The Importance of Dividends on the Total Return

Everyone in the Pension arena understands the actuarial formula: B+E = C+I, where outflows (benefits and expenses) equal inflows (contributions and investment earnings). This equation strives for harmony, but as we've witnessed through many decades, the uncertainty around I places a greater and greater emphasis on C.

When pension systems were first introduced, it was not uncommon, in fact, it was very common, that pension plans were managed in a similar fashion as lottery systems and insurance companies where liabilities (pension promises) were measured, monitored, and MANAGED. Unfortunately, we are in an environment where securing the promised benefits is passe and the focus has become an arms race trying to create the highest return. In periods of dislocation in the markets sponsoring entities are forced to contribute more and more placing a greater burden on those companies, municipalities, and states to make up for the shortfall. Does this make sense?

I just presented at the FPPTA with two members of a top consulting team. They presented data from Horizon Actuarial that had aggregated data from 39 entities forecasting future returns, risk, and correlation. Given how strong the last 12+ years have been for the markets, it isn't surprising that the forward view is for below-average returns for the next decade (regression to the mean is a real thing). They used one of their client's asset allocations and the Horizon forecasts to come up with a 5.3% expected return for this "model" portfolio for the next 10-years. This forecasted return also comes with a +/- 11+% standard deviation.

Wouldn't it be great if the expected return for equities came with less uncertainty, but in an environment in which the dividend yield for the S&P 500 is only 1.29% (as of 12/31/21), most of the total return needs to come from price appreciation. This hasn't always been the case. In fact, it was not unusual for the dividend yield on the S&P 500 to be in excess of 5% annually (the average yield has been 4.3% throughout time), with a peak yield being achieved in 1932 at 13.84%. Wow! Can you imagine starting the year with that type of return? You wouldn't need for stocks to generate any price appreciation/return to meet your return on asset assumptions (ROA). The chart below highlights the importance of dividends on the S&P 500's total return since 1940.

Why have we as investors in the US equity market accepted this recent development. Why are we assuming most, if not all, of the risk for being an equity investor? Shouldn't we be demanding that corporate America provide more robust dividends? Sure, there have been changes in tax policy industry/sector exposures that might have led to some of the deemphasis of dividends, but it certainly doesn't account for all. The current yield is only slightly higher than the lowest level achieved in 2020 (1.11%). The dividend yield used to be a value measure for the index with levels below 4% signifying over valuation. What does the 1.3% seen today portend?

As the chart above highlights, it is critically important that we allow dividends to be reinvested back into the S&P 500, as it drives roughly 60% of the total return over 20-year moving averages and 48% over 10-year moving averages. But, is that what we do within our pension systems? Not really. Plan sponsors are in search of liquidity every month to meet benefits and expenses. They often sweep all available cash from each of their managers irrespective of the growth potential for reinvestment. Given this practice, we would highly recommend that asset allocation strategies bifurcate the assets between liquidity and alpha buckets. The liquidity bucket should use the cash flows from bonds to meet all the current funding needs (liability cash flows), while the alpha bucket can now grow unencumbered as those assets are no longer a source of liquidity.

If the Horizon aggregated information with regard to return, risk, and correlation proves correct, the importance of dividends and dividends reinvested cannot be minimized. Investors shouldn't accept or settle for a dividend yield in the 1.3% range which places most of the risk on US for a return necessary to meet our pension obligations. Let's talk.

Like A Bridge Over Troubled Waters - Revisited

I produced the initial "Like A Bridge Over Troubled Waters" post on October 1, 2021. In that post, I highlighted the fact that the decade of the '00s witnessed two episodic market events that produced nearly -50% declines in each instance crushing pension funding in the process. Most of Pension America had entered the '00s with well-funded plans, and in many cases, pension systems that enjoyed a surplus. It was truly unfortunate that the focus at that time continued to be on achieving the return on asset assumption (ROA) and not on securing the promised benefits. For if they had adjusted their focus funded status and contribution costs would have been stable. Regrettably, funded ratios plummeted, and in the process, contributions skyrocketed.

The bridge that was referred to in the previous post was an asset allocation framework (not new) that called for plan assets to be bifurcated into liquidity (beta) and growth (alpha) buckets and away from a single asset allocation strategy focused exclusively on the ROA. In this implementation, benefits and expenses would be secured through the investment in a cash flow matching bond strategy that effectively used the asset cash flows from the bonds to meet the liability cash flows. This strategy bought time for the alpha assets to recoup their losses while also allowing them to grow unencumbered, as they were no longer a source of liquidity.

The markets - both stocks and bonds- have enjoyed an incredible period of time since the Great Financial Crisis that ended in March 2009. This period of time has once again created complacency for the plan sponsor and their advisors. Everyone knows that stocks outperform bonds over time (roughly 82% of the time in 10-year periods) and equities generally provide a positive return, so why do anything else - let the good times roll! Well, the growth in contributions from 2000 has been extraordinary despite the "strong" market returns of the last 12 years or so. How is that possible? Think that your system and the fund's sponsor(s) can continue to support these rapidly growing contributions? Think again!

The chart above is mindblowing! I have realinvestmentadvice.com (who created the graph) and Chris Scibelli, for bringing this to my attention. In our previous post, we talked about a bridge that spanned roughly 12-13 years. Can you imagine being in the midst of a 52-year timeframe in which equities provide no return? How about that incredible stretch being followed by 26-year and 13-year episodes? Do you still think that equity markets (as defined by the S&P 500) always outperform or add value? Do you think that the trend of plowing more and more pension assets into equity and equity-like product makes sense? What if the 39-year bull market in bonds is dead? What if equities are about to produce another -50% decline as the risk-on trade ceases to exist because all the stimulus has dried up?

If these scenarios play out, do you think that Pension America's DB systems survive? No way! I don't care if public funds think that they are perpetual. Just because they may be perpetual doesn't mean that they are sustainable! If you think that the significant increase in contribution expenses witnessed since the 2000 market correction is outrageous, just wait to see what happens when annual contributions become 30% or more of a municipality's budget.

It is no secret that rates will rise as a result of significant inflation. Bondholders will not continue to buy bonds that have 5% or greater negative real returns. In a rising interest rate environment, both bonds and stocks will be hurt. In that scenario achieving the ROA will be incredibly problematic (impossible?). Most market participants haven't lived through a bear market in bonds. It won't be pleasant.

DB pension plans need to be protected and preserved. However, doing the same old, same old, is not the right strategy. Waiting for the markets to show their hand before doing something is like playing Russian Roulette. Now is the time to convert your traditional return-seeking fixed-income assets into a cash flow matching strategy that will use bonds for their intended purpose - cash flow! Bonds are the only asset with a known payout and terminal value. Use those knowns to construct a portfolio that will ensure that you have the assets needed to SECURE the promised benefits when the time comes due to make those payments. Trying to find liquidity in a rapidly deteriorating market environment is as difficult a task as exists.

By having your cash flow-driven investing program matched carefully with your plan's liabilities, you not only improve liquidity, but you eliminate interest rate risk for that portion of the portfolio, as you will be defeasing a future value that isn't interest-rate sensitive. Furthermore, you are extending the investing horizon for those alpha assets that need time to grow. They shouldn't be a source of liquidity. It isn't too late to adopt, but time to act might be getting short.

Ready for the Weekly ARPA Update?

If given the opportunity to watch paint dry or follow closely the activity surrounding developments related to American Rescue Plan Act (ARPA) and the Special Financial Assistance (SFA), I'd encourage you to sit down and watch some paint. Just make sure that it is a color that you like!

With regard to an update on the progress being made by poorly funded multiemployer plans, there has been ONE pension system, Mid-Jersey Trucking Industry and Teamsters Local 701 Pension and Annuity Fund, that has filed an application with the PBGC in February. The good news is that it is a MPRA Suspension & Partition eligible plan making it the fourth such type to file an application with the PBGC. As a reminder, there are 18 plans that received DOL approval to reduce the promised benefits that are part of the PBGC's group 2 priority list.

Mid-Jersey Trucking has 1,621 participants in the plan and they have filed to receive $138.6 million in SFA. To date, five plans have had their applications approved and two have received their payments. The pace of approvals and distributions has been slow. Let's hope that pace accelerates now that we've gotten through year-end and the Omicron spike. Lastly, we are still waiting on the PBGC to provide the Final, Final Rules that will govern the implementation of the SFA distribution. I'm at a loss as to why the delay, which is now seven months since the Interim Final Rules were provided in July 2021.

How's Your Risk Control?

The Natixis 2021 Investment Management survey has been released. In one segment of the review 166 investment professionals across North America, who collectively represent $3.9 trillion in client assets under management and are responsible for selecting the products and strategies, were asked to assess the current environment and potential risks. Here are the results:

• 86% of those surveyed believe high valuations are distorted by super-low rates and those valuations don’t reflect company fundamentals (66%)
• 71% think the stock market has grown at a rate that isn’t sustainable (YTD 2022 performance certainly supports that notion)
• Their top portfolio risk concerns are now inflation (76%), interest rates (76%), and volatility (51%)

We certainly agree that the uncertainty surrounding rising US interest rates could profoundly impact US stocks. Higher inflation readings than those seen in the last several decades will likely lead to a meaningful seachange in direction for the US Federal Reserve and their dovish policy. If the historically low rates have distorted valuations, it won't take much of a rise in rates to see equities begin to reflect their "true" valuations. Couple the concerns raised above with the possibility of war between Russia and Ukraine and you have a formula for significantly more volatility.

As a plan sponsor, what are you doing to address these concerns? Are you looking to take risks off the table following a sustained period of improved funded status? If not, why not? If your goal is to SECURE the promised benefits at a reasonable cost and with prudent risk, doing nothing is not acceptable. Not only are you likely to witness underperformance from equities, but from traditional fixed income products, too. As we've discussed in several previous blog posts, a modest rise in rates (30 bps) will create enough of a price loss on a 7-year duration bond to produce a negative return for the year. That isn't much of an interest rate move given the current level of inflation.

Once again, we recommend that pension plans separate the asset allocation decision into liquidity or beta (bonds) and growth or alpha buckets (non-bonds). Convert your current fixed income assets from a total return orientation to one that uses bonds for the certainty of their cash flows to match the plan's liability cash flows. This conversion will improve the plan's liquidity allowing the remainder of the assets (alpha assets) to grow unencumbered. The buying of time (extending the investment horizon) is an incredibly important investment tenet. Not sure how to begin? We've been doing this for many decades, and we'd be happy to guide you through this process. Call us!

Baby Steps, but Progress None-the-Less

In the latest ARPA news, New York State Teamsters Conference Pension and Retirement Fund (Syracuse, NY) with >33,000 participants is the third MPRA pension suspension plan to file an application with the PBGC for the SFA. The estimated payout is slightly greater than $1 billion making it the third-largest anticipated federal grant that has been filed so far. Of the five applications that have been approved, we still only have two that have received payments. As a reminder, the PBGC has 120 days to either accept the application as is or reject the application requiring an amended filing, which starts the review clock all over.

There are still 19 Priority Group One applicants waiting to hear about their plan's filing. In addition, there are 5 Priority Group Two plans that have yet to hear, and many more within this cohort that have yet to file. In total, it is estimated that more than 200 plans will be eligible to seek federal support through ARPA. Now, if we can only get the "Final Final Rules" on how to invest the grant money we'll be firing on all cylinders.

Are We at Peak Equity Ownership?

Longview Economics produced the graph below, which appeared in John Authers' (Bloomberg) post today.

It certainly appears that the average US household is "all in" on equities! Previous peak ownership coincided with the massive unwinding of these positions from 1968 to 1982 and again from 2000 to 2009's bottom. The unwinding that occurred during the decade of the '00s witnessed two nearly 50% declines that wiped out incredible wealth, while significantly impairing the funded status for Pension America. Could we be on the cusp of a similar outcome? Will rising US interest rates be that catalyst? We've begun to see a great unwinding of historically low global short rates with the value of bonds with negative real rates is now at only roughly $6 trillion from an incredible $19 trillion in 2021.

As I reported earlier this year, inflows into US equity funds in 2021 (>$900 billion) eclipsed the total sum from the prior 19 years combined! Where is the fuel needed to sustain current levels of equity valuation? Will households maintain their current levels of ownership or will they begin to unwind? If the great unwinding occurs will it test the previous lows and what will that mean for US and global equity markets. Worse, what will it mean for our pension system that has made terrific strides in recent years to improve the long-term sustainability of these critically important programs?

Now is the time to rethink your asset allocation strategy, not once the household ownership is nearing levels last seen in early 2009. Secure those promised benefits by converting your current return-focused fixed income exposure into a cash flow matching program where assets and liabilities are carefully synchronized.

Much Ado About Nothing

There was an eye-popping headline on CNBC's website, "Workers at private companies have amassed more than $400 million (my emphasis) in state-run retirement programs". Sounds great, doesn't it? That's until one realizes that more than 430,000 accounts have been opened in California, Oregon, and Illinois since 2017's initial launch. Regrettably, that equals ONLY about $930 per participant. That sum won't get you much of a dignified retirement.

I believe that the only way for most individuals to save is through an employer-sponsored program. If one doesn't exist, and it is estimated that roughly 57 million Americans don't have access to an employer-sponsored plan, these state-sponsored programs could be useful in filling the void. More shocking to me than the minuscule account balances is the fact only 3 states have actually adopted legislation and implemented a program as of today. According to the article, 46 states have either adopted or "considered" legislation to sponsor a supplemental retirement program since 2012. Well, we know that three have implemented a program. What's going on with the other 43? Furthermore, why are the other four not considering something at this time?

According to Vanguard's latest report, workers appear to need all the help they can get, as the median account balance for individuals nearing retirement — those ages 55 to 64 — is only $84,714. Try living off the income produced from that account balance (roughly $1,700) in today's low-interest-rate environment. I applaud the efforts of those that have engaged in this activity to provide a means to retirement security, but we need a greater sense of urgency if we are actually going to help the 57 million Americans who'll find themselves at retirement's door with few financial resources.

I remain convinced that the only way that we are going to have a majority of our workers ready for retirement is to have them participate in an employer-sponsored defined benefit plan (DB). As important as the effort is to provide workers with a state-sponsored retirement program, we are still asking untrained individuals to fund, manage, and then disburse a benefit with little knowledge on how to accomplish that objective.

ARPA Update - New Tracking System

No new Special Financial Assistance (SFA) grants have been approved this week, as we continue to sit with five pension plan applications that have been approved by the PBGC to date. However, the House Committee on Education and Labor that is Chaired by Congressman Bobby Scott (D., VA) has released a Multiemployer Pension Rescue Tracker to highlight the pensions "saved" and businesses protected under the American Rescue Plan Act (ARPA). To date, the ARPA legislation has supported through the SFA grants the pensions for 8,088 participants and roughly 170 businesses (contributing employers). The number of businesses may be inflated as some of these contributors may participate in more than one of the approved plans. It is a good start, but much more needs to be done as the five plans represent a very small subset of those plans that remain eligible to file and receive grant money.

More To Come?

Every once in a while you come across an article that just strikes a chord with you. I'm pleased to know Ron Surz, who is as passionate about trying to help our retirement industry as I am. The following article has been produced by Ron who has been elevating his concerns for years regarding traditional target-date funds. Given the fact that most of us only have access to a DC plan, coupled with current market levels, there is an urgency in his message that should be heeded. I hope that you find Ron's insights compelling.

Most assets suffered losses at the start of the year 2022. Only commodities were spared as inflation, and inflation fears drove up their prices. Consequently, your 401(k) investments lost value. Target date funds of all vintages declined but -- no surprise -- safer TDFs defended. The “TO - THROUGH” TDF label is a distinction without a difference. “SAFE or RISKY” is much more meaningful. Defined benefit plans also suffered losses like 2040 TDFs since these roughly match DB allocations.

Legend has it that January performance predicts the performance for the year. There’s reason to believe that there’s more to come in 2022.

There is more to come

We enter 2022 with a host of economic threats:

• COVID
• Inflation
• Stock market bubble
• Bond price manipulation (ZIRP)
• Unprecedented money printing

The Federal Reserve has tried to calm the investing public with a promise to control inflation, but this will not be easy. The Fed is caught in a cycle that will be hard to break. If it raises interest rates, stock and bond prices will fall. In a repeat of 2018, the Fed will be pressured to reverse course and try to jam interest rates back toward zero.

But 2022 is not like 2018 because we have serious inflation in 2022 at 7% and threatening to go higher. This time implementing a zero interest rate policy (ZIRP) will fuel the current inflation fire because it requires massive money printing. The Fed can’t have it both ways. It cannot control inflation and continue to buoy up stock and bond prices.

Current inflation is a combination of demand-pull due to supply shortages and cost-push due to $13 trillion in money printing, which is more than our 10 most expensive wars. It is not transitory.

A prediction

There’s a formula that explains stock returns

Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1

The following table shows where we are now and highlights where we will be if P/Es revert to normal.

Stock return in 2022 mostly hinges on Price/Earnings (P/E) expansion or contraction. If multiples return to their historic average of 20, the stock market will decline by 40%. If multiples do not decline and remain at the current very elevated level of 35, the market will return 4%.

Investor psychology sets P/E. Investors are currently willing to pay a handsome premium for earnings. It’s a bubble., although it has not yet burst so it’s not yet official. Market swings of 2% up and down on a daily basis signal investor trepidation. Investors are scared, and they should be.

Protecting against losses

The usual move to defend is into cash, but current inflation threats change the game. The move to safety needs to be into inflation-protected assets like Treasury Inflation-Protected Securities (TIPs), commodities, real assets like real estate, and even cryptocurrencies. This unprecedented situation requires unprecedented reactions.

Defined benefit plan sponsors could match assets to liabilities so both would decline in tandem, maintaining funded status. Alternatively, sponsors could move to safety while the Fed is doing whatever it needs to, with the intention to match (diminished) liabilities when it’s all over. It’s complicated. Thanks, Ron!

A few Pension Facts

Fact 1: Managing a pension plan is NOT an easy endeavor. In fact, it is incredibly difficult. Forecasting the size of one's future workforce, their longevity, salary and benefit increases, inflation, market returns, contributions, etc. can be as difficult an actuarial exercise as exists. The fact that we have so many Americans collecting a pension in retirement is a testament to a job well done - by most! But we can and should be doing better.

It is truly unfortunate that traditional private defined benefit pension (DB) plans have nearly disappeared. They are hanging on for dear life within the multiemployer and public pension arenas. Some of these systems are doing incredibly well, while others continue to struggle for a variety of reasons. As contribution expenses ratchet higher and higher, as we've witnessed for more than two decades, it is inevitable that these systems will begin to face a similar struggle as we've witnessed in the private sector.

Fact 2: The primary objective in managing a DB pension is to SECURE the promised benefits at both reasonable cost and with prudent risk. The primary objective is NOT achieving a return on asset assumption (ROA) that in many cases is nothing more than a Goldilocks # driven by what "feels good" from a contribution standpoint. Given the lack of consistency in our accounting standards, it is understandable why there is confusion. There should NOT be two ways to measure US pension plan liabilities, especially when one (under GASB) allows for the discount rate to be the ROA that doesn't adjust with changes in the US interest rate environment. Incredibly, we've gone through a nearly 40-year bull market for bonds as interest rates have plummeted. Yet, this fact could easily have been lost on those valuing their plan's liabilities based on GASB accounting. It was not lost on our private sector.

Fact 3: There exists a schism within our pension community that leads to the great disconnect between the primary pension objective and what we have today. The ability to actually manage pension assets to pension liabilities is made more challenging by the fact that most asset consultants don't have any way to value a plan's liabilities on a regular basis. I have been given an opportunity to participate in a program for the IFEBP in February. I will be presenting along with two very senior and more than capable asset consultants. I had raised a point with my co-presenters about needing to reflect on the very first page of a performance report on the relationship of plan assets to a plan's specific liabilities. I wrote a post several years ago that asked that question. When I raised this concern with my co-presenters one of them asked a simple question: "Where am I supposed to get this information?" And, there lies the problem.

We have incredibly talented folks within the pension community, whether I'm speaking about the plan sponsor or the actuary, asset consultant(s), investment managers, legal counsel, etc. But there is a general lack of communication among all of these important constituents that are holding us back. We must find a way to bring all of the insights together on a more comprehensive and frequent basis. There should be no impediment for an asset consultant to have the proper insight into how that plan's liabilities are performing. Furthermore, the development of the asset allocation should reflect the plan's funded status, while also taking into consideration where we are likely to be going with regard to the capital markets than where we have been. Communication will be the key to pension funding success.

Most pension plans, thanks to their custodians, know the value of their public investments on a daily basis. They gain knowledge of their private investments with a bit of a delay, but they still have a general idea of what the total assets are. Unfortunately, most plan sponsors of multiemployer and public plans have little knowledge of the price movements of a plan's liabilities, despite the fact that the "pension promise" is the only reason why a plan exists in the first place. The accounting rules certainly don't help, but one can get around this issue by pricing liabilities using a FAS AA Corporate discount rate that would reflect a more accurate value for a liability stream and doing so on a much more frequent basis through the production of a Custom Liability Index (CLI).

Fact 4: Inappropriate decisions can and have been made based on the belief that pension liabilities and a plan's funded status were X, when in fact they were very different, with liabilities being far larger and the funded status much weaker, as we've migrated through this unprecedented declining US interest rate environment. Having greater knowledge of the true economics of a pension system may have led to different conclusions. With greater transparency comes greater insight. We should all be working with the same information. Why is a market-based discount rate appropriate for private pensions, but not public? Please don't tell me it is because public plans are "perpetual". We've seen many examples of municipalities that have frozen and then terminated their DB pension plan - so much for perpetual!

Anyone who knows Ron Ryan and I understands that we are staunch supporters of defined benefit plans. Our mission is to secure the promises that have been made to plan participants. We want DB plans to remain the primary retirement vehicle for the masses. But the battle is far from won. Success will only happen if we all work together to manage these plans through a greater focus on the benefit promises (liabilities). Can you imagine playing a football game, but only knowing what your team has scored but not the opponent? How can you possibly adjust your offense and defense to reflect the current scoreboard situation? Regrettably, that is how many of us have been managing pension plans to date. A rising US interest rate environment could be very helpful to pension funding, as the present value of future liabilities will fall. Wouldn't it be nice to know that fact? In an environment in which rates rise modestly the return on plan liabilities will likely be negative. You don't need a 7.25% return to be successful. There is the fallacy! You need asset growth to match or exceed liability growth. You need asset cash flows to match and fund liability cash flows.