Pension Asset Allocation - It's All Wet!

AP Photo/Mike Groll, File

I continue to be amazed by the asset allocation decisions of Pension America. The laser-like focus on the return on asset (ROA) assumption has placed pension plans on the asset allocation roller-coaster to hell! The picture above, which is the Star Jet roller-coaster at Seaside Heights, NJ following Superstorm Sandy, reminds me of the process. Plans ride the good markets up and then down repeating the process with every changing cycle until they get crushed and end up all wet. We need to finally get off this ride before all of Pension America collapses.

We are currently living through potentially the worst quarter of US equity market performance since 1987's fourth quarter. I was working on Wall Street at that time - this feels worse! As the chart above highlights, we have had 29 10% or worse corrections since 1968. Three of those corrections were 48% or worse with two of them coming in just the last 2 decades. Remember that when markets fall 50%, they need to rebound by 100% just to get back to even. Regrettably, these market events have brought Pension America to its knees and driven many private sector pensions to the sidelines. The American worker has suffered as a result.

Are we finally going to see pension plans get back to the basics? Will we once again focus our attention on the promises that were made to the participants as the primary objective in managing a pension plan? Markets only trade at fair value accidentally, as they move from over-valued to under-valued. Let's get away from trying to "guess" where we are in the market cycle and once again establish an asset allocation strategy that has two purposes. The first asset bucket is used to secure the promised benefits through a cash flow driven investing (CDI) approach to match the plan's Retired Lives liabilities. The remaining assets can now be focused on the pension system's long-term future liabilities that have been given the benefit of a longer-time frame in which to meet that future liability growth rate. Neither of these asset buckets has the ROA as its objective. Why should you?

Did We Learn Nothing?

The Great Financial Crisis of 2007-2009 highlighted the need for liquidity in pension plans. The lack of liquidity that was witnessed as the result of moving significant assets into private market investments spawned the growth of the secondary markets, while driving asset prices lower as liquidity was forced where natural liquidity didn't exist. Well, it doesn't appear as if our industry learned much, if anything, from that crisis. As we've reported on several occasions, pension plan allocations to equities and equity-like products are at levels greater than where they were in 2007, alternative investment allocations are up, and guess what, liquidity is once again a challenge. Did we not learn anything?

I spoke before about 600 trustees (2 sessions) at the IFEBP in San Diego in October 2019. My topic was enhanced asset allocation strategies. As an aside, I've spoken on that subject at more than one dozen conferences in the last couple of years. I asked the members of the audience how many had been trustees when the GFC took place. I was pleased to see that well more than 50% of the audience had been long-tenured trustees. I also asked them if they remembered what they were thinking about in 2006 and early 2007 as it related to their pension systems. Were they thinking that a stock market crash was around the corner? More importantly, what are you thinking about now (10/19)? I challenged them to start thinking very hard because the bull market at that time was 10+ years old and we don't know when or why a sell-off will occur, but it will happen - it always does.

I suspect that little was done to protect pension plans from seeing their funded status crushed during this recent crisis. I read with interest this morning an article in Chief Investment Officer magazine by Michael Katz titled, "It’s a Terrible Time for Pensions to Have Weak Liquidity" followed by "Market downturn could force some public pensions to sell assets for a loss." Here we go again. Did we not learn anything?

The article went on to say that according to S&P, US public pension plans have an average of 1% of their portfolio assets held in cash and short-term investments to pay ongoing expenses, such as benefit payments and administrative costs. Well, that just isn't good enough. Again, my feeling is that Pension America has been misdirected in focusing on return instead of the primary objective of securing the promised benefits.

Had pension plans adopted the cash flow driven investing (CDI) approach that Ron and I have spoken about for years, there would be no issue today. They would have the cash on hand to meet expenses, no interest rate risk, a longer investing horizon for the alpha assets, and no forced liquidity that would exacerbate the poor performance of their plan. Will this time be different? Will they actually adopt a new strategy or will we once again be discussing this liquidity issue in 2025?

It Would Be A Mistake

I saw a brief article today in the WSJ regarding conversations that are taking place about possibly restricting the ability to short stocks in the U.S. I was extremely fortunate to be leading Invesco's quant group during the Great Financial Crisis when the U.S. last restricted short selling. We were managing a series of products that utilized shorting techniques, and the restrictions were harmful, as we had about $3 billion in AUM in those strategies. I felt that it was a mistake back then and I continue to believe that it would be a mistake once again.

As a reminder, when selling a stock short, investors are hoping to sell high and then buy lower. Typically, an investor taking a short position does not own the shares prior to the transaction, but borrows the stock through a prime brokerage relationship from another investor. The risk to the short seller is that the security's price increases, instead of falling, that triggers a loss when the investor must buy it back at a higher cost. There is also a cost to borrow the stock that is to be shorted. Depending on the demand for that issue, the rebate rate can be quite high. An investor needs to have a fairly high conviction that the price fall will exceed the cost to borrow.

I believe, as do many market participants, that the ability to short equities creates a more liquid and efficient market. There are many academic papers that support this claim. "“We shouldn’t be banning short selling,” Securities and Exchange Commission Chairman Jay Clayton said Monday in an interview on CNBC. “You need to be able to be on the short side of the market in order to facilitate ordinary market trading”" (WSJ). James Overdahl, the SEC's Chief Economist from 2007-2010 was recently quoted as saying "what we found was, on net, it was harmful. There were many unintended consequences". We have enough to be worried about at this time. Let us not had more hurdles.

Pension Lessons Learned

Ron Ryan and I will be participating in a new webinar series hosted by the Opal Group. The series, titled "Pension Lessons Learned" will have at least 2 episodes. The first session slated for 2pm DST on Wednesday, April 15, is "Protection From Market Disruptions" and the second webinar in the series in slated for April 22nd at the same time, and it will address "Enhanced Asset Allocation" strategies. We hope that you will consider joining us.

As a reminder, the true objective of a pension plan is to secure benefits in a cost-effective manner. Regrettably, Pension America has gotten away from focusing on the primary objective and has instead chased the return on asset (ROA) assumption. This has lead to a dramatic increase in allocations to risk assets, created a poorer liquidity profile, and lead to greater uncertainty in achieving the securing of plan benefits.

We hope that you can join us for both sessions. You can check out the following links for more information on the Opal Group website and the instructions to register for these events.

Website: https://opalgroup.net/conference/pension-lessons-learned-2020/

Registration link: https://zoom.us/webinar/register/6015852510588/WN_PM4XlQuNR9aL7N78aDR4tQ

The financial security for so many Americans is directly correlated to the successful management of these important retirement vehicles. Continuing down the same asset allocation path has failed all of us. We need to take a path that is less traveled and one that might just return us to a route taken when pension plans were first introduced. Tune in - you won't be disappointed!

In Pursuit of the ROA and the Long-term Implications

We've suggested for years that the pursuit of the return on asset (ROA) assumption as the primary goal of pension America was misguided and the latest market events certainly support our point. As plan sponsors and their asset consultants chased the ROA the asset allocation strategies pursued more products that were private in nature - equity, debt, real estate, infrastructure, etc. The hope of more return has likely not been realized and we may soon find out that true valuations have been masked. We certainly understand that pension plan liquidity has been diminished significantly.

With regard to private equity valuations, according to a new report from Investec, "private equity is about to go through a period of violent repricing matched only by the collapse in the global financial crisis: some 50% over the next 3 months!"

In the report from Investec’s Fund Finance team, authors Michael Zornitta and Ian Wiese write "that valuations will fall this month, with major adjustments downward foreseen in June reporting, and that hedging transactions are on the rise as risk management becomes the priority for fund managers. Just one problem: one hedges before the crisis, not after."

According to the folks at Investec, "almost all managers have shifted their focus from deploying capital to defending assets,” Zornitta and Wiese wrote. Managers are looking into "alternative forms of liquidity to prop up companies, prevent breaches and reduce the possibility of having to call any remaining capital" from investors, they wrote.

DB plans have seen substantial re-pricing for traditional domestic and international equities, and high yield. A repricing of anything near the 50% prediction by Investec will be devastating. We encourage all plans to once again focus on the promise that has been made to your participants (liabilities) to drive asset allocation and invest structure decisions, and to get away from chasing the ROA as if it were the Holy Grail. It is nothing more than a tarnished artifact!

Why Pension Reform Is Absolutely Necessary!

For those of you who are perhaps wondering why I've become so passionate about pension reform, there is a social and economic crisis impacting American retirees within the multiemployer universe of Critical and Declining plans (roughly 125) that is about to get even worse, as many of the plans once deemed Critical are likely to have fallen in status with the recent market action.

In 2014, Congress passed legislation (MPRA) that allowed for struggling multiemployer pension plans to file for benefit reductions. To date, there are roughly 15 funds that have been granted permission to "renegotiate" the benefits. These funds have about 75,000 retirees who have seen their benefits reduced. When my friend, John (a retired Teamster) first did his analysis on the impact from these CUTS, there were 43,000 retirees that were in funds that had seen benefit reductions. Their benefit reductions amounted to nearly $34,000,000 / month. What he discovered through his polling and outreach was shocking! Here are just some of the highlights:

95% were not able to work

72% were providing primary care for an ailing loved one

65% were not able to maintain healthcare insurance

60% had lost their home

55% were forced to file for bankruptcy

80% were living benefit check to benefit check

100% of the PBGC maximum benefit payout was inadequate ($12,870 of a retiree with 30-years of work)

50% of the retirees were U.S. service veterans

How could you not be shocked by these numbers? It is wonderful that we have seen action to help American families and businesses negatively impacted by the Coronavirus, but these American workers have been left behind and their fate won't improve once the virus has subsided. Furthermore, there are 1.3 million American workers/retirees in failing plans that are right behind them in line! Are we truly okay with dooming them to a similar fate as those original 43,000 who have suffered so much? I am not! It bothers me to no end that our industry has failed to protect these pensioners. How is it that so many of us have prospered so greatly from our participation in this industry, yet the people who counted on us have not?

Still No Relief For Struggling Multiemployer Pension Plans

House Democrats had crafted their own proposed legislation to compete with the Senate's stimulus proposal. The House version included the Butch Lewis Act to help those Critical and Declining multiemployer pension plans that are on the verge of collapse. Regrettably, the Senate version that passed last night does nothing to help the 1.4 million American workers and retirees in the roughly 125 C&D pension plans. Furthermore, given the devastating impact on pensions from collapsing equity markets and lower interest rates, there are likely to be many more multiemployer plans that now fall into the C&D bucket. Prior to the last month or so there were roughly 200 multiemployer plans that were in the Critical zone.

According to my contact on the front lines of this battle, there may in fact be another bill that specifically addresses the pension crisis. Let's hope that is the case, as these plans have less time to be saved than they did just two months ago. While Congress tinkers, the fate for millions of retirees and near-retirees becomes more tenuous.

I Am Truly Torn

I read with great interest a P&I article from last Friday that mentioned a group of retirement industry trade groups (roughly 25*) had sent a letter to Congress seeking immediate action to help employers that sponsor retirement programs, participants, and retirees during this unprecedented crisis. According to the article they were calling "for allowing penalty-free qualified distributions and loan modifications for individuals impacted by the coronavirus pandemic; providing a temporary waiver for calendar year 2020 of the rules for required minimum distributions from defined contribution plans and individual retirement accounts; assisting defined benefit plan sponsors by freezing the interest rate at pre-COVID-19 pandemic levels, and extending the final contribution due dates, among other suggestions."

I am all for protecting the few remaining corporate DB pension plans, so whatever action needs to be taken to protect them I say, "let's go for it!" But, I am much more concerned about the impact that this crisis is having on both current plan participants and retirees.

My anxiety has to do with these proposed short-term actions to help DC participants and retirees and whether or not they will lead to significantly greater issues in the future. I can't begin to tell you how many articles/posts I've written regarding DC plans being nothing more than glorified savings accounts. Dire circumstances such as the present show that more clearly than ever.

Regrettably, there is no question that a significant percentage of Americans will be harmed by the sudden loss of their livelihoods. The financial impact will be devastating to so many; providing a little lifeline to those individuals that actually have some savings in a defined contribution plan may make all the difference in their ability to keep a roof over their head and food on their table. I get it! But, allowing the raiding of one's retirement plan will likely sabotage them later in life. We need to make sure that any actions we take now are not setting us up for more pain down the road.

"Financial relief and support is critical as we work through this crisis," said Tim Rouse, executive director at the SPARK Institute. "The retirement community stands ready to do its part. Really? Where were these groups when DB plans were being wiped away and the dream of a retirement for most Americans crushed?

We have had a slowly unfolding social crisis in our country for decades where a significant percentage of those working full-time barely earn enough to provide the very basics needed to live - our "working poor". Adequately funding a DC retirement account is out of the question for many even in good times. What we need is real reform that once again provides the American worker with a professionally managed retirement program that can't be accessed until retirement and is paid out in the form of a monthly annuity. This will then allow workers to use DC-like plans like the glorified savings account that they've become. We should allow for payroll withdrawals to fund these emergency accounts so that the financial burden from a crisis of this magnitude can be mitigated to a certain extent.

Let’s not muddy the waters here. We have a retirement crisis that will impact lives for generations which is separate from the immediate crisis that threatens both our economy and our broader way of life. Allowing participants to draw-down their scant retirement savings is not only robbing Peter to pay Paul, it’s robbing Peter and Paul to take out a contract on both of their lives.

We need an enormous Federal stimulus somewhere on the order of 15% to 25% of GDP (i.e. $3-5 trillion) that recognizes the existential threat to American families and immediately provides them with direct cash resources, debt forgiveness, and jobs guarantees in crucial industries to weather this storm. We also need the Senate to pass the Butch Lewis Act now. This loan program is needed now more than ever, as the market action of the past month has likely expedited the insolvency that has been predicted for many of these funds and that which jeopardizes the "golden years" for more than 1.4 million American workers and retirees.. No financial package should be passed without addressing the retirement crisis. Furthermore, we absolutely should not encourage American workers to mortgage their futures by borrowing from what little retirement savings we have.

*note: According to P&I, the groups that signed the letter to Congress were the SPARK Institute; American Benefits Council; American Council of Life Insurers; American Retirement Association; Association for Advanced Life Underwriting; Committee on Investment of Employee Benefit Assets; Defined Contribution Alternatives Association; ERISA Industry Committee; Financial Services Institute; Insured Retirement Institute; Investment Adviser Association; Investment Company Institute; National Association of Insurance and Financial Advisors; National Association of Manufacturers; NTCA-The Rural Broadband Association; Retirement Industry Trust Association; Retirement Industry Trust Association; Securities Industry and Financial Markets Association; Small Business Council of America; Small Business Legislative Council; and Stable Value Investment Association.

Is It A Tactical Move?

Bond funds have seen unprecedented outflows. According to Refintiv Lipper data released yesterday, U.S. investment-grade bond funds saw $35.6 billion pulled in the week ending March 18th. To put that in context, the previous "record" was $7.3 billion that had been established just the week before. If that isn't enough, municipal bond funds experienced withdrawals that were nearly 3 times greater than the previous record, as $12.2 billion was taken out. Actually, nothing was spared within the universe of bonds, as mortgage, high yield, and leveraged loan funds also experienced nearly unprecedented activity.

What is inspiring this dramatic pace of withdrawals? Are the actions specific to fears related to the bonds themselves, such as lower quality corporate bonds that might be in industries most susceptible to the impact from the Coronavirus or are their other reasons? One explanation may be a tactical move back into equities, as DB pension plans, E&Fs, and individuals rebalance their asset allocation back to equities following their precipitous fall. There is some support for the latter explanation, as Vanguard S&P 500 ETF had experienced 19 straight days of inflows until Tuesday.

At Ryan ALM, we have been encouraging our clients and prospects to sell long-dated treasuries (10-years and longer) to take advantage of the strong performance that they've experienced and to use those proceeds to establish a cash flow matching portfolio to defease the plan's, in the case of DB plans, Retired Lives liability. With the nearly unprecedented widening that we've witnessed in the yield spreads of corporates, both investment grade and high yield, relative to Treasuries, we believe that the timing is very good.

Pension LDI: Cash flow Matching Versus Duration Matching

We are pleased to share with you the latest research piece from Ron Ryan and Ryan ALM. We believe that all DB plans should actively de-risk at least enough of their portfolio in order to defease the next 10-years of the plan's Retried Lives liability. But, how? As this report will highlight, we think that it makes far greater sense to use a cash flow matching approach than traditional duration matching. We hope that you enjoy Ron's thoughts on this subject and we encourage you to reach out to us with any questions. We stand ready to assist.

Oh, and based on recent market action regarding the widening of spreads for corporate bonds, now is a particularly good time to act.