Rightly So.

On June 23, 2020, the Department of Labor (DOL) announced a proposed rule to provide further guidance for Employee Retirement Income Security Act (ERISA) plan fiduciaries interested in environmental, social, and governance (ESG) investing. These ESG strategies must be chosen based on their financial merits and CANNOT be selected solely for ethical investing purposes if they are to gain access to defined benefit (DB) and defined contribution (DC) plans. I couldn't agree more.

The securing of the promised benefits needs to be the number one priority for DB plans. Selecting investment programs/strategies that even marginally reduces the chance to accomplish that objective should not be considered. Furthermore, despite the growing popularity of the ESG strategies, I haven't seen any evidence that they are producing superior results to traditional active strategies.

Given the extremely crowded investing field, I can't help but to think that highlighting an ESG capability is just one way to further differentiate one firm from the next. However, I've witnessed to many fads during my nearly four decades in the business to think that ESG investing isn't just another one for the history books.

DB plans need to be protected and preserved as the primary retirement vehicle for the majority of American workers. Let's get back to basics in securing the promised benefits for DB participants. There are other pockets of money that can explore all the investing fads that they want.

No Fairy Tale

Once upon a time in a land not so far from here, defined benefit pension systems were over funded and cash flow positive. Yes, really! As recently as 1999, most DB pension plans were showing strong funded ratios and were at least cash flow neutral. Oh, how 20 years can dramatically alter the landscape. What happened?

Unfortunately, neither the US interest rate environment nor global equity markets cooperated. US interest rates collapsed until long Treasuries were sitting at historically low levels (US 30-year Treasury Bond is 1.34% today), while we tried to migrate through equity market gyrations ('01-'02, '07-'09, Q4'18, and 1Q'20) that would have Elvis Presley's hips jealous.

As a result, we have an environment that has corporate DB plans doing their best impression of a dinosaur, roughly 130 multiemployer plans that are on life support impacting the financial future of an estimated 1.4 million American workers, and a public pension system that still believes that their programs are perpetual despite several examples of plans with funded ratios below 20%. All we need is for Freddie Krueger to start showing up at industry events!

We don't have a retirement system without DB plans. We can kid ourselves about DC plans being a viable alternative, but asking untrained individuals to fund, manage, and disburse this "benefit" is poor policy and nothing more than a pipe dream. As an industry we need to get back to basics. This means that we once again focus on why these plans exist in the first place, which is to pay the promise that was made to the employee when they were first hired. It means managing to this promise every day. It means securing the promised benefits for some extended time so that the plan doesn't have to force liquidity in environments where it doesn't exist.

What it doesn't mean is that plan sponsors and their consultants have to redo their ROA target or asset allocation framework. We can get pension America back to the basics by just converting the plan's current fixed income exposure into a cash flow driven investing (CDI) strategy. It is an implementation that provides the necessary cash flow for the next 10 years to pay the plan's monthly benefits and expenses.

By utilizing a CDI approach, plans will see dramatically improved liquidity, the elimination of interest rate risk, the extension of the investing horizon for the balance of the plan's assets, and an 10% to 20% savings relative to the current pay as you go approach to meeting monthly benefit payments. Furthermore, the savings is realized immediately, and those assets which are not needed to support the CDI portfolio can be used in the alpha portfolio to meet future liabilities.

Corporate America has done a much better job of managing the volatility of both the funded status and contribution expenses. Perhaps the reason is that they are forced to under more stringent accounting rules. But, given their relative success, why aren't publics and multis embracing these tools? Again, we don't have a true retirement system without DB plans, but we are just kidding ourselves if we think that these plans will survive without a change in course. Benefits need to be paid. A CDI approach is the only strategy that actually secures those promised benefits. Isn't it time?

Ryan ALM 2Q'20 Newsletter

We are pleased to share with you the 2Q'20 Ryan ALM Newsletter.

This edition highlights our effort to bring forth perspective on a number of critical pension-related issues. Both Ron and I believe that education is the key to protecting and preserving defined benefit pension systems. Please don't hesitate to go to our website at RyanALM.com to find our research, newsletters, and blog postings.

We also encourage debate, so please challenge us on anything that you question. We'd appreciate getting your thoughts. Have a great day!

No, They Aren't!

I recently read an article that began with the statement that "pensions and 401(k) plans are totally different retirement plans" - I agree. It then went on to state that "one isn't better than the next" - I couldn't disagree more! The economic crisis associated with Covid-19 has highlighted once again for me just how challenging, if not impossible, it is for individuals trying to manage a defined contribution retirement plan.

First, as we've discussed on many occasions, many (most) Americans don't have either the financial means to fund or the investment skill to manage these complex programs. Couple that with the fact that they have to guess as to how long they will live in retirement, and you have a math problem that even the brightest at MIT struggle to solve. Third, many employers have taken the opportunity during this crisis to suspend or eliminate their contribution to an individual's plan. Some will reinstate them when the economy reopens, but it isn't a guarantee. So, the funding burden becomes even more challenging for the individual employee.

I would argue that there are few American workers that wouldn't prefer to have their employer fund, professionally manage, and then disburse a guaranteed retirement benefit every month until one's death. Sure, there is the issue of portability that makes defined contribution plans attractive to some, but studies have highlighted the fact that a considerable percentage of premature withdrawals are the result of individuals not rolling over their accounts to their new employers and taking the withdrawal instead when shifting jobs. Furthermore, loans, which are a very slippery slope, reduce the compounding of returns that are so critical to building an appropriately sized balance.

As we reported yesterday, companies have taken every opportunity during the last several decades to restrict wage growth and benefits, and the elimination of the traditional pension plan in the private sector in favor of the defined contribution plan epitomizes this trend. A 2018 study by the National Institute of Retirement Security (NIRS) found that 59% of working-age individuals had not saved anything for retirement. I understand that DB pension plans were not available throughout the private sector and at the peak of pensions only about 45% of workers were covered, but that 45% certainly had a greater likelihood of enjoying a dignified retirement than those Americans stuck in 401(k) plans as their primary retirement vehicle.

It would be wonderful if every American worker had access to both a traditional pension plan and a DC-type supplemental retirement vehicle. Regrettably, that ship has sailed. Today's employee is unlikely to have access to a DB plan, and for many workers, they don't even have an opportunity to invest in a DC plan. For those that do have the opportunity to invest in a DC plan, many participants treat them as nothing more than glorified savings accounts. Even Congress, through the CARES Act, is encouraging the use of retirement plans to bridge unemployment that has resulted from the Covid-19 crisis. This is just setting up more Americans to have little to retire on in the future. We have a retirement crisis, and little is being done to address it. Saying that pensions and DC plans are equally good is neither helpful nor true!

The Financial Needs for Most Americans Are NOT Being Met!

It isn't rocket science to understand why defined contribution plans are inferior to defined benefit plans for the simple reason that most American workers do not have the discretionary income to fund one's retirement account, if they even have access to one. In a well-publicized report, the National Institute on Retirement Security (NIRS) has estimated that 59% of working-age Americans has not saved a single penny for retirement and regrettably they also don't have access to a DB plan.

In another recent article published on Bloomberg's site, "How The American Worker Got Fleeced", it was highlighted how wage growth has been stagnant, traditional benefits cut, and workers' rights revoked during the last several decades. As the graph below reflects, there once existed a fairly steady relationship between wages and productivity, but that relationship suffered a nasty divorce in the early 1970s. As a result, most Americans are being dramatically underpaid for the output that they are producing.

It should also be noted that these lower wages have been compounded by the impact of greater inflation for many household expenditures, including housing, healthcare, and education. In addition, the federal minimum wage, stuck at $7.25 since 2009, is worth roughly 70% of what it was in 1968, and about a third of what it would be had it kept pace with productivity. In fact, the bottom 90% of wage earners (those making <$120,000) has seen only a very modest increase in their incomes during last two decades. For workers receiving the minimum wage, they are making less today than in 1998, when inflation adjusted.

Couple these trends with the fact that benefits for healthcare and retirement have been scaled back and you have a formula for financial disaster, which is exactly what is transpiring today. The loss of union membership has left the private sector without a voice in salary and benefit negotiations. The movement to more of an on-call labor force has also compounded these trends. These sub-contracted workers allow companies to significantly reduce the liabilities that normally come with a full-time employee.

I've just ordered the book Supreme Inequality, which is a look at the US Supreme Court decisions of the last 50-years that has created a more unjust America for the American worker. I'll have to report back on Adam Cohen's work in a future blog post. In the meantime, we need to do everything we can to protect and preserve DB plans for the masses, as the above mentioned trends are doing everything to reduce the likelihood that today's American worker will ever retire, let alone retire with dignity. I find this development to be shameful.

Is The Muni Market Foreshadowing Public Pension Funding Issues?

The WSJ has an article in today's edition that frankly is pretty scary, but has gotten little press. According to Municipal Market Analytics Data, ten municipal borrowers defaulted in May and another 10 in June, the most for these months since 2012, as municipalities and states deal with the dramatic impact on revenues from the loss of income, sales, and hotel taxes, lotteries, airports, and other sources like tool roads, etc.

As these municipalities and states bootstrap their budgets, where do pension contributions fall within the pecking order? In some states there is no wiggle-room as the required annual pension contribution must be paid in full, but other states, such as NJ, don't have such a mandate, and have rarely made the full contribution even under the best of economic environments. Just how bad can this situation get? New Jersey is forecasting a $10 billion shortfall for the next two years. The state's annual budget is only $38.5 billion.

"The many U.S. towns that thrive on local or regional tourism are in particular distress, and nearly 90% of cities are projecting budget shortfalls, according to April surveys by the National League of Cities and the U.S. Conference of Mayors. More than a third reported they were having to make cuts to capital improvements, infrastructure maintenance and other critical public works services." WSJ

Given that there are still more than 19 million continuing unemployment claims and the promise of more furloughs and cuts in public employees - NYC is forecasting that 22,000 furloughs/cuts are likely in the fall - it seems unlikely that full pension contributions will be forthcoming in the near future. Couple this development with asset value losses and rising liabilities, and you have a formula for disaster. As a result, these pension systems need to buy time. Implementing a CDI program allows for ample time (10-years) to see asset values once again rise, full contributions restored, and hopefully rising interest rates that will reduce the present value of the plan's liabilities. RyanALM.com has a terrific research piece on buying time. Check it out!

We wish for you and your family a Happy Fourth or July!

Maximize The Efficiency of The Asset Allocation

We believe that the primary objective of managing a pension plan is to secure the promised benefits through a cash flow driven investing (CDI) approach. However, there is a very important secondary benefit when using CDI and that is the fact that a plan's asset allocation becomes much more efficient.

In this era of very low US interest rates, exposure to both cash reserves and traditional fixed income can weigh on a plan's ability to achieve the ROA. How excited would you be as a plan sponsor if you could take your current 20% exposure to fixed income and reduce it to 3.5%, while still having the cash flow to fund all of the net benefits and expenses each year for the next 10 years? It would be quite beneficial to the long-term success of the plan to use the 16.5% that had been sitting in fixed income in a more aggressive implementation.

Let me present a hypothetical case for you. ABC public pension has $2.5 billion in assets, a 7.5% ROA objective, 20% in fixed income, and net benefits and expenses of $10 million / year (after contributions). The traditional fixed income portfolio is generating a 2% YTM in this market, which exceeds the Bloomberg Barclays Aggregate index by about 40 bps. If the fixed income account is the primary source of cash flow to meet the $10 million in annual net benefits and expenses, then the $500 million that is currently allocated will just about do the trick ($500 million X a 2% YTM gets you $10 million/year).

In this example the remaining 80% of the corpus is invested however the plan sponsor and their consultant(s) decide with the goal to achieve a rate of return greater than 7.5%, since the 20% of fixed income exposure generating 2% earns the plan only 0.4% of the 7.5% goal. Given this example, the remaining 80% would need to generate a return of 8.875% to accomplish the objective.

Now, consider the following example using a CDI approach to secure and fund the net benefits and expenses of $10 million/year. In a CDI approach income, principal, and re-invested income are used to fund the net benefits. If the goal is to secure the next 10-years of net payouts, an allocation to fixed income would only have to be $84 million in present value $s to meet the future $100 million in payouts. The remaining $416 million (original allocation was $500 million) would now be available to use in the alpha bucket to help generate additional excess returns.

In this example, the 3.5% allocated to the CDI program will generate a roughly 3.3% yield, as it is invested in investment grade corporate bonds contributing roughly 11.6 bps to the overall return. If the residual 96.5% in the alpha bucket can achieve the 8.875% that was needed in the previous example, the "expected" ROA moves from 7.5% to 8.68%, far improving the probability of success. In addition to this improved performance, the plan has secured the benefits and expenses for the next 10 years, reduced funding volatility, eliminated interest rate risk, improved liquidity, and extended the investing horizon for the alpha assets to grow unencumbered for the next 10-years. Seems like a much more efficient implementation to me. Questions? We are ready to help you think through this strategy enhancement.

Not Your Father's POB

I was reading an opinion piece in The Press-Enterprise, titled "Game-Changer For Riverside's (CA) Budget". The piece discussed The Riverside Council's action to reduce the budget by 10% due to a loss of revenue and rising expenditures related to Covid-19. I was impressed. As a Councilman in Midland Park, NJ, I know how difficult it must have been to identify those cuts. But, more important for me was the fact that they had approved going to the market for a Pension Obligation Bond (POB).

What I found interesting was the fact that the author was opposed to the use of POBs, and cited the fact that the Government Finance Officers Association (GFOA) "isn’t a big fan of pension obligation bonds because of downside risks". Historically, POB proceeds were invested in a plan's traditional asset allocation with the hope that the ROA would be achieved and the arbitrage between the ROA and the cost to borrow would be realized. In many cases, the bond proceeds were invested at the height of the market only to suffer significant losses. Yes, that implementation comes with downside risk!

We don't believe that you engage in a POB to play roulette with the proceeds. We believe that sound policy has you investing those assets in a cash flow driven investing (CDI) implementation that defeases as much of the plan's retired lives liability as possible. This significantly reduces the downside risk, insures that retirees get their promised benefits, stabilizes contribution expenses and the funded status, extends the investing horizon for the remaining alpha assets, and eliminates interest rate risk. There are other benefits to this implementation, but I think that you get the drift.

Based on what has transpired since the outbreak of the Covid-19 virus, it is highly likely that state and municipal budgets will be impacted for years to come. DB pension systems are too important to the participants, their communities, and to the local economy to mess around with the funding. Now is the time to adopt a POB, but utilize our implementation and don't play games with the proceeds. We stand ready to assist you in any way that we can.

Another Fallacy

Countless articles mention the burgeoning US federal deficit, as if it is a rival to the Covid-19 virus, getting ready to unleash long-term harm the likes of which we've never witnessed. They are WRONG! Yes, deficits for individuals, businesses, states/municipalities, etc. must be closed or financial harm could be realized, but the US federal government enjoys the benefits of a fiat currency. As such, we are NOT constrained by what is raised in taxes or issued through bond sales.

In fact, deficits ADD to private saving, as witnessed in April when record savings were achieved, and people's incomes. To the extent that people spend this money, MORE goods and services will be sold. According to my former colleague, Charles DuBois, "all else equal, this stronger business will increase investment spending". There is no crowding out. Regrettably, there is very little pushback regarding this misconception except for proponents of Modern Monetary Theory (MMT). We should embrace the recent activity as a positive action to support the US private sector.

A fly In The Ointment?

We are huge fans of cash flow driven investing (CDI). We believe that securing pension benefit payments is the number one objective for a DB plan. Maximizing the efficiency of the asset allocation process is also critical, especially for those pension plans focused on achieving the ROA. Plan sponsors and their consultants use CDI approaches to match every cash flow net of contributions (the first source to fund benefits) each month from the next payment to as far out as their program allocation can afford to go.

Most CDI implementations favor the use of publicly traded bonds, as they are the only instruments with a known terminal value allowing for the greater efficiency in matching those monthly payments. This universe may include Treasuries (lowest yielding), agencies (prepayment risk), and investment grade and high yield corporate bonds (credit risk). In some cases, senior secured debt, bank loans, and other private investments have been used sparingly to potentially enhance the yield reducing the overall cost to implement the strategy.

We are also aware that some investment managers are incorporating dividends in their attempt to capture many sources of liquidity within an overall plan. However, we would caution the use of dividends to help secure benefit payments, as dividends are not guaranteed. The current environment is a perfect example of companies that are cutting or eliminating their dividends. It is too early to know the full extent of the impact, but it has been substantial. As a point of reference, in the great recession, nearly $100 billion in dividend income was lost in 2008 and 2009.

The uncertainty surrounding dividend payouts makes the securing of benefits very difficult, if not impossible. One way to overcome this issue is to accumulate a significant reserve to meet those futures payouts, but given where yields on cash are in this current environment that is a less than desirable implementation. Corporate spreads on investment grade and high yield bonds certainly widened considerably early this year, but they have narrowed significantly since March. In addition, widening doesn't impact the semi-annual payout of the interest, and in fact, made for a greater cost savings with any new money coming into the program. Don't hesitate to reach out to us if we can help you create an efficient CDI program.