Wouldn't That Be Loverly!

Every once in a while I read something that just makes me shake my head in disbelief. Today I had such an experience. The gist of the article to which I am referring had to do with a question that was posed regarding the funding of one's retirement account while on unemployment.

For most Americans - yes, most Americans, having an abundance of financial resources is a pipe dream. Unemployment, as we've witnessed during the last 3 months, can be financially devastating in a relatively short period of time. Furthermore, most studies suggest that American workers truly only save for retirement through an employer-sponsored plan. Losing one's job eliminates both the financial resources AND the access to a retirement vehicle. The fact that this question was asked is actually mind-boggling.

There has been little real wage growth during the last several decades, while expenditures for education, housing, healthcare, food, etc. have grown substantially. As a result, the Covid-19 impact on the economy and workers revealed the fragility by which most Americans live. We've seen a dramatic increase in loans not being paid, mortgage and rent relief, and unemployment benefits dramatically enhanced (extra $600/week), and it still isn't enough for many displaced workers, especially if they live in a major city, such as NYC or San Francisco.

Furthermore, the article went on to discuss the establishment for a rainy day or emergency fund. Yes, I agree wholeheartedly that it is wise to set aside funds for an unexpected life event, but in reality most Americans are living paycheck to paycheck, and barely have the means to meet life's necessities on a daily basis. This is not because they are buying lattes or eating avocado toast everyday. For Millennials, the reality is that twice as many representatives of this cohort have 50% more in student loan debt than the Gen Xers who preceded them.

My favorite line in the article was "when you're unemployed, your emergency fund should ideally be heftier than normal". Now there's a brilliant statement. Well, if every American knew the day that they would become unemployed, I'm sure that they would do everything in their power to save a little more. Regrettably, the Covid-19 virus didn't give us a heads up and I suspect that most employers didn't do the same thing for their employees: they seldom do.

We have significant economic issues in our country, and worrying about whether or not someone on unemployment should continue to fund a 401(k) isn't near the top of the priority list nor is it realistic. It would be wonderful if the general working population were earning enough in wages that their basic living expenses were more than covered, but we know that is just not the case. Until we get to that desired outcome, we will have to live with the knowledge that shocks to our economy can happen at anytime.

A Penalty That Should Be Eliminated

The Covid-19 crisis has raised awareness regarding many social ills, including the lack of emergency funds, the fragility of the labor force, especially for older workers, and inequality in general. These all need to be addressed in time, but there is another issue that should be a priority for immediate consideration. I am referring to the Social Security "earnings test" that penalizes workers who are collecting SS benefits prior to achieving full retirement age. As an FYI, "full" retirement age is different for workers based on the year of your birth. For instance, anyone born 1959 (my year of birth) I am considered at full retirement age when I am 66 years old and 10 months.

Why is this important? It has taken on greater urgency because of the significant job losses experienced during this crisis. Many older Americans will have a difficult time reentering the labor market and may in fact be forced to take an early SS benefit to supplement any savings that have been accumulated, which we know are scant for a significant percentage of the population. Those taking early SS benefits will be required to forfeit $1 for every $2 earned above $18,240. The penalty becomes less onerous once you reach the year in which you achieve full retirement age. For someone born in 1959, they would have 46 months of the $2 penalty, and 1-year of the $1 for every $3 earned above an income threshold of $48,600.

Even without this crisis, it seems unreasonable that American workers can't supplement their "retirement" incomes without incurring a penalty. I'm sure that critics of this proposal will cite the Federal government's widening deficits and fears of a collapsing SS system that is forecast to go bust at some point in the future. Those concerns are unfounded as the US government can always meet their obligations thanks to possessing a fiat currency. When many Americans find themselves unemployed, and economic activity has taken it on the chin, we should be looking for ways to further stimulate demand for goods and services. Allowing American workers collecting SS benefits prior to achieving full retirement age would now have additional spending power.

Retirement Plans Being Tested?

Of course they are!

Recently, there has been more reporting about 401(k) participation taking a hit amidst the COVID-19 pandemic. Now, that is a shocker.

According to folks at LIMRA Workplace Benefits Research, their findings reveal that among workers with access to a DC plan, roughly 36% say they have decreased or eliminated contributions. For those participants who once contributed but stopped (that’s about 10% overall), more than half (56%) ceased their participation in the wake of the COVID-19 crisis.

Regrettably, the change in behavior is not limited to the plan participant, as the sponsoring organizations are also reacting to market forces with more than 30% having either eliminated or reduced the company match. For those employers (with 10 or more employees) who have a DC plan in place they've also noted other behaviors that will likely impact wealth creation for the participants, including the fact that 13% of the plans have seen an increase in hardship withdrawals, while another 10% have seen increases in loan demand. Lastly, they note that more than 20% of plan participants have made asset allocation changes, which likely means (and I'm speculating) that equities were sold in late March or early April before the rally.

I know that I tend to come down harshly on DC plans, but they were never designed to be anyone's primary retirement vehicle. I think that they are great for accumulating supplemental income. Furthermore, asking untrained, and lowly compensated workers, to fund, manage, and disburse a benefit that many professionals have difficulty handling is just not acceptable.

It is because of these issues that Ron and I are trying to reeducate the DB market on strategies that will secure the promised benefits while preserving DB systems for future generations of workers. The millennial cohort is already behind Boomers in wealth creation by roughly 34%. The lack of access to DB plans will likely increase that deficit and make the hope of a dignified retirement more unlikely!

Question: Did You Win?

Here is the question of the day: If your pension plan beats the ROA, but loses to liability growth, did you win?

I suspect that most plan sponsors and many consultants would suggest that they have won the game. But, have they really?

Despite the "fact" that GASB permits public pension systems to discount their plan's liabilities at the ROA, liabilities are bond-like in nature and are repriced based on interest rate changes. As we've witnessed during the last nearly four decades of collapsing rates, pension liabilities have blown out. The impact on funded ratios and contribution expenses has been particularly onerous this century, creating a very challenging environment for sponsors of public and multiemployer systems.

On the other hand, if your plan generates only a 4% annual return failing to achieve the 7.25% ROA, but liability growth is -2% during the same time frame: didn't you win?

The good news for Pension America going forward is that historically low interest rates are not likely to fall much further, if at all. A rising interest-rate regime will negatively impact liability growth creating an environment that will allow modestly growing assets to add significant value in a relatively short period of time.

Unfortunately, most plan sponsors do not see this relationship because of the accounting rules. Going forward, all pension plans should be given multiple views of their liabilities, including a risk-free rate. Of course, a pension liability in this low-interest-rate environment will look atrocious and the funded status very weak. However, given the likelihood that rates will rise going forward, plans could see a dramatic improvement in all metrics. Decisions by trustees should be predicated on the truth, including an accurate funded ratio/funded status, but without complete transparency with regard to plan liabilities (benefit payment), this is not possible.

That's NOT The Correct Objective!

The New Jersey Pension Fund has reported that the system generated a -2.47% return for the 10-months ending April 30, 2020, which is obviously quite poor given their annual return on asset target (ROA) of 7.5%. Furthermore, they are reporting that the benchmark return to which they compare their assets produced a net return of 0.72%, or more than 3% better than the fund. However, neither the ROA nor the asset benchmark is the right objective.

Let's stop playing these performance games, especially since NJ seems to underperform on a very consistent basis trailing the asset benchmark on a 3- and 5-year basis, while besting the hybrid index by 5 basis points over 10-years (but, trailing the ROA). The only reason that the NJ pension fund exists is to pay the promised benefits to the plan participants, which means that the only true objective for the assets are the plan's liabilities. Despite the fact that liabilities do not grow at the same rate as assets, GASB accounting rules permit the discounting of plan liabilities at the ROA. Even under this misguided accounting methodology, NJ's system is woefully funded.

Unfortunately, it is being reported that NJ will once again fail to make the annual required contribution, as the impact from the Covid-19 crisis weighs on revenues while expenses rise. Not surprising, the state's funded status continues to deteriorate, and the growing required contribution is negatively impacting the funds available to support the social safety net. If a true measure of the plan's liabilities were determined, the funded ratio would be in the low 20% range and the underfunded liability would be about $300 billion! Yes, that is correct that a state with a roughly $40 billion annual budget is saddled with a $300 billion unfunded liability.

NJ's public fund participants, who have worked for and funded this benefit, deserve a better outcome. The plan's investment team and board of trustees need to finally understand that managing assets against an asset benchmark accomplishes very little. NJ will not get their arms around this funding crisis until they recognize the true objective is plan liabilities. Once they comprehend that fact they will then be able to begin to tackle this problem.

It's All About Contributions!

The most significant cause of the current pension crisis is the failure to contribute enough to these plans! As a result, too much emphasis has been placed on generating out-sized returns, which have failed to materialize. Oh, we've had brief moments of glory (decade of the '90s), but far too often we've had these riskier portfolios subjected to significant market corrections ('00-'02, '07-'09, Q4'18, 2/20-3/20). When will we finally choose another course?

Federal Reserve policy decisions that have lead to rapidly falling US rates have proven incredibly harmful to Pension America and savers in general. But, instead of ponying up more cash in the form of contributions, we tried to game the system by juicing up possible returns. We got the volatility, but not returns! The chart below tells an amazing story.

The chart above highlights the cost to secure a $1,000 benefit payment 30-years out, and at various points in time throughout my career. The green line is representative of the average ROA for the 50 US states. When we discuss the impact that the Federal Reserve policy decisions have had on Pension America, this is exactly to which we are referring.

In 1981, when I first entered this industry, you could secure a $1,000 pension benefit payment 30-years out with just $14.37. Incredible! The US 30-year Treasury bond yield was 14.8% at that time. The power of compounding (is it the eighth "wonder of the world"?) provided you with an amazing opportunity that we are likely never to see again in the US. Given this environment, one has to wonder why Pension America didn't immunize and defease every pension system and secure the victory for decades to come?

Interestingly, pension systems that had an "average" ROA (they were higher in the early '80s than what we are depicting) were paying more into the system than they needed to in 1981, as the discounting mechanism for liabilities was lower than the prevailing 30-year yield. In our example, plan sponsors were contributing $109.49 more than they needed to if they actually achieved the projected ROA. They continued to contribute more into their systems through the early 1990s, but as interest rates began to plummet, those contributions fell further and further behind.

In fact, today we have a situation in which that same $1,000 would cost you $622.61 in present value $s. Regrettably, because pension systems are using an inflated discounting mechanism of 7.21% (the ROA), they are under contributing to these systems by about 5X. Instead of funding that $1,000 at $623, they are only putting into their systems $123.86. Again, this forces pension systems to try to spike returns, and as a result, we get this constant roller-coaster effect to ruin. Remember what Hurricane Sandy did to the NJ shore communities.

Enough is enough. As we discussed in our most recent blog, most state and municipal pension systems are not going to invest their way to improved funding, as the hole that has been dug is just too deep. Plan sponsors need to find additional resources to enhance contributions. Without addressing the need for greater contributions plan assets will continue to be whipsawed by market action, and the sustainability of these systems will once again be called into question.

Saving Pension America - There Aren't an Infinite Number of Possibilities!

Anyone who knows Ryan ALM and who has followed our blog posts for years knows that we are big supporters of DB plans as the primary retirement vehicle for the masses. We've discussed our rationale for this stance numerous times. That said, recent market action and economic activity have put public pension systems once again in the spotlight. The battle to control the outbreak of Covid-19 has impacted many state budgets from both a revenue (income and sales taxes, lotteries, fees, etc.) and expenses standpoint (Covid-19 emergency responders, PPE, etc.), and the likelihood of escalating contributions into state pension systems may be too much for some states to handle. What can be done?

Unfortunately, there aren't an infinite number of actions that will improve plan funding, and in the cases of states like NJ, IL, and others, dramatically improve their systems' funded status. In fact, there are really only five actions that would lead to improved pension funding, including; 1) assets outperform the ROA target, 2) the present value of future liabilities fall, 3) both actions 1 and 2 occur, 4) borrow additional resources (POB), and 5) renege on a portion of the promised benefits.

With regard to action 1, plans have been relying on asset performance for years to make up for contribution shortfalls. In most cases this goal has been met with enhanced volatility, but little reward. As we pointed out in a previous blog, the Bloomberg Barclays Aggregate Index bested the S&P 500 for the 20-years ending March 31, 2020, despite a greater than 10-year bull market for equities, little improvement in funded status occurred.

We have been in a protracted bull market for bonds since I entered the industry in 1981. The impact on pension systems from falling interest rates (action 2) has been devastating (I will have more on this issue in a subsequent blog post). How likely are rates to rise from here? Most participants in our industry have felt that rates would "normalize" for years, only to see one event after another drive rates further lower. Action by the US Federal Reserve has damaged (permanently?) pensions and retirees, who need income to sustain quality retirements. The movement of rates lower has correlated with plans and pensioners taking on more risk to try to create additional income. It has also proven to be a disaster.

Ideally, we would enter a protracted period of asset appreciation and rising interest rates that would lead to a fairly quick recovery in pension funding. For instance, at such low market interest rates, a 30 bps increase in rates would create negative liability growth for the plan. Given that dynamic, a Funded Ratio of 60% could improve significantly to 89.4% if in the next 5 years average asset growth was just 4% and average liability growth was -4%. The improvement is even more dramatic if during the next 5 years assets grew by 5%. In this case, the funded ratio would improve to 94.0% if liability growth proved to be negative 4% during this period. But given that our economy is just opening up now, how much economic growth, inflation, and rising rates can we expect in the near-term?

Action 5, the trimming of promised benefits, (yes, I jumped over my fourth "opportunity") is a last resort action, and in many cases individual state laws prohibit such an action. Since the Great Financial Crisis (GFC), a majority of public pension systems have altered benefit formulas directed at new employees, but that does little to tackle the current under-funding. Furthermore, these plan participants have invested both years of time and their own contributions into a system with the expectation that they would receive the promised benefits. Anything less is truly an affront.

With regard to action 4 and the borrowing of funds, I believe that for states such as NJ, IL, KY, CT, etc. the issuance of a pension obligation bond (POB) is the only way for these systems to climb out from the huge hole that was dug by years of habitually under-funding their plans. POBs have been tried many times before and with mixed results, but I believe that the investment of the bond proceeds was implemented inappropriately, which ultimately lead to the failure of the action.

Historically, a pension plan would take the proceeds from the bond and invest those assets in a traditional asset allocation. As a result, the proceeds are subjected to the whims of the markets. In many cases these assets have been injected at an inappropriate (market peaks) time leading to losses. The plan is then on the hook for the original interest payment on the POB and the loss suffered on the "investment". To mitigate this risk, any proceeds from the POB MUST be used to defease the plan's retired lives liability. The current assets in the plan and any future annual contributions would then be used to meet future liabilities. Given the magnitude of the funding crisis, HOPING that assets will dramatically outperform, while interest rates rapidly rise is a lot to ask for. Cutting benefits is a non-starter. Issuing a POB and injecting significant assets into the system to SECURE pension promises seems to me to be the most viable alternative.

Let us know what you think.

That's Some List!

Representatives from the Federal Reserve Bank in St. Louis recently discussed on a defined contribution webinar the implications for the retirement industry as a result of the Covid-19 crisis. The key action items discussed were all significant issues prior to the virus's impact on our economy and markets, but the magnitude of the issues has certainly been exacerbated. Many of the following items have been highlighted in this blog before.

There is an urgent need to address these issues, which include: 1) Americans' lack of emergency savings, 2) racial and economic inequality in retirement savings, 3) lack of access to workplace retirement plans, and 4) the Millennial cohort. As you can see, there is a host of critical issues just involving retirement savings, let alone all the other issues that are dominating our political and cultural landscape today.

Most of these issues have to do with the fact that a majority of Americans just don't have wages that provide them with more than enough to just meet their basic needs. As a result, they don't have funds to meet emergency expenditures. We've been reading about this for years how the average American can't meet a $400 medical or auto expenditure without having to borrow. Even if these American workers had access to a retirement plan, and only about 50% do, they don't have the disposable income to put money aside.

With regard to inequality, two-thirds of white families have 401(k) plans, while only about 1/3 of nonwhite families are participating in a DC-like plan. For those that are participating in a DC retirement plan, white families have saved on average $155,000, while non-white families have about $60,000, and those figures are from before the recent market sell-off. Trends in the American labor force (on-call arrangements) and the impact of that trend on wages and benefits are constraining one's ability to save. Nonwhite Americans suffer as a result of the lack of wealth transfers from one generation to the next.

Lastly, as the father of five children (4 millennials), I am particularly concerned about the continuing impact of one crisis after another on this generation. The children of the '80s and early '90s have been stung by the burden of excessive student loan debt and the Great Financial crisis, just as they were entering the workforce, which had a profound impact on their starting salaries. At the point where some of this cohort may have just been recovering, they are hit with the Covid-19 crisis. This generation is clearly losing the "birth lottery". According to recent studies, this generation's wealth is 34% below where one would expect it to be at this age. Clearly, the implications for the long-term are devastating.

With so many Americans living within 200% of the poverty line, we need to address income inequality, but that might not be enough to help close the retirement gap. We need to rethink the inappropriateness of DC plans as one's primary retirement vehicle, and once again consider them nothing more than supplemental income funds. If an American has a job, they should be receiving credit towards a defined benefit system. If this needs to be done outside of their employer/employee relationship - so be it! Asking untrained and underpaid employees to fund, manage, and disburse a retirement benefit is a failing policy that is leading to a disastrous outcome.

CHAPTER and Verse on Cash Flow Matching

We, at Ryan ALM, are proud to share with you Ron Ryan's chapter on Cash Flow Matching, also known as cash flow driven investing (CDI), that will appear in Dr. Frank Fabozzi's latest edition of the "Handbook of Fixed Income Securities". This is quite an honor and recognizes Ron, and the Ryan ALM team, as one of the true experts on this subject. Fabozzi’s Handbook is usually required reading for the CFA degree, university Finance courses, as well as a valuable reference for many fixed income practitioners.

Importantly, this work highlights the differences between cash flow matching and duration matching, which has been the preferred pension de-risking strategy in the U.S., while CDI is the preferred method among plan sponsors in Europe. We would encourage you to take a look. One of my favorite sections is the "seven flaws of duration" in the CDI versus LDI section. I think that you'll find Ron's thought on this subject to be incredibly insightful.

As we've recently witnessed, once again, stock and bond market performance can dramatically impair even the best funded pension systems when the unexpected presents itself. Adopting a cash flow driven approach helps Pension America protect critically important plans in the short- to near-term, while the growth (alpha) assets enjoy an extended investing horizon to overcome recent weakness without becoming a source of liquidity. We would certainly welcome an opportunity to respond to any questions that you have regarding this subject.

Talk About a Long Liability!

I read with both interest and fascination an article in the WSJ today that mentioned that the last surviving Civil War pension recipient had just passed away. Irene Triplett was born in 1930. Her dad, Mose Triplett, was 83 when she was born. His wife at the time was nearly 50 years his junior. As a result of his military service, his daughter, who was 90 when she recently passed away, received a $73.13 monthly benefit from the Department of Veteran Affairs. The pension liability lasted 156 years! I'm not sure that is a record, but it has to be close.

One of the issues impacting pension America is the fact that pensioners, on average, are living longer, and as a result liability tables are being rewritten to account for this extended aging. That said, I doubt that anyone expected a pension liability earned in 1864 to extend to 2020.

When we at Ryan ALM ask for liability data - estimated benefits and contributions - we ask for a minimum of 20 years so that we can produce our Custom Liability Index (CLI). I guess that we will now need to rethink our request. Do we really need to get the actuary to forecast the next 150 years?