The Size of the SFA Very Dependent on the Discount Rate

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

We've had the opportunity to produce Custom Liability Indexes (CLIs) for several multiemployer plans going through the ARPA/SFA process. In all but one case, the SFA grant received or likely to be received falls far short of the goal to secure 30-years of benefits through 2051. Why? More than anything, it really comes down to the discount rate used by the multiemployer plan. The ARPA legislation allows a plan's actuary to use the lower of either ARPA's 3rd segment (PPA) plus 200 bps rate (roughly 5.5%) or the plan's current discount rate. Most plans have been using a discount rate equal to the return on asset assumption (ROA) or one quite similar (>7%). The one case where our CLI shows full 30-year coverage of pension liabilities net of forecasted contributions is for a plan that adopted a 4% discount rate given its severe funding challenges.

As a reminder, the size of the SFA is determined through multiple factors, such as the size of the current legacy assets, the discount rate used to determine the present value of the plan's future liabilities, future "earnings", and forecasted/estimated contributions. A discount rate much greater than the ARPA rate will significantly reduce the future value of the benefit payments. We've encouraged the PBGC through our outreach to use all three segments and not just the 3rd segment rate while eliminating the kicker of 200 bps. It is inconsistent and unfair to use the third segment rate (20+ years) since benefits are paid chronologically and the SFA grant may only be able to fund less than the next 20 years of benefits. Although the PBGC hasn't released its Final Final Rules (as they are still being reviewed by the OMB), it is highly unlikely that the discount rate formula will be amended given the potentially dramatic increase in the cost of the legislation currently estimated at about $95 billion.

I mentioned above that the plan using the 4% discount rate could defease net pension liabilities through 2051. How comforting would that be to plan participants? If the pension plan were to use the contributions to support the current legacy assets, the SFA assets alone would defease 15-years and 9 months of benefit payments - still very attractive! My question to our readers, would you rather use contributions to support a full defeasement through 2051, as the legislation intended, or use future contributions (which are truly unknown) to support the legacy assets with the hope that future returns on those contributions would be outsized relative to the return generated by the cash flow matching strategy (CDI)? Please remember that plans receiving SFA assets cannot increase benefit payments prior to 2051's conclusion. The higher potential return on future contributions would have to be used to beef up the number of assets to meet pension promises after 2051. If risk is best defined as the uncertainty of achieving the objective, wouldn’t it be most risk-averse to use contributions and the SFA grant to fund benefits as far out as possible through a cash flow matching strategy?

Like future contributions, future returns are not guaranteed either. A plan striving for a 7% annual return may have a two standard deviation (95% of observations) volatility in the return pattern of +/- 24% to 30%. One way to reduce some of the uncertainty would be to include only those contributions that have been fully negotiated in the net calculation of future benefit payments. If a plan has a 3- or 5-year negotiated rate for their contributions, only use those contributions in the cash flow matching strategy which would extend the life of the CDI program beyond the 15+ years. Again, how comforting it is for both sponsor and participant to know that the promised benefits have been absolutely secured for that length of time.

ARPA Update as of May 27, 2022

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

Before getting into the most recent update regarding the ARPA legislation, I'd like to express my sincere gratitude to the men and women who gave the ultimate sacrifice to defend our nation. God Bless you and your families.

Activity surrounding ARPA/SFA was fairly modest last week following several weeks of intense activity. There were no new applications filed or approved. Fortunately, there were none that were denied. However, there were two plans New York State Teamsters Conference Pension and Retirement Fund and Freight Drivers and Helpers Local Union No. 557 Pension Plan, both Priority Group 2 members, which withdrew their applications. The NYS Teamsters had filed their initial application on 1/28/22, so they were within days of getting their application acted on, while the Freight Drivers submitted their application on March 4, 2022. There have been dozens of applications withdrawn to date, but in every case, a new application was submitted. It shouldn't be long until we see new applications filed on behalf of these two plans that represent just under 36,000 plan participants.

As we reported last week, the PBGC has sent its Final, Final Rules to the OMB and it shouldn't be too much longer before we get the update that everyone has been waiting for since the Interim Final Rules were announced last July. Have a great week, and please don’t hesitate to reach out to us with any questions/comments.

"Higher and For Longer"

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

According to the US Federal Reserve's minutes from early in May, there is a chance that the Fed will have to raise US interest rates "higher and for longer" than originally anticipated. Those four words scare the heck out of me! Yet, the US equity market rallied on the news. Sure, there was no indication that the Fed was contemplating Fed Fund rate increases greater than 50bps at each of the next two meetings, but that isn't guaranteed. It also isn't guaranteed that the inputs (war, covid-19, production bottlenecks, etc.) to this inflation crisis will have been eradicated by the end of July 2022.

Perhaps equity market participants feel that interest rates having to rise higher and for longer indicates that a recession isn't in the near future. Perhaps. But, at some point in the not-to-distant-future bond yields will hit an inflection point that puts real pressure on equities. Remember, pension systems used to have substantial exposure to bonds. Regrettably, that exposure was trimmed quite significantly and consistently as yields fell below the return on asset assumption (ROA) back in 1988. This migration from fixed income to equities and alternatives certainly helped to boost the performance of those asset classes as positive cash flow drives markets higher.

What is likely to happen when holding bonds at attractive yields and with more modest variability starts to impact those fund flows into non-bond asset classes? Could we see significant selling pressure within equities? As pension systems look to de-risk their pension liabilities, they aren't going to maintain the same level of equity and alternative exposure. At what level of interest rates is that inflection point? We've benefited tremendously from a nearly 40-year bond bull market in which plummeting interest rates pushed forward the incredible gains achieved in a variety of markets - real estate, equities, bonds, alternatives, etc. Do you recall how challenging the environment was prior to 1982? It was ugly!

While we sit back and wait for the Federal Reserve to do their thing for potentially longer, US fixed-income investors with a total return focus will get spanked. We've already experienced the most challenging performance environment for bonds in the last four decades. If the Fed is true to its pronouncements, total return fixed income programs will continue to see significant losses in principal. Regrettably, the current level of rates (income) isn't substantial enough to offset much of that principal loss. Now is the time to convert traditional return-seeking strategies to cash flow matched investments that are tailored to meet your plan's liability cash flows. Importantly, by defeasing benefit payments that are future values, a cash flow matching strategy mitigates interest rate risk. In addition, should we see both equities and bonds sell off, a cash flow matching strategy buys time for the non-bond assets to recover as they are no longer a source of liquidity.

Again, I don't know about you, but the phrase "higher and for longer" scares me. Given the improved funding that was observed throughout Pension America in 2021 isn't de-risking the prudent approach as opposed to "guessing" how the Fed will act and more importantly, how the market will respond? Be responsive to today's environment.

Milliman's Q1'22 Public Fund Update

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

The Milliman organization produces an outstanding report each quarter that covers changes in the funding levels for both corporate as well as public pension systems. The Public Pension Funding Index (PPFI) report was released recently and it covers the top 100 public pension defined benefit plans through March 31, 2022. According to Milliman, the top public pension systems recorded investment losses of roughly 3.4% during those three months resulting in a funded status deterioration of $167 billion. The collective funded ratio declined from 85.5% at the end of 2021 to 82.7% on March 31, 2022.

Public pension systems operate under GASB accounting standards which allow pension liabilities to be valued using the return on asset assumption (ROA) as the discount rate to price liabilities. This discount rate is static and doesn't reflect changes in the US interest rate environment. The good news for public pension systems is that pension liabilities are like bonds. The present value of those liabilities would fall in a rising rate environment if priced on a market value (economic) basis. Yes, pension assets have struggled so far in 2022, but we believe that the average public pension system's longer duration liabilities would have struggled more. As a result, the $167 billion estimated loss in funded status may not be correct and may actually have improved on an economic basis despite the struggles in the capital markets. Ryan ALM provides a quarterly Newsletter on pension funding. You can check out our Q1'22 report at ryanalm.com/newsletter. 

ARPA Update through May 20, 2022

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

Happy to report that there was some more activity related to ARPA and the rescue of struggling multiemployer plans during the last week. As of this writing, there have been 25 ARPA SFA applications approved by the PBGC including two more last week. The newly approved applications were for the Management-Labor Pension Fund Local 1730 ILA and Iron Workers Local 17 Pension Fund which collectively covers 2,378 plan participants. The funds are seeking roughly $110 million in SFA grant money. Since the inception of the ARPA program, 13 funds have received grants totaling just under $2.4 billion.

Two more plans filed their initial SFA applications last week. There are currently 12 applications with the PBGC awaiting action. To date, none of the previous applications that have been filed were rejected. As I reported this morning, it appears that we are getting close to receiving the Final, Final Rules from the PBGC on how this legislation should be enacted. Perhaps news of that development will inspire those Priority groups, 1, 2, and 3 plans that have remained on the sidelines to finally file. More to come! Have a great week.

An Answer from the PBGC - Finally?

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

Good morning to all my friends in multiemployer pension systems that have filed or will soon file applications with the PBGC to receive Special Financial Assistance (SFA) grants under ARPA. I have just been informed that the PBGC's Final, Final Rules are with the Office of Management and Budget (OMB). This has always been an important step in the process of getting the final guidelines from the PBGC approved. Let's hope that this review process can be handled swiftly. Equally important, let's hope that these final rules don't create potential harm.

What do I mean by that? I've been very consistent in expressing my opinions that the intent of the legislation was to SECURE the promised benefits for as long as possible. The securing of benefits chronologically can only occur through a cash flow matching defeasement strategy, as bonds are the only asset that has a known terminal value (par) and a set of future income cash flows (semi-annual interest). These asset cash flows can be used to match and fund liability cash flows (benefit payments). Let's not bring uncertainty into this process by expanding the restricted investment list to include stocks, real estate, private equity, etc. These assets don't do anything to secure the promised benefits. They bring greater volatility and uncertainty, which goes against the legislation's intent.

This pension legislation is potentially helping millions of Americans gain (regain) more retirement security. It is the first real rescue of the promises made to pension participants in a long time. I am praying that the updated guidelines don't set this effort backward.

Why is Buying Time so Critical?

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

As most investors appreciate, trying to time the markets can prove to be a fool's game. We know that timing the tops, bottoms, and dips is incredibly challenging and often leads to excessive turnover coupled with transaction costs that can erode potential value-added. As a result, it is best to remain in the equity markets through thick and thin, but does that mean you do nothing? Of course not. The graph below only goes through August 2019, but it dates back to 1970 and clearly demonstrates the impact on the total return to the S&P 500 when missing just a couple of handfuls of trading days.

Do you have the strategy in place to remain patient?

First, the plan's investment policy statement (IPS) must clearly highlight a targeted allocation for equities (S&P 500 in this case) with an appropriate range above and below that target used for rebalancing purposes (+/- 5%?). The graph above highlights the impact of an all-or-nothing strategy, which pension systems would likely never engage in, but they should bring discipline to the asset allocation process by taking profits when equities have demonstrated enough outperformance relative to other asset classes to have the allocation reach the upper band. Equally important is the realization that stocks will provide value over the long term. Forcing a buy decision at the bottom of an allocation band, although it may not be easy, is the right decision in the long run.

That said, we have a tendency in our industry to seek liquidity wherever it can be found in order to meet the required monthly benefit payments and expenses. This often leads to assets having to be sold when enough liquidity cannot be found. Unfortunately, this may lead to selling equities near the bottom of their market cycle instead of buying them at that point. One way to avoid this unfortunate occurrence is to put in place an asset allocation strategy that divides the assets into liquidity (beta) and growth (alpha) buckets that each have a specific role within the portfolio.

In our model, the liquidity bucket uses investment grade fixed income to meet all of the plan's cash flow needs. Bonds are the only asset with a known semi-annual cash flow (interest payment) and terminal value at maturity (par) which is why bonds have always been used to defease liabilities (pensions, lotteries, NDTs, OPEBs, and insurance companies). This liquidity bucket will be used to meet all of your ongoing liability cash flows as long as the allocation lasts. We recommend sustaining a 10-year allocation, if possible, by back-filling (rebalancing) the bond cash flow matched portfolio on an annual basis.

Creating a liquidity bucket will permit the alpha assets to grow unencumbered. There will be no forced selling of these assets during periods of challenged liquidity. During market downturns similar to what we are currently experiencing, there will be no temptation to sell, as you've built a 10-year horizon for your equities to wade through the troubled waters. Importantly, your fund gets to reinvest the dividends back into the equity market instead of using them as a cash proxy. Studies that we've highlighted previously suggest that the S&P 500 derives a significant percentage of its total return from dividends and the reinvestment of those dividends (as much as 48% on a 10-year moving average).

Having all of your eggs (assets) in an asset allocation basket singularly focused on a return on asset (ROA) assumption, as our industry continues to do, has created volatility of returns but no guarantee of success. We believe that the primary objective in managing a DB pension plan is to secure the promised benefits in a cost-efficient manner and with prudent risk. It is not the achieving of the ROA. Split your assets into two buckets. Allow the liquidity bucket to take care of all your funding. Doing so will allow you to sleep better at night knowing that you have the participants' benefits covered and you've now bought time for your equity assets to grow unencumbered. It is a win, win!

This Result shouldn't Be Surprising

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

Everyone knows that this has been a very challenging year for traditional fixed-income programs. In fact, it has been the most challenging year in the past 40-years. As of yesterday, May 16, 2022, the Bloomberg Barclays Aggregate index is down -9.52% YTD. With US Treasury yields rising across the yield curve today, that Agg index will be off some more. It still seems like everyone uses the Aggregate index as the primary benchmark to compare Core and Core+ fixed income managers. As a reminder, my colleague, Ron Ryan, created the index back in the '80s when he was the Director of Research at Lehman Brothers.

What does the index look like today? The Aggregate is a very large and diversified portfolio of bonds with the following summary statistics as of March 31, 2022:

# of issues	9,982	Treasury	39.80%	AAA	68.92%
YTM	2.92%	Agency	4.00%	AA	2.92%
Duration	6.58 yrs.	Mtg. Backed	29.90%	A	11.16%
Avg Maturity	8.78 yrs.	Corporates	26.30%	BBB	15.38%

BB Aggregate Index as of March 31, 2022

This poor performance result has been created despite the heavy emphasis on AAA-rated securities and a fairly modest duration of only 6.58 years. As a result of the higher quality emphasis, the yield to maturity (YTM) is only 2.92%. If the US Federal Reserve is true to its recent pronouncements, there is likely much more pain ahead for both fixed income advisors and plan sponsors. In addition to the potentially large negative return, fixed income portfolios are a source to fund benefits and expenses. Because most traditional fixed income products are return-focused and not cash flow matched to the pension system's liability cash flows, bonds in these accounts will likely be sold at losses and this cost to transact may escalate in a rising rate environment where liquidity is not abundant.

Now, let's compare that scenario to a cash flow matched portfolio used to SECURE the promised benefits. Ryan ALM just constructed a cash flow matched portfolio for a multiemployer plan that is expecting to receive SFA grant assets. The size of the allocation and the current rising interest rate environment allowed us to fully defease 29-years of benefit payments with the SFA proceeds! A homerun! Furthermore, the YTM of our portfolio is 4.68%, or 176 bps greater than the yield on the Aggregate index. Although the modified duration is slightly longer at 8.84 years, our portfolio is defeasing future values (benefit payments) that are not interest-rate sensitive. The plan's liabilities and these assets will move in lockstep. That is certainly not guaranteed when using a traditional total return fixed income mandate.

Those advantages alone are incredible and certainly favor using a cash flow matching strategy to secure the promised benefits, but when you also factor in the greater liquidity (no forced selling) and the "buying" of time for the remainder of your assets to wade through choppy markets, the decision to use a cash flow matching strategy instead of a total return mandate becomes a no-brainer.

Spread Widening - It's been Significant

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

I suspect that most participants in the capital markets are aware of the implications of rising US inflation and the impact it has had on US interest rates so far in 2022. The US Federal Reserve has certainly raised awareness by twice elevating the Federal Funds Rate by a total of 75 basis points so far with a clear message that more is to come. Perhaps much more! What might be less apparent to the average investor is the impact of widening corporate credit spreads relative to Treasury securities.

My colleague and Ryan ALM's Head Trader, Steven DeVito, has put together the following chart highlighting the major widening (yield change in the right two columns) that has occurred this year:

How wide will they go?

What we have witnessed so far is a widening of AA versus comparable Treasuries, but more important is the credit spread widening of BBBs versus AA. What was a 58 bps difference has ballooned to 90 bps as of last Friday. This action can have a profound impact on total return bond programs especially if there is a need for liquidity in the portfolio. On the other hand, credit spread widening has little to no impact on existing cash flow matching portfolios as the bonds are held to maturity.

On a positive note, wider spreads reduce the cost of defeasing pension liabilities when constructing new portfolios. As we've mentioned in previous blog posts, higher US interest rates and wider corporate credit spreads are creating an environment in which the cost to defease a pension liability stream is falling and in some cases, depending on the maturity of the program, quite significantly! We've just created a Liability Beta Portfolio™ for an SFA recipient that covers 30-years (to 2051) and generates a >40% savings on the cost of those future benefit payments. Who wouldn't be pleased with that result?

Steve has promised to continue to monitor this widening situation. It will be interesting to see how high US interest rates go and just how wide the corporate spreads get. We may be able to provide benefit security for pennies on the $.

ARPA Update as of May 13, 2022

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

Following a flurry of activity during the previous three weeks, the PBGC and Special Financial Assistance (SFA) candidates took a well-deserved breather, as no new applications were either filed or approved. In addition, none of the 13 approved plans waiting to receive the SFA received those payments last week. There remain 12 applications still to be approved, including Priority Group 3 member the Central States, Southeast & Southwest Areas Pension Plan that covers nearly 365,000 plan participants. To date, nearly $6.5 billion in SFA has been approved and just over $2 billion awarded. Those sums will look quite paltry once the Central States plan gets its approval, as they have filed for a grant in excess of $35 billion.

Perhaps this will be the week that we get the Final, Final Rules from the PBGC. While we've waited for the final implementation criteria, we have seen US interest rates rise substantially. The good news: the cost to defease (and secure) the promised benefits has fallen allowing for potentially more benefits to be paid from the SFA grants and for longer. This is one of the few benefits of a rising interest rate environment.