising Rates and the Impact on ARPA

By Russ Kamp, Managing, Director, Ryan ALM, Inc.

There was a little more activity related to ARPA and SFA approvals, which I will address in my next update. However, the bigger news surrounding ARPA is the impact of rising rates on both pension assets and pension liabilities. For those plans that have filed applications already, the impact of rising rates has more of an impact on the asset side of the equation. As a reminder, SFA assets are to be kept separate from the plan’s legacy assets. Under the Interim, Final Rules, the SFA assets received (7 funds have been paid to date) are to invest those proceeds in investment-grade fixed income. They can do that in one of two ways: either create a total return-focused portfolio or a cash flow match portfolio of plan assets to plan liabilities – the strategy that we at Ryan ALM espouse.

I suspect that those that have received their payouts have likely invested those assets in an IG portfolio designed to outperform some generic index – likely the BB Aggregate Index. If so, their assets have taken it on the chin as rising rates have impaired bond prices. For instance, the Aggregate index has declined on a total return basis by -8.8% YTD through April 19th. The biggest annual loss since 1981 is <3%. Oh, boy!

Depending on the size of the SFA payment, a pension system might be able to defease 8-12 years of pension liabilities. The present value (PV) of pension liabilities falls as interest rates rise, which provides a plan that is defeasing liabilities the opportunity to defease more of those future payments. As mentioned, the assets get hurt in a rising rate environment, but higher rates also help reduce future costs. Furthermore, once the defeasing strategy is constructed, the savings to the plan are locked in and assets and liabilities move in tandem whether that is up or down. Interest rate risk has been eliminated.

Now the liability news. The ARPA legislation calls for eligible pension plans to use either PPA’s 3rd Segment Rate + 200 basis points or the plan’s current discount rate, whichever is lower. A higher discount rate reduces the economic present value of pension liabilities, which impacts the amount of SFA to be received, so a rising rate environment would reduce the present value of that future liability. Fortunately, the legislation uses a 24-month average (unadjusted) to calculate the current 3rd Segment Rate, which as of April is 3.29% before the addition of the 200 bps. Despite the significant rise in rates in 2022, the 3rd segment +200 bps rate has not moved much at all, as US interest rates were in the 4% range for the 3rd Segment in 2020. As that year falls out of the 24-month calculation it is being replaced by a slightly lower # at this time.

We, at Ryan ALM, are not in the business of predicting rates. We are in the business of SECURING the promised benefits. Allowing pension assets to potentially swing wildly as a result of harmful interest rate moves is not a sound financial strategy. We highly recommend that plan sponsors defease pension liabilities with the SFA proceeds. As a reminder, the ARPA legislation’s goal was to secure the promised benefits for 30-years. We know that isn’t going to happen because of how the SFA is being calculated, but there is no reason to not secure benefits for as long as possible. Doing so allows the pension plan’s legacy assets to now grow unencumbered as they build to meet future pension liabilities. Rising interest rates are not a panacea for pension assets, but they do help pension liabilities and defeasement strategies. More to come on this subject!