Party Like It's 1999

A short note from the WSJ this morning, “Just five stocks account for nearly 1/5 of the S&P 500’s total market capitalization—the highest share since the dot-com bubble peaked at the turn of the century (1999). They are: Facebook, Apple, Amazon, Microsoft and Alphabet. Still, Goldman Sachs said it’s not yet a cause to worry, as the companies don’t look as expensive as their counterparts from 2000, and their recent earnings show that their businesses remain on strong footing.”

“As expensive” is relative term that scares the heck out of me, as we’ve seen this story before. Is this another “new Paradigm”?
 

Are We At An Inflection Point?

Is it time to sell your long bonds?

America has been in a prolonged bull market for bonds since 1982 when long Treasuries hit 14% yields. Today that 30-year bond has a yield of just 2.0%. One needn’t think too long or hard to see why we have a funding crisis within defined benefit plans of all types. For those plans that have had exposure to the long end of the interest rate curve – congratulations – but is the party about to end? As we asked above, is it time to sell your long bonds?

With the 30-year U.S. Treasury Bond yield at 2.0%, an insignificant 13 basis point increase in yield to maturity would create a negative total return even over a year’s horizon. The silver lining here is that pension liabilities behave like bonds. If you have a pension deficit, as most plans do, leaving the deficit on the tail (longer benefit payment dates) seems like a prudent strategy at this time. If interest rates (discount rates) go up over time, these long liabilities will go down in present value, perhaps significantly, thereby enhancing the funded status without having to rely on the asset side of the equation to outperform.

Another proven strategy is to Cash Flow Match benefits chronologically for the next 10-years on a rolling basis (continue to add a year, as the previous year rolls off). This strategy eliminates interest rate risk, as we will be defeasing future values (benefit payments) and it will simultaneously buy time for the remaining assets (alpha assets) to grow without being touched to make benefit payments, especially given how many plans have dramatically increased their use of less liquid alternative investments.

With this approach you will want to replace all long bonds in your fund with a cash flow driven investing approach (CDI) for the next 10-years. Cash flow matching (using our Liability Beta Portfolio™) will secure the next 10-years benefits at low cost and low risk, help to stabilize the funded status of your plan, while also reducing the volatility of contribution expenses for that portion of the plan that has been defeased.

The Ryan ALM LBP is a cost optimization model that will fund benefits at low or optimal cost savings. This should be the core portfolio of any pension plan or LDI strategy. Since bonds shouldn’t be looked at as performance generators, you will also want to replace your generic market bond index benchmarks with a Custom Liability Index (CLI) that best represents the client’s benefit payment schedule. Replacing your bond index benchmark with our CLI will provide all the calculations and data needed to effectively manage assets vs. liabilities.   

Lastly, if you believe in an inflation premium (2%+) on long bonds then we need 4% interest rates on long Treasuries.  We don’t know when history will repeat itself, but it is time to prepare for an eventual interest rate correction on long maturities.

Future Values Versus Present Values

Actuarial practices use present values (PV) to calculate the funded ratio and funded status. But benefit payments are future values (FV). This suggests that the future value of assets versus the future value of liabilities is the most critical evaluation, but this comparison is rarely seen in the consultants’ reports, if at all. Why? Most asset classes are difficult to ascertain their future value. Do you know what the price of GM’s, or any company’s stock will be three years from now? This is why the PV is used. Only bonds (and insurance annuities) have a known future value and that is why they have historically been used to cash flow match liabilities (i.e. defeasance, dedication, etc.). To prove our point as to the potential misinformation with using a PV calculation, let’s use a simple example below.

Pension

Composition

YTM

PV

FV

A

100% Treasuries

3.00%

$100 million

$150 million

B

100% Corporates

4.00%

$100 million

$180 million

Two pensions both at $100 million market value would have the same funded ratio in PV dollars. But pension B is 100% invested in corporate bonds that out-yield pension A (100% invested in Treasuries) by 100 bps per year. Certainly, plan B has a much greater future value (20% higher) and funded status if we used future values. This suggests that the funded ratio and funded status are not that accurate or even good indicators of the true economic solvency of a pension system.

The point of all this is that we need to focus more on the FV of assets versus liabilities. If we value liabilities at market rates, they would have discount rates of AA corporates (FASB method) or even better U.S. Treasury STRIPS (defeasance method). A corporate bond portfolio matched to liabilities that out-yields liabilities would enhance the funded ratio on a future value basis thereby reducing funding costs (i.e. contribution costs). This is why “cash flow driven investing” (CDI) of liability future values is the most prudent risk and lowest cost methodology to de-risking a pension through asset-liability management (ALM).

Not a Good Combination

I’ve been discussing during my conference presentations the need for American pension systems to take some risk off the table, especially given the fact that we have enjoyed 10+ years of a bull market for US equities. I wish that my crystal ball was better than everyone else’s, but it isn’t! Given that I have no idea when the next bear market will begin, I look for opportunities to reduce risk where and when I can. This bull market has been longer than any previous one and only falls behind the great run of the ’90s when discussing gains. Why let your exposure to equities continue to grow as if this were some game of chance in Las Vegas or Atlantic City?

As a result of this nearly unprecedented move, many pension plans have enjoyed improved funded status. Do we really want to jeopardize those improvements? Can Pension America truly survive another major market decline that causes funded ratios to plummet and contribution expenses escalate to perhaps unsustainable levels? I don’t think so, at least not based on the number of plans that were forced to take corrective action following the last two such cycles.

Today’s market action, supposedly related to the Coronavirus and its potential impact on global growth, may prove to be nothing more than a blip on the radar, but it may not. Who knows? But, I do know that the combination of falling stock prices combined with falling interest rates negatively impacts a plan’s funded status and ultimately its level of contributions. Are we going to wait until well after the fact to de-risk or do we take a more proactive (dynamic) approach to asset allocation and pension management that has us managing near-term pension liabilities so that the remaining growth assets now have the luxury of time to work through any potential corrections in this equity bull market run?

I once asked an audience at an IFEBP conference if they recall what they were thinking in the Fall of 2006 and the Spring of 2007 regarding their plan’s asset allocation and risk profile. Were they concerned about the next leg in the market cycle? If so, did they do anything about it?  Well, we may be approaching the next cycle in this market environment.  What are you thinking about right now? I would encourage you not to become complacent. Call us, as we have a roadmap that would be specific to your plan’s liabilities and risk profile.

 

Have We Outsmarted Ourselves?

I entered the retirement industry in 1981 when asset consulting was still in its infancy. At that time many defined benefit plans were managed by a single balanced investment program (60% equity and 40% fixed income), and often it was a bank trust department that was responsible for the program’s implementation. They had recently taken responsibility for pension assets from fixed income managers who defeased the pension liabilities in a similar fashion to how lottery systems were managed then as they are today. That low-risk approach was deemed to be too expensive.

Unfortunately, plan sponsors were coerced into believing that asset consultants possessed a better mousetrap and through this enhanced asset allocation framework asset performance would be superior and contribution expense would be lower. So specialist managers were added and then real estate when stock and bond managers didn’t produce enough return to meet the ROA objective. As U.S. interest rates fell and U.S. equities outperformed, more plans shifted assets further away from the only assets (bonds) in the portfolio that were highly correlated to plan liabilities thus creating a huge mismatch.

Things got much more interesting when interest rates continued to fall and equities got smacked around twice by significant bear markets. In an attempt to enhance returns and lower volatility, significant exposure was given to alternative investments including private equity and debt, timber, agriculture, commodities, infrastructure, and worse, hedge funds! When this combination of products became too much for many plan sponsors to handle from an education and monitoring standpoint, the OCIO model was introduced.  Unfortunately, funded status has plummeted for many plans, while contribution expenses have risen rapidly.

One must now ask are we better off today than we were in 1981?  It seems as if going back to a single manager – the OCIO – hasn’t necessarily improved performance, but it certainly has created a far more complicated structure. It is amazing to see how exposure to U.S. equities has fallen for all plan types to about 26% (P&I) for Union and Public plans, while corporates are at about 16.5%.  Most pension plans would have benefitted last year from a good old fashion 60% equity/40% fixed income portfolio, as it would have generated a roughly 22.4% return slightly topping plan liabilities that came in at 22.2% (FAS 715 rates). Unfortunately, the more complicated asset allocation with very little exposure to US equities generated a roughly 15.7% return that underperformed liabilities by 6.5% and a traditional 60%/40% mix by nearly 7%. OUCH! Public and multiemployer plans faired better as the slightly greater exposure to US large-cap equities helped plans to a roughly 17.9% and 17.6% returns, respectively.

We’ve been running around the country speaking about bringing the basics back to pension plan management with a greater focus on liabilities.  It seems that a return to basics on the asset side of the equation may be warranted, too. How about building a simple portfolio that has the first 10-years of Retired Lives liabilities defeased, which might take between 20%-40% of the assets depending on the funded status, while the remainder of the assets is invested in traditional equities.  I would favor small-cap value for periods greater than 10 years, but that is just me.

Ya Gotta Love New Jersey

I have lived in New Jersey my entire life. I can only blame my parents for the first 18 years of my existence in this state. Beyond that is no one’s fault but my own.  I mention this because NJ ranks LAST among all 50 states for their current fiscal condition. People and businesses are migrating to other parts of this country to get away from this fiscal mess, but here I remain. Please help me!!

When I have opportunities to speak at conferences around the U.S. I often mention my fate, but there are many others living in states that have similar situations to NJ, such as Illinois, California, Connecticut, etc., so I really don’t get much sympathy. Why mention this today? Well, back in 2018, state Senate President Steve Sweeney put together a commission to explore solutions to NJ’s fiscal woes. The commission put together legislation that went before the Senate last May calling for a hybrid pension solution, but nothing happened as the bill sat in the senate (sounds eerily familiar to what transpired with the Butch Lewis Act and the U.S. Senate). Shocking!

In addition to the legislation to create a hybrid plan, there was a bill introduced that would have created a New Jersey economic and fiscal policy review commission to “provide ongoing review of state and local tax structure, economic conditions, and related fiscal issues,” including employee retirement matters, according to a bill summary. But alas, Governor Murphy vetoed the proposed legislation without explanation.  Is this another example of don’t ask, don’t tell?

Not only does NJ have ridiculously high property taxes, but the state income and sales taxes create a melange of real pain for residents. Couple this burden with the gaping financial hole within the NJ pension system (estimated at about $80 billion) and you have a formula for disaster. I give Sweeney and his commission credit for trying to do something before it is too late.  As anyone knows who reads these blogs, I am a huge fan of DB plans, but NJ’s may not be salvageable. In that case, exploring a hybrid solution is certainly more appropriate than thrusting NJ’s public employees into a defined contribution vehicle.

When are we going to get real leadership willing to put aside political differences to tackle real problems facing our residents? Everyone can’t live in Florida and Texas, but it sure seems like the thing to do these days! I’ve always teased my family about wanting to live on a ranch in Montana. That is getting to be more attractive every day!

We Can’t Do The Same Old, Same Old

I frequently write about the state of multiemployer plans in the U.S. There is a “grading” system that makes it easy to identify more successful plans (Green) from those that are in trouble, which are defined in not so favorable terms as Critical and Declining. Regrettably, we don’t have a similar warning system for our public funds, although many of us know that states such as Connecticut, Illinois, and my home state, New Jersey, would certainly not receive a grade of green, but likely one that has them more appropriately designated as being on life support.

Pension plans used to be managed like a lottery system where future promises (liabilities) were known and a present value calculation was used to determine the assets needed to defease that promise. Those assets were then basically set aside until the promised payout was due. Regrettably, we’ve gotten away from that course of action and decided that generating the highest return was the more effective approach to ensuring that future promises were funded and paid. Unfortunately, what has happened is that the funded status for these systems has deteriorated, returns have fallen short, plans have had to reduce benefits, add tiers, and contribute significantly more to these pension plans.

Many of the states have resorted to significantly increasing taxes to meet their pension promises. How has that worked? Well, according to data from the US Census Bureau, millions of Americans have fled high-tax states, such as Connecticut, Illinois, New Jersey, and New York to find more economically palatable locations, such as Texas, whose population growth was greater during the last decade than all of Connecticut. In fact, four of the six highest-tax states in 2010 were among the nine with population growth below 1 percent for the decade in which the US’s population grew by 6%. None of the 10 states with population growth over 11% for the last 10 years were among the 20 highest-tax states early in the decade and it shouldn’t be surprising to read that four were among the seven with no personal income or investment taxes.

So if public pension systems think that they can continue to ramp up taxes on their residents without consequence they will be sadly mistaken. Those days are over. Pension systems need to reduce the volatility of the plan’s asset allocation and the variability in both funded status and contribution expense. Doing the same old, same old has proven to be an unsuccessful approach.  It is time to go back to the future! We can help!