The following is an excerpt taken from Thomas Jefferson’s letter to James Madison. It reads, “I hold it that a little rebellion now and then is a good thing, and as necessary in the political world as storms in the physical…An observation of this truth should render honest republican governors so mild in their punishment of rebellions as not to discourage them too much. It is a medicine necessary for the sound health of government.” As we get set to celebrate our nation’s rebellion this Fourth of July, these words remind me how important it is in our pension/investment industry to challenge the status quo.

We’ve witnessed a significant decline in the use of defined benefit plans. Is this a good thing? I’ve written quite often that I believe that it isn’t, as we are asking untrained individuals to fund, manage, and then disburse a retirement benefit through a defined contribution-type fund with little know-how on how to accomplish this task. There are many reasons why DB plans have lost favor with pension sponsors, despite most American workers favoring them. One of the primary reasons has been the volatility in funded status and contribution expenses, which have resembled a ride on a roller-coaster. I believe that this has been brought about by the continuing focus on “achieving” a return on asset assumption (ROA) as opposed to the promise made to the plan participant (secure plan benefits or liabilities)… this is the reason that the plan exists in the first place.

Fortunately, despite this funding issue for many public fund plans they continue to provide these important retirement vehicles to their workforce. But will they be able to continue? Perhaps, but a change in how they are managed must be implemented. The “rebellion” that I encourage starts with a return to pension basics. It calls for a commitment on the part of everyone involved in pension management to focus first and foremost on the plan’s funded ratio (assets/liabilities) and funded status (assets – liabilities) to drive asset allocation and investment structure decisions.

Since every plan’s liabilities are unique, no generic index is appropriate for this evaluation. Each plan must have a routine (quarterly) review of how assets are performing relative to their liabilities. Once the plan’s liabilities and cash flows have been modeled the allocation of assets can be done and monitored. But unlike today’s strategy of having asset allocation focus on the ROA we recommend that the plan’s assets be bifurcated into beta and alpha buckets. The beta portfolio will consist of fixed income assets whose objective is to cash flow match (defease) and fund the plan’s benefit chronologically in a cost efficient manner with acceptable risk. The alpha bucket (the growth portfolio) will be invested in a variety of investment options that can now grow unencumbered since they are no longer a source of liquidity.

The defeasing of assets to liabilities is a strategy currently used by insurance companies and lottery systems. More importantly, it is how DB pension systems were run prior to the adoption of a return-oriented focus. The time is now to return to pension basics. To paraphrase Jefferson, a little rebellion now and then is a good thing, and as necessary in the investment industry as storms in the physical! Are you ready to join us in this quest?

I’ve been blessed to be in the pension/investment industry for 40 years, and I truly believe that we possess tremendous responsibility to those that we serve – mainly the plan participant. But I’m often frustrated by the fact those that we have been asked to serve are not reaping the benefits that they were promised or deserve. I recently came across an article that touched upon Social Security. The gist of article pertained to a survey conducted by a major investment management organization whose primary focus was on when eligible recipients were likely to begin to claim the SS benefit (age 62-70). According to the survey, only 13% of those >60-years-old who haven’t begun collecting their benefit said that they would wait until age 70 to maximize their benefit. Of those currently receiving a SS check, only 5% had waited to age 70.

Here’s the issue: “Social security is the primary source of income for the majority of Americans we surveyed, which is why we were surprised to see so many deciding to take early SS payments at age 62, sacrificing their full benefits by tapping them early”. “It might come down to not being able to afford to wait”. Do you think? From the same survey: “for 52% of non-retired Americans and 58% of those retired, Social Security will be the primary source of income in retirement”. As a reminder, the average monthly SS benefit is only $1,543/month. By taking it early at age 62, the beneficiary is forfeiting 30% of their possible benefit had they waited to full retirement age. When asked, 64% of those not retired and 62% of those that have retired said that benefits wouldn’t be enough to live on.”

Is the fact that a majority of Americans will be forced to live primarily on SS benefits something for us as a retirement industry to be proud? The demise of defined benefit plans and the rise of defined contribution plans in their stead is not helping matters. This substitution is creating an untenable situation for many Americans that are now asked to fund, manage, and then disburse a benefit with little experience and knowledge to do so. Unfortunately, DC offerings are proving to be glorified savings accounts for many Americans. They are often used to bridge periods of unemployment until a new job is found or retirement is thrust upon them. The gap between employment and the ability to claim SS can be years. Assets that were supposed to be used for “retirement” are often exhausted during this process. Regrettably, most American workers haven’t come close to saving enough to weather such a storm let alone have a dignified retirement. The fact that this survey even mentioned that taking SS benefits prematurely might come down to affordability speaks to the dramatic lack of understanding as to what is truly occurring in our country.

Many people in our industry have done just fine from a financial perspective. Why is it that the people we are supposed to be serving haven’t? Why do we have a majority of Americans living on very meager SS benefits? I find this shameful!

Pension Oversight Boards are getting some press recently, and in many cases the coverage is pretty negative. Many US states have adopted independent oversight boards to monitor the activities of state-sponsored defined benefit pension systems. As an example, Ohio has what is known as the Ohio Retirement Study Council (ORSC) and according to their website, “the general purpose of the Ohio Retirement Study Council is to provide legislative oversight as well as advise and inform the state legislature on all matters relating to the benefits, funding, investment, and administration of the five state retirement systems in Ohio.” That is a lot of responsibility, especially given the fact that the 5 DB plans that they oversee have combined assets >$200 billion and more than 2 million participants. So, how do they do that?

I’m not looking to pick on any one oversight board because these committees have great responsibility and, in many cases, lack the tools necessary to provide appropriate oversight. That said, I think that generally their focus is misplaced. In the case of Ohio, each fund has a substantial team supported by consultants, actuaries, investment managers, custodians, etc. These paid professionals should be permitted to do their job. If they fail, it should be up to the individual boards to act. There is no way that an oversight board has the knowledge or time to monitor investment decisions originating in each of these funds.

The most important job for the oversight board should be to make certain that the plan’s liabilities (the promise to participants) are in focus. At the end of the day this is the only reason why a pension plan exists. They should insist that these plans are run in such a way that the promised benefits are secured at both reasonable cost and risk. In order to monitor these funds appropriately, the oversight boards should get a quarterly update on how each fund’s assets are performing relative to the plan’s liabilities (funded status). Each liability stream is unique to that particular fund and it is imperative that a custom liability index (CLI) is produced on a regular basis (quarterly), as liabilities are bond-like in nature and move with changes in the interest rate environment. The CLI should value the liabilities at both the ROA and ASC 715 (AA corporate yield curve) discount rates so the oversight board can see the difference between actuarial valuation and economic valuation of the funded status. It should be noted here that Moody’s has chosen the ASC 715 discount rates to assess credit ratings.  As a reminder, asset allocation should be driven by the funded status and not the return on assets assumption (ROA).

In addition, the oversight committee should ensure that the annual required contribution is being paid in full. Why have an actuary go through this annual exercise only to have someone decide not to make the ARC? Public pension systems that are struggling with poor funded status can often attribute their issues to a lack of discipline in making the required contributions. By habitually underfunding their plans, they force the assets to try to work harder. This ensures greater risk without the promise of greater return.

I believe that independent oversight boards are an essential part of our defined benefit landscape, but until they focus their attention on liabilities and cash flows, they are not going to be as effective as they could be.

Headline: Kentucky Teachers Retirement System adds $3 billion in unfunded liabilities to their books basically overnight. In actuality, they really didn’t. What they did do was to reduce a high discount of 7.5% to a more reasonable assumption of 7.1%. Do we hear 6.5%? In addition, they adjusted the assumptions for annual salary increases from 3.5% to 2.75% and extended longevity for the average participant. These are all very reasonable. Yes, on paper it looks as if Kentucky’s taxpayers are on the hook for more (roughly $200 million per year), but in actuality, they were already on the hook for much more than that! These moves are just more in line with reality! Good for them. The fact that accounting rules and actuarial practices allow public pension plans to discount their liabilities at the return on asset assumption (ROA) distorts economic reality, especially in an historically low interest rate environment. Economic reality and greater transparency would actually reveal a funded status that is not 54%, but something dramatically lower.

The argument in using the ROA to discount a plan’s liabilities has been that public pension plans are perpetual – baloney! We’ve seen a number of situations over the years that had public fund DB plans being shuttered and hybrid or DC plans being offered in their place to new employees. Furthermore, even without freezing and terminating, the use of multiple tiers reflects the reality that the original promise wasn’t going to be met for the entirety of the plan’s participants. Adopting a truer, more realistic, discount rate for the pricing of liabilities will help keep these plans better funded, as annual contributions will be greater. Please note that corporate pensions use market value discount rates and are much better funded. It also means that asset allocations can be less risky. Given current extreme valuations for both equities and bonds, this might just be a very good time to act. We congratulate KY on taking these steps and hope that other public pension systems follow a similar course.

Summer is here. It officially started at 11:30 pm (DST) on Sunday, June 20th (Happy Father’s Day). Maybe that is why I’m feeling restless today and perhaps a little rambunctious. That said, I need to get something off my chest! I recently had the opportunity to view a quarterly report for a major public pension system. The report by the asset consultant was massive (thank God I didn’t drop it on my foot!), as it contained 282 pages and every conceivable metric to evaluate an investment manager’s performance. Despite the 282 pages, there was not a single reference to the pension plan’s liabilities – not one! A comparison of the plan’s total assets to total liabilities should be on the first page. There is nothing more important! It doesn’t matter how assets do versus the plan’s return on assets (ROA) assumption or some hybrid index. It the total assets fail to beat liability growth the plan loses. As a reminder, these plans only exist because a promise was made to a plan participant. It is that promise (the liability) that must be funded.

At Ryan ALM we believe that the primary pension objective in managing a defined benefit plan is to SECURE the promised benefits in a cost-efficient manner with prudent risk. The ONLY way that this objective is met is to measure and monitor the plan’s liabilities on a regular basis. Since most actuaries only produce annual reports on the plan’s liabilities, it behooves plan trustees to find an alternative source for this information. The plan’s liabilities must be used to drive investment structure and asset allocation. I’ve written plenty on this subject in many different blog posts that can be found at Kampconsultingblog.com, so I won’t repeat myself now.

But where are trustees getting the knowledge necessary to focus on plan liabilities to make these critically important asset allocation decisions? I’ve been very pleased during the last several decades to see the effort put forward to educate public pension trustees through organizations such as FPPTA, IPPFA, MACRS, TexPERS, and many more. They have invested many $s and hours into making sure that plan trustees know everything about the asset-side of the pension equation, but how much time do they spend on liabilities? If you were to take a look at the tests that trustees need to take in order to get a certificate, what percentage of that test would be on plan liabilities? Unfortunately, I would guess very little to none. This needs to change.

As I shared the other day, tremendous asset growth has been achieved during the fiscal year 2021. As Moody’s has suggested, it is time to take some risk off the table so that plans don’t continue to risk these gains or worse. But a plan sponsor will need to know the liability side of the pension equation to make the necessary decisions. Waiting until the next actuarial report is produced is not an option.

Moody’s has recently published a very balanced analysis on the current state of public pension systems. Most of the article discusses the outstanding, perhaps historic, performance results achieved during fiscal year-to-date 2020-2021. Let’s hope that the last couple of weeks in this fiscal year don’t bring any surprises. As a result of the terrific performance and slightly higher interest rates, most DB plans have witnessed improvement in the plan’s funded status. There weren’t many people in our industry who would have expected this performance turnaround when we were living through the depths of uncertainty brought on by the Covid-19 pandemic during 2020’s first quarter.

Despite the rosy performance picture, Moody’s does remind us that “unless US public pension systems move to significantly de-risk their investment portfolios, the potential downside to government credit quality from their reach-for-yield strategies will remain” even after these recent outsized returns. Given the heavy exposure to both equities and alternatives, the average public pension fund’s asset allocation “carries significant volatility risk”. Whether these pension plans de-risk remains quite uncertain. But according to Moody’s, given the 7% target return, the average asset allocation has a one-in-six chance of producing a -5% return or worse annual result. They also suggest that these mature systems, with their large benefit payouts, could see funding gains evaporated and funded status fall to June 2020 levels should the poor performance results occur.

When we at Ryan ALM discuss de-risking DB plans, we are not encouraging a UK-like process. According to John Authors, Bloomberg, the average UK pension plan has reduced equity exposure from 61% to 20% during the last 15 years, as UK regulators encouraged DB pension systems to de-risk. We believe that costs will be dramatically increased if the US were to adopt a similar approach. At Ryan ALM, we suggest that DB pension plans convert their current fixed income exposure from a return-seeking focus to a cash flow matching mandate that enhances liquidity, removes interest rate risk, secures the promised benefits, while also extending the investing horizon for the alpha portfolio that will have a significant exposure to equities and alternatives.

Letting your winnings ride in Las Vegas may occasionally prove fruitful, but it shouldn’t be the approach used to manage DB pension plans. After this incredible performance year, plans would be wise to take some chips off the table and finally begin to manage their plan’s assets versus plan liabilities. Everyone will sleep better at night knowing that the promised benefits have been secured.

We have been doing an analysis on a fairly good sized municipality’s pension system using our Custom Liability Index (CLI). The fund appears to have a roughly 35% funded ratio when using standard accounting rules and actuarial practices. However, when you include projected future contributions (provided by the actuary), the plan is well over-funded. It begs the question, why aren’t contributions part of the funded ratio calculation? Does it make sense to have future liabilities in the equation but not future contributions? As a result of this inconsistency, plan sponsors are forced to make important decisions related to benefits, COLAs, ROA targets, asset allocation, etc. without having the full economic picture.

In this case, future contributions are massive and dramatically overstated. In our analysis we were able to suggest a reduction in annual contributions of $5 million/year for a savings of nearly $100 million during the evaluation period and the plan would still be fully funded. This is a tremendous savings that can now be used to support the other important programs within this city’s social safety net. Furthermore, the fund only needs a very modest return (i.e. 3%), far smaller than the current return on asset assumption (7.25%), to maintain a healthy funded status. Without this insight, the plan sponsor and their advisors would continue to manage a much more aggressive asset allocation injecting unnecessary risk into the process and jeopardizing the current funded status.

There are a lot of things that don’t make sense in our industry. Why do we have two accounting standards – GASB (public funds) and FASB (private plans)? Why don’t we account for future contributions (as assets) while including future liabilities? Why do pension systems focus on the ROA and not the promise (projected benefits) that has been made to the plan participants which is the only reason that these plans exist in the first place? Finally, how can a plan be managed when only focusing on the asset side of the equation? This would be like playing a football game and only knowing how many points you’ve scored. Every pension plan should have an x-ray (asset/liability review) taken quarterly that demonstrates the health of the pension system. Without this review, you could end up throwing a “Hail Mary” when 3 yards and a cloud of dust is all that is necessary.

Inflation is on everyone’s mind these days, and for most of the investment community higher inflation is not welcomed! But there is a group that might just benefit a little from a bit of inflation. I am specifically referring to Social Security recipients. Every October the Social Security Administration announces the COLA for the next year. Unfortunately, COLA increases have been running at 1.92% for the last four years, bringing with them annual increases of roughly $20/month to $39/month for a recipient who gets the “average” monthly payout. Clearly not enough to be life changing.

We’ve reported on these developments in the past, and have discussed using the CPI-E instead of the standard CPI-U, as the CPI-E measures the inflationary impact on senior citizens. The CPI-E has run about 0.2% higher than the CPI-U since it was first reported. That change has not been adopted yet. The Bureau of Labor Statistics recently released the inflation number for May, which showed a 0.6% increase following April’s 0.8% surge.

“In May, The Senior Citizens League (TSCL) released its first forecast of the 2022 COLA after analyzing the April CPI data and had it pegged at 4.7%.”(401(K)Specialist) Given May’s continuing inflationary upward trend, it is not inconceivable that the forecast for 2022’s COLA could rise further. If the COLA ends up being anywhere near the 4.7% increase or greater, it will represent a >3Xs increase on 2021’s 1.3% allocation. Again, the annual COLA is intended to help recipients stay one step ahead of inflation but given the use of the CPI-U instead of the CPI-E, our seniors may still be falling behind.

I just read this morning that ForUsAll Inc., a 401(k) provider to roughly 400 plans (total AUM of $1.7 billion) has entered into agreement with a division of Coinbase Global to offer access to cryptocurrencies – bitcoin, ether, litecoin, etc. – through the workers’ 401(k). The potential investment is limited to 5%. Do we really want unsophisticated employees making an investment in these instruments given the extreme volatility we are witnessing? There are on-going efforts within the 401(k) community to provide participants with access to private/alternative investments, but in nearly every other example, there is an underlying fundamental story or balance sheet supporting the product.

The WSJ article did not mention the cost of investing in cryptos, but they did highlight the fact that ForUsAll would notify the participant when their exposure neared or exceeded 5% so that they could rebalance their exposure. Are they going to inform the participant when the original investment has been cut in 1/2 or more?

A Bank of America research note published recently suggests that the significant improvement in corporate pension plan funding (Milliman calculates the collective funded status at >98%) will likely lead to a “massive rotation” from equities into corporate bonds. We absolutely agree that it should. Many private sector pension systems have frozen and terminated their pensions during the last 4 decades, but many 1,000s still exist. For those that haven’t yet terminated or frozen their plan, engaging in a de-risking strategy at these funding levels makes absolute sense. Why wait? Market timing, predicting equity markets and interest rates, shouldn’t be driving this decision. For instance, the US Treasury 10-year note has rallied despite inflationary expectations and the yield sits at 1.47% this morning down from 1.75% on March 31, 2021. Most market participants were expecting rates to continue to climb.

“I think this becomes a pretty big story, and it becomes a support for credit spreads in the back end of the curve
especially,” Hans Mikkelsen, BofA’s head of high-grade credit strategy, said in an interview. We agree that it likely supports credit spreads, which have tightened, but we disagree that it particularly supports the back-end of the curve. Engaging in asset liability management (ALM) is NOT about buying long corporate bonds. Effectively managing assets versus plan liabilities calls for the cash flow matching of assets along a liability yield curve of projected annual benefit payments, with the next month’s benefit payment being the most important. Sitting with a bunch of long corporate bonds and thinking that you have somehow “immunized” the  assets to match liabilities is just wrong, while opening the plan to significant interest rate risk.

There are only two ways to secure benefits – insurance buyout annuities (IBA) and cash flow matching (CDI). Doing a pension risk transfer through an IBA can be very expensive, especially relative to managing the plan’s liabilities through a cash flow matching strategy. Our experience and analysis suggest that a CDI approach can save the plan about 30% on the future costs of the benefit relative to engaging in an IBA. Furthermore, if a plan is focused on eventually doing a pension risk transfer a cash flow matching portfolio is the perfect vehicle to meet this objective as the insurance company will likely be happy to do a portfolio transfer-in-kind. Go to RyanALM.com to see multiple research pieces on this subject.