Message for ARPA SFA recipients: Beware of What Fixed Income Securities You Buy!

By: Ronald J. Ryan, CFA, CEO, Ryan ALM, Inc.

The American Rescue Plan Act became legal as of March 11, 2021. Section 9704 of ARPA provides Special Financial Assistance (SFA) to pension plans who are in critical funding status as follows:

“The amount of financial assistance… shall be such amount required for the plan to pay all benefits due during the period beginning on the date of payment of the special financial assistance payment under this section and ending on the last day of the plan year ending in 2051, with no reduction in a participant’s or beneficiary’s accrued benefit…”.

It seems apparent that the SFA section of ARPA requires the funding of benefits beginning on the date of the SFA payment. This means funding benefits chronologically as far out as the SFA grant can fund. Based on how the SFA is calculated, plans will not come close to securing 30-years of benefits, but they should strive to defease and secure as many years as possible chronologically.

What we know:

• The SFA assets must be segregated from the fund’s legacy assets
• Based on the Interim Final Rules, only Investment-grade bonds can be used for investment purposes

Funding and Securing the promised benefits:

The only way to secure the promised benefits for as long as possible is to use a cash flow matching strategy (currently called cash flow driven investments (CDI)) that matches and funds liability cash flows with asset cash flows (income, principal, and re-invested income) chronologically.

WARNING: Managing bonds to a generic bond index will NOT cash flow match liability cash flows. Every pension plan has unique projected benefits (and expenses). No generic bond index could possibly have asset cash flows that match the unique liability cash flows of any plan sponsor.

The Ryan ALM turnkey process:

Ryan ALM starts with the plan sponsor’s actuarial projections to create a Custom Liability Index (CLI) that best measures and monitors the plan liability cash flows and should become… the plan’s index benchmark!

We then produce a cost-optimized cash flow matching portfolio (Liability Beta Portfolio™ or LBP) that will maximize the SFA assets by securing the promised benefits at the lowest cost to the plan through our model. Importantly, bond math drives the cost optimization model. The longer the maturity and the higher the yield… the lower the cost to fund liability cash flows. The longest maturity in the LBP will not exceed the longest benefit payment that is to be cash flow matched. 

Based on the CLI data, Ryan ALM will build an LBP portfolio by overweighting longer maturity, higher-yielding investment-grade bonds (skewed to A/BBB+) within the area funded and in compliance with the client’s investment policy constraints. For instance, if the SFA can secure 8-years of benefits based on the output from the CLI, the longest maturity in our portfolio will be 8-years. The LBP will be carefully crafted to match the liability cash flow needs chronologically as far out as the SFA allocation will support. The portfolio will be 100% corporate investment-grade bonds with a heavy emphasis on A/BBB+ rated bonds to optimize cost savings (higher yields produce > cost savings). It should be noted that the corporate bond investment-grade universe is heavily skewed to A/BBB which provides our LBP with a great selection of securities.

Once the LBP has been constructed, the plan’s assets and liabilities will move in lockstep. It does not matter the direction of interest rates as the cash flows are matching future values which are not interest-rate sensitive. This is a significant advantage of using a cash flow matching approach instead of a total return-oriented bond product.

Why one shouldn’t use a total return-oriented bond program:

Bonds are interest-rate sensitive. The longer the maturity the greater the interest rate risk. Bond prices fall when interest rates rise. After a 39-year bull market for bonds and historically low-interest rates, it is highly likely that interest rates will continue to rise from current levels especially given current inflation trends and Fed monetary policy. If the SFA assets are managed against a generic bond index and rates continue to rise, there is a serious mismatch of asset cash flows versus the liability cash flows as well as negative returns on the bond holdings. As a result, it is likely that some of the portfolio’s holdings will have to be liquidated each month to meet cash flow needs causing losses on the bonds and subjecting the portfolio to liquidity risk. The most popular bond index benchmark (Aggregate) is heavily skewed to very low-yielding Treasury/Agency/AAA bonds with a high percentage in long-maturity bonds. As a result, using bonds for a total return focus certainly doesn’t fund and secure benefit payments in a cost-efficient manner.

Proper Fixed Income Strategy To conform to SFA requirements, adopt a cash flow matching approach for the grant proceeds which will secure the promised benefits chronologically in a cost-efficient manner. Avoid adopting a total return focus of bonds managed to a generic bond index which will mismatch asset cash flows versus liability cash flows. Avoid taking losses for immediate liquidity needs. Using bonds as required under SFA can eliminate the need for a bond allocation in the legacy assets that can now grow unencumbered to meet liabilities past the horizon that the SFA funds. This should enhance the ROA and the funded status which could reduce contribution costs.

Given the wrong index objective… you will get the wrong risk/reward!

He Said What?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Ryan ALM is a (THE) leading voice within the US Pension community regarding the need to protect and preserve defined benefit (DB) pension plans through de-risking strategies. We've been imploring plan sponsors to adjust their focus away from the return on asset (ROA) assumption as the primary goal to one where SECURING the promised benefits at a reasonable cost and with prudent risk. Our fear continues to be associated with the asset allocation roller-coaster that pension systems ride. We are currently on the downward slope of another trip and for how long and how far is anyone's guess. At what level of funding will the plan be at when the cart begins its journey back up?

Institutional Investor is out with a recent article highlighting the fact that Q1'22 produced the largest $ amount of pension risk transfer (PRT) activity ever at $5.5 billion and those involved in the conversation expected that robust trend to continue and perhaps accelerate given what is transpiring in our capital markets. They were focused on the asset side of the equation coming under pressure from a number of influences such as inflation, rising US interest rates, the war in Ukraine, etc. There was very little discussion focused on the fact that funded ratios improved during the quarter as a result of higher US rates impacting the discounting of pension liabilities to a greater extent than markets impacted asset levels.

What grabbed my attention the most, however, had to do with the points that were made by Serge Agres, Managing Director, Cambridge Associates. Serge to his credit said that "plan terminations are expensive." He believes that plan sponsors may be "overpaying for a minuscule amount of risk protection". Importantly, Agres believes that the best option for plan sponsors is to manage risk through asset allocation. We at Ryan ALM have been saying for years that a carefully constructed cash flow matching strategy can dramatically reduce the cost of securing future benefits and expenses. In fact, we believe that we can save the plan sponsor roughly 20-25% of the cost that would be associated with a PRT or lift-out. Of note is the recent Milliman study showing that corporate pensions are now so well funded that they have turned pension expenses into pension income for the first time since the 1990s. If the main reason for a pension risk transfer (PRT) was the cost hit to an income statement, then this "problem" may have now become a positive effect on income statements.

Agres further stated that "a good liability hedging strategy...can reduce a lot of your risk from things like equity markets or interest rates." Hear, hear! We couldn't agree more! As we've stated, bi-furcate the plan's assets into liquidity (beta) and growth (alpha) buckets. The liquidity bucket will consist of bonds, whose cash flows of principal, interest, and re-invested interest will match and fund the plan's liability cash flows chronologically from the next payment as far out as the allocation will go. The alpha bucket is everything else that is found in your fund. The alpha assets now have time to grow unencumbered. The splitting of assets into these two buckets will mitigate interest rate risk as future benefit payments are not interest-rate sensitive. Liquidity is certainly improved, as all the payments are met by the beta bucket.

We applaud Agres for thinking outside the box when it comes to pension management. Again, these plans need to be protected and preserved. Shifting the pension liabilities to an insurance company doesn't accomplish that objective and it is expensive. We recommend that you maintain your plan. The rising US interest rates may just provide the corporate plan sponsor with pension earnings, as opposed to pension expenses. Lastly, keeping a DB pension plan alive may just be a way to minimize the impact of the "Great Resignation".

It is only 1/2 the Story!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There appears in today's WSJ an article titled, "Pensions' Bad Year Poised to Get Worse". The writer of the article, Heather Gillers, references data from the Wilshire Trust Universe Comparison Service (TUCS). As she describes, the first quarter of 2022 for public pension systems was the most challenging from a return standpoint since before the pandemic with the median fund producing a -4.1% return. Performance has obviously continued to deteriorate since the end of the quarter with both bonds and stocks recording double-digit declines. But is that the full story?

Yes, the asset side of the pension equation has performed poorly recently. However, pension plan liability growth has been even more negative. You’ll find that public pension funding has actually improved when one uses a discount rate that is more responsive to changes in the interest rate environment, such as FASB’s ASC 715 rates (AA corporate yield curve) rather than the return on asset assumption (ROA) used under GASB accounting. The appropriateness of the discount rate is a major issue with public pensions. Given GASB accounting rules, public pension liabilities have been habitually understated since US interest rates fell below the ROA target (@ 1988). As a result, the true cost of offering these pension promises has been masked as US interest rates fell to historically low levels.

Now, the relationship of assets vs. liabilities (funded status) may be entering a more favorable environment despite the lower asset values witnessed so far in 2022. The duration of a public pension’s liabilities is likely 12-15 years. A 1% move up in rates creates a significant negative return for pension liabilities, which are bond-like in nature. Assets don't need to achieve the ROA in such an environment. A -4.1% asset return may look just fine compared to a reduction in the economic present value of plan liabilities that decline by 10% or more.

With all due respect to Heather and all the reporters covering Pension America, there should be no reporting of pension asset performance without the context of how the liability side is performing, too. As a reminder, we believe that the primary objective in managing a pension plan should be to secure the promised benefits at both reasonable cost and with prudent risk. The pension objective is not achieving a specified return (ROA). With this understanding comes the ability to make more informed decisions regarding asset allocation, asset management, and performance measurement.

More Thoughts on the Benefits of Rising Rates on Pensions

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

You may recall that I wrote on May 3rd that rising US interest rates might just be the antidote needed to slow the demise of DB pension plans, as rising rates make the present value (PV) of those future benefit payments cheaper. Happy to report that Bloomberg's John Authers has written on this subject in his daily blog (which is always excellent). Importantly, John wrote, "If pension managers can match their liabilities with yields at their present level, they have a huge incentive to buy bonds. Yes, yields might rise still further, but the opportunity to be able to finance their pension guarantees with certainty may not come again." All hail, John!

A rising US interest rate environment will create significant headwinds for a traditional fixed-income portfolio. Instead, have the wind at your back by using bond cash flows to match pension liability cash flows and you have SECURED the promises chronologically for as far out as the allocation will permit. Why live with great uncertainty regarding the plan's funded status? Bi-furcate your plan's asset allocation. First, establish a cash flow matching strategy by replacing your current core and core-plus fixed income allocation to help stabilize your funded ratio. Second, let the remainder of your assets now occupy an alpha bucket used to enhance the funded status. Furthermore, given what has transpired in the markets to date, you are buying time for the alpha assets to grow unencumbered without being a source of liquidity that would lock in recent losses.

Now is not the time to just sit on the sidelines...be responsive!

ARPA Update Through May 6th

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

We are pleased to see an acceleration in the approval process for ARPA/SFA applications. As of Friday, May 6, 2022, 23 applications have now been approved by the PBGC. These 23 funds are expected to receive $6.5 billion in Special Financial Assistance (SFA) grants which will be used to partially secure the promised benefits for 123,486 plan participants, while importantly restoring benefits that had been reduced through MPRA. This is a monumental accomplishment that is still only in the second inning of the legislation's implementation.

To date, 10 funds have received the SFA payments. My question: What have the plan sponsors done with the proceeds? According to the PBGC's interim rules, only investment-grade fixed-income securities can be used in the segregated SFA bucket. We know that a rising interest rate environment is hurting total return-seeking fixed income portfolios and the US Federal Reserve has indicated that they are not yet done addressing inflation which likely means further interest rate increases. Those plans receiving recent payments from the PBGC will not have been hurt as much as those plans that were "fortunate" to be paid earlier in the year. Have any of these plans done as we suggested and defeased their liability cash flows with bond cash flows? As a reminder, this is the only way to SECURE the promised benefits for as long as the SFA allocation lasts. Are they sitting in cash hoping that the PBGC produces less constrained investment guidelines?

At Ryan ALM, we believe that the intent of the legislation was to secure the promised benefits chronologically as far out as the allocation could go. It won't come close to the 30-years (2051) that the legislation had hoped to achieve, but it is still found money that should be used to "guarantee" that monthly benefits will be paid as promised as far into the future as possible. Both equity and fixed income markets have declined significantly to begin 2022. Some in the industry are suggesting that it might make sense to expand the list of permissible investments to take advantage of lower valuations. But is their crystal ball any better than my very foggy one? Do they truly know how low these markets can go? We've seen nearly 50% equity declines twice in the last two decades. Is a decline of that magnitude possible? I hope not, but I have no way of knowing where equity (and bond) valuations will eventually settle.

As a result, don't play the total return game. Don't try to time these markets. Implement a strategy that truly secures those promised benefits as far out as possible. Buying time for the legacy assets to recoup current losses is critical. Using the SFA bucket for all of the plan's liquidity needs is the intent of the ARPA legislation. We urge SFA recipients to use these grants in a way that maximizes the value of investment grade bonds. By establishing a defeased bond portfolio assets and liabilities become matched. A cash flow matching strategy mitigates interest rate risk as the defeased portfolio is matching future values (benefits) that are not interest-rate sensitive. Given the higher interest rates there is a very good chance that the SFA allocation can secure 10 or more years!

Here are the ten funds that have received the SFA payout.

Local 138 Pension Trust Fund

Idaho Signatory Employers-Laborers Pension Plan

Bricklayers and Allied Craftworkers Local 5 New York Retirement Fund Pension Plan Road Carriers

Local 707 Pension Plan

Local 408 International Brotherhood of Teamsters, Chauffeurs, Warehousemen and Helpers of America Pension Plan

Milk Industry Office Employees Pension Trust Fund

Local 584 Pension Trust Fund

Teamsters Local 641 Pension Plan

Laborers' Pension Plan Local Union No. 186

San Francisco Lithographers Pension Plan

I'm interested to learn what they've done with the SFA assets. Please share the details with me if you know. Thanks!

How to Properly Invest the SFA

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There seems to be a school of thought evolving within SFA eligible multiemployer plans on how to invest the grant's proceeds. We are hearing that plan sponsors and their advisors will invest the SFA assets in investment-grade fixed-income as instructed by the PBGC's Interim, Final Rules. However, we are led to believe that they are investing with the goal of generating a total return and not for the bonds' cash flows which can be used to secure the promised benefits. Their goal is to pay benefits as quickly as possible from this segregated bucket given the low return expectation from fixed income while hoping that the legacy assets generate outsized returns to compensate for the SFA bucket's lower expected returns. This is the wrong approach, especially given that we are living in a likely persistently rising rate environment in which interest rate risk is the single greatest driver of negative returns. Plan sponsors should be trying to manage these assets within the spirit of the legislation.

Here is our roadmap on how we believe that these critically important assets should be invested.

ARPA’s goal/objective:

To fund and secure the promised benefits chronologically.

Section 9704 of ARPA provides Special Financial Assistance (SFA) to pension plans who are in critical funding status as follows:

“The amount of financial assistance… shall be such amount required for the plan

to pay all benefits due during the period beginning on the date of payment of the

special financial assistance payment under this section and ending on the last day

of the plan year ending in 2051, with no reduction in a participant’s or beneficiary’s

accrued benefit…”.

Note: Based on how the SFA is calculated, plans will not come close to securing 30-years of benefits, but they should strive to defease and secure as many years as possible.

What we know:

• The SFA assets must be segregated from the fund’s legacy assets
• Based on the Interim, Final Rules, only Investment-grade bonds can be used for investment purposes

Funding and Securing the promised benefits:

The only way to secure the promised benefits for as long as possible is to use a cash flow matching strategy (CDI) that matches and funds liability cash flows with asset cash flows (income, principal, and re-invested income) chronologically.

The process:

Ryan ALM, Inc using the actuarial output from the SFA candidate's actuarial firm we will create a Custom Liability Index (CLI) that becomes the plan’s roadmap for their pension liabilities… the portfolio’s index benchmark!

We then produce a cost-optimized cash flow matching portfolio (Liability Beta Portfolio™ or LBP) that will maximize the SFA assets while securing the promised benefits at the lowest cost to the plan.

Note: Importantly, bond math drives the cost optimization model. The longer the maturity and the higher the yield… the lower the cost. The longest maturity in the LBP will not exceed the longest benefit payment that is cash flow matched.  

Based on the CLI data, Ryan ALM will build an LBP or CDI portfolio by overweighting longer maturity, higher yielding investment-grade bonds (skewed to A/BBB+) within the constraints of the cash flow limitations. For instance, if the SFA can secure 8-years of benefits based on the output from the CLI, the longest maturity in our portfolio will be 8-years. If we can go out 11-years, then we cap the longest maturity bond at 11 years.

The LBP will be carefully crafted to match the fund’s cash flow needs chronologically from the next benefit payments as far out as the SFA allocation will support. The portfolio will be 100% corporate investment-grade bonds with a heavy emphasis on A/BBB+ rated bonds (higher yields produce cost savings).

Once the LBP has been constructed, the plan’s assets and liabilities will move in lockstep. It does not matter the direction of interest rates as the cash flows are matching future values which are not interest-rate sensitive. This is the significant advantage of using a CDI approach instead of a total return-oriented bond product.

Why one shouldn’t use a total return-oriented bond program:

Bonds are interest-rate sensitive. The longer the maturity the greater the interest rate risk. Bond prices fall when interest rates rise. After a 39-year bull market for bonds and historically low-interest rates, it is highly likely that US interest rates rise from current levels especially given current inflation trends and Fed monetary policy. If the SFA assets are managed against a generic bond index and rates continue to rise, there is a serious mismatch of asset cash flows versus the liability cash flows. It is likely that some of the portfolio’s holdings will have to be liquidated each month to meet cash flow needs causing losses on the bonds and subjecting the portfolio to liquidity risk. Moreover, the popular bond index benchmarks (i.e. the Aggregate) are heavily skewed to low-yielding Treasury/Agency/AAA bonds with a high percentage in long maturity bonds. A total return focus certainly doesn’t fund and secure benefit payments in a cost-efficient manner.

Proper Fixed Income Strategy

Adopt a CDI approach that will secure the promised benefits chronologically in a cost-efficient manner. Avoid a total return focus of bonds managed to a generic bond index which will mismatch asset cash flows versus liability cash flows. Avoid taking losses for immediate liquidity needs. Using bonds here for SFA can eliminate the need for a bond allocation in the legacy assets that can now grow unencumbered to meet liabilities past the horizon that the SFA funds.

Could Rising Rates be THE Antidote?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

As everyone knows, corporate defined benefit (DB) plans have been disappearing like the dinosaur. However, rising US interest rates following a 39-year bond bull market might just prove to be the antidote needed to stem this tide. Milliman's 2022 Pension Funding Study is out, and as usual, it provides a great overview of the top 100 corporate plans (ranked by plan assets). Corporate funding has improved dramatically in the last several years as investment returns have eclipsed the average plan's return on asset (ROA) assumptions by a substantial sum. At year-end 2021, corporate pension funding stood at 96.3% compared to 88.1% at year-end 2020. According to the study, only 1 of the 100 plans in this study failed to see improvement in their funded status.

Furthermore, expenses associated with offering a DB plan have fallen substantially. In fact, the aggregate improvement in funding created $18.1 billion in pension earnings (credit) in 2021. There were 53 plans in this study that reported pension earnings in 2021. Importantly, this is the first time that we have had pension earnings since 2001. In addition, and despite the increase in PBGC premiums, total PBGC expenditures fell during fiscal 2021, too. These developments are potentially watershed events.

Despite the struggles year-to-date for both the bond and equity markets, corporate funding has likely continued to improve as the present value impact on plan liabilities from rising US interest rates will have been greater than the losses incurred on the asset side of the pension ledger. Could funded ratios eclipse 100%? If the Federal Reserve is true to its word and given its hyper-focus on inflation, US interest rates could see substantial increases. If such an action occurs, it would not be surprising to once again see aggregate funding achieve fully-funded status. Would this success encourage Corporate America to reduce actions designed to eliminate pensions, such as Pension Risk Transfers (PRT)? We could only hope. Furthermore, the "Great Resignation" that we've been witnessing may be tempered with the ongoing support of DB pension systems.

It is also critically important to understand that pension risk transfers are not a panacea. According to Milliman, "PRTs in the form of buyout programs are deemed by plan sponsors to be an effective way to reduce a pension plan’s balance sheet footprint, but generally they have an adverse effect on the plan’s funded status (my emphasis), as assets paid to transfer accrued pension liabilities are higher than the corresponding actuarial liabilities that are extinguished from plans. Much of this incongruity stems from Financial Accounting Standards Board (FASB) pension plan valuation rules, which differ from an insurance company’s underwriting assessment of the same liabilities." Moreover, we are now witnessing a positive impact on the income statement thru pension income for the first time since the 1990s.

With lower costs, improved funded status, and a need to keep staff during these volatile and challenging times, is it too much to hope that a new day may be dawning for traditional DB pension plans? There are wonderful investment strategies that can be used to lock in the improved funding and secure the promised benefits. We believe that a cash flow matching strategy can secure benefits at a much lower cost than a PRT. We also believe that cash flow matching is the only LDI/ALM strategy that also ensures the necessary liquidity to meet the promised benefits and corresponding expenses. We'd welcome the opportunity to provide assistance to any plan looking for ways to keep its pension plan thriving. Lastly, asking untrained employees to fund, manage, and then disburse a "retirement" benefit through a defined contribution plan is not a good policy. These supplemental plans may also create an unintended consequence given the portability. Let's go back to the future!

ARPA Update Through April 29, 2022

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

A massive Blue Fin Tuna was caught off the coast of Florida a couple of days ago. The 832-pound tuna may prove to be a Florida state record, but it doesn't compare to the whale of a pension plan that has filed for Special Financial Assistance (SFA) with the PBGC. The Central States, Southeast & Southwest Areas Pension Plan filed the application on April 28th seeking more than $35.1 billion in SFA grant assets to secure the promised benefits for 364,908 plan participants. This plan, if the application is approved, will claim about 35%-38% of the total estimated cost of the ARPA rescue plan assets. The Central States is the first Priority Group 3 plan to file since becoming eligible on April 1st.

In other news, members of the PBGC were quite busy last week approving applications for SFA grants for an additional 7 funds, including three Priority Group 2 applications. The new approvals will help cover the promised benefits for 99,588 participants, as they are expected to receive roughly $3.7 billion in grants. Since last July, 20 plans have had the SFA applications approved covering >117,000 participants with $6.08 billion in grants.

Despite the positive momentum now being witnessed, multiemployer plans (and their advisors) are still waiting for the PBGC's Final, Final Rules as to how the SFA and legacy assets should be managed. As we've discussed, those plans that have already received their assets may have been hurt in this rising rate environment. However, those plans that have yet to receive the approved assets are lucky, as they will now have an opportunity to use the SFA grant assets to defease their plan's liabilities at higher interest rates, which reduces the economic present value of that future liability payment.

Another Wasted Opportunity?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I published a year-end post (actually December 27, 2021). Here was the concluding paragraph:

So, in conclusion, 2021 was a terrific year for pensions. Now what? Given the improved funding and general expectations for more challenging environments for both equity and bond markets, plan sponsors should seriously consider reducing risk. It would be a travesty to waste all this good news by letting asset allocations remain static and subject to the whims of the markets. Use this unique time to reconfigure your fixed-income exposure to better manage assets versus plan liabilities. This reconfiguration will dramatically improve the plan’s liquidity while eliminating interest rate risk for the portion of the portfolio that will now focus on defeasing liabilities. This action will also buy time for the plan’s alpha assets (non-fixed income) to grow unencumbered, as they are no longer a source of liquidity to meet benefits and expenses. Furthermore, the buying of extra time allows markets to recover should we witness another major market correction. As we conclude 2021 we celebrate the great success enjoyed by Pension America. But, now is not the time to sit on one’s laurels.

Markets are down across the board, the US Federal Reserve is threatening to aggressively pursue a higher rate strategy to thwart inflation, the war in Ukraine continues unabated, and yet little has been done by Pension America to take some risk off the table. What will it take to finally get away from the pursuit of the ROA and focus on securing the promised benefits? There are consequences to maintaining the status quo. Please refer to my February 24, 2022 blog post for a reminder. Such an unnecessary waste!

It Hasn't been Ideal, But...

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

The start to 2022 hasn't been great unless you are a long-suffering Mets Fan - great 5-run rally in the 9th to win last night. But I digress. It has been a very challenging environment for our capital markets, which usually means that Pension America is suffering, too. But is that the case this time? The best (most ideal) environment for Pensions is one in which interest rates are rising (liabilities down) and asset levels are flat to up. We haven't experienced that scenario in quite some time, as we've lived through a protracted fall in US interest rates that has harmed pension funding for decades.

Corporate pension sponsors appreciate this fact as FASB mandates a liability discount rate that is market-price based, unlike GASB's accounting standard that permits public pension systems to utilize the return on asset (ROA) assumption for the discounting of their pension liabilities. This masking of the true level of pension liabilities has been harmful in that decisions related to benefits, contributions, and asset allocation have been made with less than accurate economic information.

Fortunately, in 2022 the US interest rate rise has had a greater impact on a plan's liabilities than the markets have had on plan assets given the longer average duration of pension liabilities. As we reported in the Ryan ALM Q1'22 Newsletter, plan assets outperformed plan liabilities by roughly 7.2% when using FAS AA Corporate discount rates. We'd already been encouraging plan sponsors to take some risks off the table to preserve the funding gains that had been achieved in 2021 given very strong (unsustainable) market returns. With the continuing improvement in the average plan's funded status through March 31, 2022, it becomes even more imperative that these gains be preserved.

One easy way to achieve this outcome is to migrate longer maturity fixed income portfolios from a return-seeking mandate to one that cash flow matches pension liabilities chronologically from the next month as far out as the current allocation will permit. This ensures that the fixed income assets will have a shorter duration than the plan's duration of the liabilities, which is generally somewhere from 10-15 years depending on the maturity of the plan's workforce. Importantly, a cash flow matching portfolio will ensure that assets and liabilities will move in lockstep with each other stabilizing the funded status for that segment of the portfolio.

If rates continue to rise in a secular trend for many months, long-maturity bonds and pension liabilities will go down in present value significantly. Most total return-focused bond portfolios look like their index benchmark with a sizable amount in maturities longer than 10 years. Cash flow matching is skewed to a much shorter maturity/duration profile which will be much less interest rate sensitive thereby outperforming not only current bond index benchmarks but liabilities as well. We've seen the impact of falling rates and falling asset values ('00-'02 and '07-'09) on pension funding. That combination can be devastating. Fortunately, 2022 hasn't produced such a combination. Our current scenario of higher rates could be the solution to funding liabilities at lower costs and enhancing the funding status if we transfer from a total return focus on bonds to a cash flow match focus of liabilities chronologically.

Do you know how your plan's liabilities have performed? If not, call us. We will be happy to provide you with the appropriate insights through our Custom Liability Index (CLI).