Buying the Dip?

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

Buying the dip is always a challenging objective. Given the current inflationary environment and the goal of the Federal Reserve to conquer inflation, buying this dip may be premature.

A huge negative inflation premium persists

As the graph above depicts, the spread between the US 10-year Treasury bond yield and the consumer price index (CPI) has been significantly positive (i.e. inflation premium) throughout history with a few exceptions. As of April 30, 2022, the negative real return from owing the 10-year Treasury was the greatest in history. May's inflation # of 8.6% certainly didn't reduce this unusual relationship. Yet, recent market activity seems to suggest that the Fed's recent 75 bps increase in the Fed Fund's Rate may have already started the US economy on a slippery slope to recession. I think that is a bit premature.

Fed Governor Bowman was quoted in the WSJ yesterday stating that "since inflation is unacceptably high, it doesn’t make sense to have the nominal federal-funds rate below near-term inflation expectations”. She continued, “I am therefore committed to a policy that will bring the real federal-funds rate back into positive territory.” Can her message be any clearer? Given that the 10-year Treasury yield's real rate is -5.5% today, it seems obvious to me that the Fed is nowhere close to slowing down its forecasted rate increases, even if you assume some magical collapse in the inflationary environment to roughly 4% by year-end.

There have always been short-term rallies throughout the history of market corrections, but they often don't signal the bottom of the markets. Given the drivers of inflation and the primary objective of the Fed to curtail said inflation, buying this dip may be premature. You might have to wait until you can buy the canyon! Stagflation or recession? Neither is good for stocks and rising rates are a killer for total return-focused bond programs. Bifurcate your assets into two buckets - liquidity and growth. Use bond cash flows to meet liability cash flows… liquidity assets. This strategy will enhance your fund's liquidity while buying time for those growth assets to grow unencumbered. You won't have to guess when you've hit the bottom of a cycle.

How Do Changes in the Fed Fund's Rate Impact ARPA Legislation?

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

I've recently seen questions raised about the recent interest rate increase in the Fed Fund's Rate and the potential impact that has on the pension rescue through ARPA. I'm happy to address this issue since the discount rate chosen was a source of concern for me and others. Interest rate increases, such as we've witnessed so far in 2022, have the potential to impact both the pension plan's liabilities and assets.

First, and as it pertains to the legislation's impact, the recent increase in the Fed Fund's rate of 75 basis points will have little to no impact on the discount rate used to calculate the potential SFA. As a reminder, legislators chose to use the 3rd segment (under PPA) plus 200 bps as the discount rate in helping to determine the size of the Special Financial Assistance (SFA). The three rates under PPA reflect different maturity buckets. It was surprising that the third segment was used given that it reflects benefits that would be paid for periods greater than 20 years. Obviously, pension systems eligible for SFA payouts will be paying benefits for the next 20 years. At the very least all three segments under PPA should have been used in the discount rate calculation. In addition, this rate uses a 24-month smoothing in its calculation. So, Fed Fund Rate increases have little impact on the 3rd segment rate given these are short-term rates that are being increased. Fortunately, that works to the plan sponsor's advantage given that a higher discount rate would lessen the amount of the potential SFA allocation.

With regard to increased interest rates on assets, there are both benefits and drawbacks. First the drawbacks. US interest rates are rising as a result of decades high inflation. The Federal Reserve is aggressively pursuing a tighter monetary policy in an attempt to thwart the onerous impact of this inflation spiral. Increased interest rates are negatively impacting most asset classes that pensions invest in, especially stocks and bonds. These asset classes have experienced double-digit losses so far in 2022. This reduces the current value of the legacy assets. This result doesn't help those plans that have already filed the application and received SFA payment, but it reduces the existing asset value for SFA calculations for those plans that have yet to file which will increase the potential SFA. The impact will be very much dependent on the size of the legacy portfolio, expected return on investment, forecasted contributions, etc.

Plans that have received the SFA are currently mandated to invest those proceeds in investment-grade fixed-income only (bonds). This mandate may change based on the Final, Final Rules that we've all been waiting to get since the Interim Final Rules were shared last July. Any investment in a total return-seeking fixed income strategy will have suffered losses as a result of the rising rate environment. The size of the loss is very much dependent on the timing of the investment implementation. As mentioned previously, the Fed has promised to be diligent in its fight to moderate inflation. This suggests to me that we have not seen the end of rising US rates. Further increases in US interest rates will continue to weigh heavily on fixed income returns within the SFA bucket and those of other asset classes in the legacy asset pool.

We've been encouraging recipients of SFA payouts to cash flow match their future benefits and expenses chronologically. By matching asset cash flows of principal and income with liability cash flows (benefits and expenses) the impact of rising rates is mitigated since we are dealing with future values (cash flows) that are not interest-rate sensitive. Even the present values are not an issue as those values will rise and fall in lock-step with each other. It is unfortunate that many plans that have received SFA payouts have not initiated a cash flow matching program. The legislation specifically had as its goal to SECURE the promised benefits for 30 years. You can only secure benefits through either an insurance annuity or cash flow matching. Plans that haven't pursued a cashflow-driven investment (CDI) program are jeopardizing the security of those assets.

For plans that haven't yet received the SFA, the rising rate environment is a blessing, as the cost to secure benefits and expenses is falling rapidly across the yield curve, including short-term interest rates most affected by the Fed's action. As an example, we recently produced a cash flow matching portfolio for an SFA-eligible multiemployer plan that would have those benefits secured for the next 17 years. The yield-to-maturity (YTM) on that portfolio was a robust 5.34% and it was accomplished using a conservative universe of potential bond investments restricted to BBB+ credit ratings or better. Furthermore, this portfolio saved the client nearly $93 million in future payouts equaling about a 34% savings. Further increases in rates will continue to lower the cost of securing those benefits.

It really makes no sense given the current rate environment to engage in an active total return-focused bond program. Use the rising rate environment to secure the promised benefits as sought by the ARPA legislation. Everyone will sleep better knowing that the promised benefits have been secured for some extended timeframe!

ARPA Update as of June 17, 2022

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

Although it seems like everyone is busy at this time of year, the PBGC bucked that trend with little activity once again. During this past week, there were no SFA applications either approved or denied. Two funds received the SFA payments whose applications had been approved - Management-Labor Pension Fund Local 1730 and ILA Iron Workers Local 17 Pension Fund, which received $110.9 million to help cover the benefits for 2,378 participants. In addition to this activity, I'm pleased to report that two applications were submitted. The Southern California, Arizona, Colorado & Southern Nevada Glaziers, Architectural Metal & Glass Workers Pension Plan (this fund gets an award for the longest name of any SFA application) refiled an application that had been initially submitted to the PBGC in December 2021. This Priority Group 1 plan is seeking $422.5 million in SFA for its plan that covers the benefits for 3,606 participants.

The second plan to file was the Sheet Metal Workers Local Pension Plan out of Massillon, OH, which is a Priority Group 2 plan, seeking $27.9 million in SFA for its 1,649 participants. The PBGC has 120 days from the June 13th filing date to act on this application. Since the inception of the ARPA legislation in July 2021, 26 pension systems have received approval for their SFA applications totaling $6.7 billion in grants, and all but one of these plans have received their payments as of June 17th.

While Nero fiddled Rome burnt. While we await the Final, Final Rules from the PBGC/OMB, the capital markets are plummeting. Will this market action impact the PBGC's decisions on various aspects of the legislation? Again, I hope not as the ARPA legislation is designed to secure benefits through the SFA payments for as long as possible. The securing of benefits can only occur through either an annuity purchase or a defeasing bond strategy. The Federal Reserve's tightening action to tame inflation has negatively impacted both bonds and stocks. Given recent comments by Fed officials, it doesn't seem that they are inclined to pause their pace of increases in the Fed Fund's Rate. This action will likely continue to weigh on markets until the Fed's objective is met. What that ultimately means for the market's performance is anyone's guess.

How's Your Liquidity?

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

Many pension systems lack a formal liquidity policy. As a result, they often ask their custodians to sweep cash (residual cash among managers, dividends, interest, and distributions) from wherever they can find it. But is that the right approach to meeting monthly benefits and expenses? We'd say NO primarily for the reason that the total return of the S&P 500 benefits greatly from dividends and dividends reinvested over 10- and 20-year timeframes. In fact, one study suggests that nearly 50% of the total return of the S&P 500 is generated through the distribution of dividends and their reinvestment. Sweeping cash dividends may dramatically reduce future equity returns. But even worse than sweeping cash is having to sell equity and fixed income exposures - since you aren't selling alternatives - when your liquidity needs exceed available cash.

Do you believe that liquidity is abundant at this time with significant corrections occurring in both domestic equity and US bonds, let alone foreign securities? How likely is it that you can sell what you need without increased transaction costs? I'm not referring to commission costs, which are just the tip of the iceberg. Below the surface exist execution costs and unexecuted orders that can dramatically increase costs for the plan. Sure, plan sponsors and their advisors may use periods of dislocation such as this one to rebalance back to policy normal levels and skim a little for benefit payments, but how realistic is that when both stocks and bonds are getting smacked? Again, your alternative exposure has likely grown on a relative basis (perhaps because there is no current market value) when compared to bond and equity allocations, but are you going to be able to reduce exposure to these alternative funds that often come with 10-year lock-ups? Likely not.

Is there an alternative to this questionable activity? Sure. In an environment of rising (rapidly) US interest rates, total return core bond strategies will get crushed, as witnessed so far in 2022 as the BB Aggregate Index is down more than 11% as of yesterday's close. Regrettably, rates look as if they will continue to rise putting additional pressure on your fixed-income assets. We'd suggest converting a traditional bond mandate from one seeking a total return to one that SECURES the fund's promised benefits by matching asset cash flows (principal and income) to the plan's liability cash flows.

Not only does a cash flow matching (CDI) strategy protect the funded status for that portion of the pension plan, but liquidity is no longer an issue, as the assets and liabilities cash flows are matched to meet every payment chronologically as far out as the CDI allocation will fund. There is no more scurrying for cash or forced liquidations where the transactions may not be possible without greater cost. Furthermore, there is no longer an exposure to an asset class that won't add value as long as rates are rising (bonds). The bond allocation will now meet all of your liquidity needs. In this environment, a 10-year cash-flow matching portfolio has a yield in the high 4% area and, given how rates are moving, it wouldn't be surprising to see these portfolios with yields well into the mid 5% range soon.

So, if liquidity is an issue, we have a solution! If significantly underperforming bond portfolios are an issue, we have a solution! If you want to maximize the potential equity return from investments such as the S&P 500, we have a solution! It has been decades since we last suffered through a protracted rising rate environment. It can be quite destructive to a pension plan's assets and funded status. Protect your funded status and stabilize contribution expenses by adopting a tried and true many decades old approach - cash flow matching. Don't just ride the asset allocation rollercoaster up and down. Jump off now and try something that will truly provide numerous benefits. This strategy will help both you and the plan's participants sleep well at night.

ARPA Update as of June 10, 2022

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

Either the Summer doldrums have set in as it relates to the PBGC and ARPA activity or everyone is just waiting on the Final, Final Rules to be approved and published. There was hardly any activity last week. Only Local 557 (Freight Drivers and Helpers Pension Plan) resubmitted their application which had been withdrawn on May 24th. The new application is seeking $186.5 million in SFA proceeds up from the initial request of $185.3 million. No additional applications were filed, none were rejected, and no others were withdrawn. Ho-hum!

With regard to the Final Rules, I pray that they don't loosen the guidelines on permissible investments. Why? Just look at what is happening in the capital markets. The ARPA legislation providing the Special Financial Assistance sought to SECURE the promised benefits. That can only be accomplished through the purchase of bonds and the defeasing of liability cash flows through the cash flows (principal and interest) from the bond portfolio. An investment-grade bond portfolio attempting to generate a total return has been crushed in this environment, as US interest rates continue to rise and likely will for the foreseeable future. Why jeopardize this precious resource trying to "earn" a few more $s? Securing the benefit will ensure that assets are readily available to meet the promised benefits for years to come. Let's stop playing games with the lives of plan participants.

Vanguard Drops A Bomb

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

Vanguard is out with their annual survey results accumulated from their millions of account holders. To listen to many in our retirement industry, you'd think that everything is just hunky-dory. They often cite the total amount of retirement assets that have been accumulated, while also referencing the "average" account balance within defined contribution plans. Well, the use of these metrics is dramatically hiding the truth of what the "average" American hoping to retire is facing.

According to Vanguard's output, the median 401(k) balance is a paltry $35,000. They also indicated that 40% of the DC account holders had saved <$20,000. Sure, there is a subset of Americans that have accumulated tremendous wealth that will help them retire, but what about the significant majority of American workers who have very little to fall back on. These numbers reported by Vanguard are staggering especially when one reflects on the fact that we've had an incredible 40-year investing period driven by significantly falling interest rates and incredibly modest inflation. If American workers can't save during that period, how bad will it be for them in an environment in which inflation continues to run unabated, US interest rates rise, and stocks and other assets, including real estate, get crushed?

The demise of traditional defined benefit (DB) plans is forcing untrained individuals to fund, manage, and then disburse their own retirement benefit with little knowledge on how to accomplish that objective. Why did we think that this transition from DB to DC was going to go smoothly? DC plans were never intended to be anyone's primary retirement tool. They were developed to be supplemental to the DB plan. How has that gone? Lest we forget, these numbers from Vanguard are for individuals that actually have a 401(k) sponsored by their employer. There is a good chunk of American workers that don't have access to a retirement plan through work. We know that most Americans ONLY save through employer-sponsored programs. Add together those with modest balances and those with no plan, and you have a crisis that will produce significant long-term negative consequences.

Workers who had accumulated some retirement savings as of 2007 witnessed their 401(k) becoming a 201(k) in a relatively short period of time. Worse, you were financially crippled if you had just retired because the sequencing of returns is particularly onerous for those stuck with only a DC option. For those still in the workforce in 2007, you were forced to work many more years just to get back to even. A successful retirement shouldn't be predicated on when you retire! Trying to retire this year or next? How's your target-date fund doing? These "conservative" options are anything but that! Both bonds and equities are being hammered at present. The toll could be devastating. We need to preserve and protect DB plans. Everyone should have the opportunity to retire with dignity. Not just the top 10% of income earners.

"Higher and For Longer"

On May 25th I wrote a post regarding the prospect of "higher and for longer" and said that those four words scared the hell out of me. Well, based on the latest CPI reading of 8.6%, the prospect of higher for longer seems more likely. Markets may finally be coming to a similar conclusion as both bond and stock markets are off substantially. Why did it take so long to sink in? The FOMC meets again next week. It wouldn't shock me if they announce that September's meeting will also result in a 50 bps increase in the Fed Fund's Rate. More to come.

Are These Really the Reasons?

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

There was an article in today's WSJ that addressed the issue of transparency among hedge funds, private equity, and private debt offerings. There are a plethora of institutional entities imploring the SEC to require greater disclosure. Not surprising that this objective is being met with harsh criticism from the targeted investment firms. I'm all for more transparency and disclosures and the idea that performance is going to be hurt by enhanced reporting doesn't carry water in my opinion.

That said, I am much more interested in the following paragraph that was embedded in the article: "Many pension plans are having a hard time meeting their payout obligations to members, the result of decades of underfunding, benefit overpromises, and unrealistic demands from unions. This year’s simultaneous decline in stocks and bonds has only made matters worse. To compensate, many pension plans are increasingly putting their money into private-market investments like hedge funds, private-equity funds, and private debt funds." Do we really believe those are the primary reasons for poor pension funding where it exists? Furthermore, do we really believe that investing greater and greater sums of money into HFs, PE, and PD will be the Holy Grail to full-funding success? I certainly don't!

Sure, there have been some entities that haven't fully funded that annual required contribution, but many funds have met those obligations. Aren't benefits, as well as other plan provisions, part of a negotiation process? Since when do unions make demands on their own without a counterparty involved in the process? No, the biggest contributor to poor funding among some pension systems has to do with not having the right objective in place. Our industry is enamored with the idea that achieving a target return solves all problems. It doesn't. Given this unhealthy pursuit, it isn't surprising that plans and their advisors are allocating more money to these private alternatives. Just remember that too much money into any asset class can significantly diminish future returns.

If generating a return is not the primary objective then what is? It is the SECURING of the promise that has been made to a plan participant that guarantees a certain payout each and every month in retirement until death. Meeting that objective is the only reason why that plan exists. Given that reality, it becomes obvious why that promise needs to be secured in such a fashion as to significantly reduce funding volatility. There is no reason to blame the size of the benefit or the union's demands. Once that benefit has been agreed to the process becomes very simple as B+E=C+I, where contributions (C) and investment gains (I) and the existing corpus must be sufficient to meet the promised benefits (B) plus the expenses (E) necessary to meet those benefit payments.

With greater and greater emphasis on investments to drive success, we get potentially greater variability in a plan's funded status as markets and market returns are not linear. Pension systems need to spend more time understanding their plan's specific liabilities and then managing plan assets versus those promises and not some generic asset-based index. The roller-coaster gyrations that traditional asset allocations follow lead to significant volatility in contribution expenses. Get off that roller-coaster. Put in place a bifurcated approach to pension asset allocation that will enhance liquidity to meet the promises while buying time for all the private investments to which plans have flocked. Bonds are NOT going to be return generators in a rising interest rate environment. I have no idea how high rates will go, but I do know that their trajectory is higher - the Fed told me and everyone else. Use your plan's fixed-income cash flows to meet your plan's liability cash flows. Securing the promised benefits for the next 10-years or so buys ample time for your alpha assets (non-bonds) to achieve their expected outcomes.

Pension plans are much too important to rely solely on markets to create success. Put in place an objective to secure the promised benefits that elevates the probability of success!

ARPA Update Through June 3, 2022

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

There was modest activity last week as it relates to the ARPA pension legislation, as only one plan, Mid-Jersey Trucking Industry and Teamsters Local 701 Pension and Annuity Fund, received approval from the PBGC on their application for Special Financial Assistance. This fund will receive $142.2 million to help stabilize and secure the promised benefits for 1,623 plan participants. To date, $6.7 billion in SFA support has been approved by the PBGC and of that total, $6.45 billion has been disbursed including three more funds last week. There were no new applications submitted among Priority Group 1, 2, and 3 plans. Priority Group 4 candidates may begin filing their applications on July 1, 2022.

All attention continues to be focused on the Office of Management and Budget (OMB) which received the PBGC's Final, Final Rules about two weeks ago. We should be hearing something soon from them. Have a great week, and as always, don't hesitate to reach out to us if we can be of any assistance to you.

SFA Discount Rates - Part II

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

What do you do on a rainy day? If you are in NJ, you may just decide to read through 38 ARPA/SFA applications residing on the PBGC's website. Sounds like fun, right?

Today's blog is a follow-up to yesterday's post when we discussed the importance of the discount rate used for the SFA calculation. We specifically mentioned that smaller is better, and I wanted to get a sense of how many plans were submitting applications with discount rates lower than the 3rd segment (PPA) plus 200 bps that is embedded in the legislation. Well, it turns out to be quite a few - fortunately!

For instance, 25 Priority Group 1 applications have been filed. This group consists of plans that are already insolvent or were projected to become insolvent before 3/11/2022. Their actuaries did a fine job lowering the discount rate to reflect the poor (critical) funded status. In fact, all but 7 of the 25 had a discount rate lower than the 3rd segment plus 200 bps rate. The average discount rate for the 25 applications was only 3.94% and they ranged from 0% to 5.38%.

On the other hand, of the 12 Priority Group 2 plans, those plans that are expected to be insolvent within one year of the date the plan's application is filed or those that Implemented MPRA benefit suspensions before 3/11/2021, only 1 plan had a discount rate lower than the legislation's rate - Freight Drivers and Helpers Local Union No. 557 Pension Plan. That fund's discount rate was a very conservative 4%. There remains only 1 Priority Group 3 submission (Central States) and given their extremely poor funded status it shouldn't come as a surprise that they are using a 3% discount rate for SFA purposes.

Again, the lower the discount rate the greater the present value (PV) cost of those future benefits and expenses and the greater the gap when netting out current assets, future contributions, and investment earnings. I can't imagine that these plans and their actuaries knew this legislation was forthcoming. The fact that they used such conservative discount rates is a testament to their professionalism. I suspect that most of the plans yet to file will have discount rates at or above the 3rd segment plus 200 bps rate, but I've been surprised before. We'll keep you updated as additional applications are submitted. We are about to enter Summer in NJ where afternoon storms are not rare. I'll need something to do!