Compliance April 13, 2021

Potential Pitfalls in Union Pension Relief Program

The relief included in the latest stimulus program is a major win for stressed union pensions, but sources say there are some challenging hurdles yet to jump.
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Signed into law in early March, the American Rescue Plan Act (ARPA) included $1.9 trillion in collective economic relief, much of it targeted to address the coronavirus pandemic.

Along with other provisions aimed at supporting the retirement planning sector, the law allowed for substantial relief payments to be targeted at stressed multiemployer pension plans sponsored by unions. Specifically, the law allows multiemployer plans that are in “critical and declining” status, as defined by prior legislation, to get a lump sum of money to make benefit payments for the next 30 years, or through 2051.

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The law says plans can use the money to make benefit payments and pay plan expenses, and, unlike the Butch Lewis Act, which served as the loose foundation for this part of the stimulus program, the payments going to stressed union pensions are not loans. They are grants with no obligation to repay.

In the view of Russell Kamp, managing director at Ryan ALM, the relief included in the stimulus program is a major win for stressed union pensions, and, more importantly, for the participants and beneficiaries in these plans. For context, Ryan ALM’s stated mission is to solve liability-driven problems faced by pensions and other institutional investors through the provision of “low-cost, low-risk solutions.” Additionally, Kamp worked on the team of government and industry professionals that drafted the Butch Lewis Act.

“This is a wonderful development,” he says. “After so many years of worry and struggle for the participants and beneficiaries at the heart of these plans, they are finally getting the security that they so desperately need. What’s really important is to see that those 18 plans that have actually filed for and received approval to reduce benefits will be made whole. That’s just fantastic to see, because we’ve seen how much pain, anxiety and financial stress that has caused.”

Kamp notes that some participants in the most stressed plans, including people who are disabled or widowed, have seen their benefits cut by more than 60%.

“That is just unacceptable, and so we should all be glad to see this step, even those of us with no pension or any direction connection to these plans,” Kamp says.

Karen Friedman, the executive director of the Pension Rights Center, agrees that multiemployer plans collectively have a reason to celebrate.

“To say that we are ecstatic is an understatement,” she says. “We have worked with grassroots activists and allied organizations for eight long years to push for a solution to the multiemployer crisis and we are now breathing a long sigh of relief that finally, finally Congress has acted to save their promised benefits. This is a historic day.”

While Kamp, Friedman and others continue to voice enthusiasm about the forthcoming relief, they also say there a few issues and ambiguities with the law that remain to be solved. Broadly speaking, the concerns fall into four camps, all of which are likely to be at least partially addressed by the Pension Benefit Guaranty Corporation (PBGC) when it issues its mandated guidance in July.

Issue No. 1 – Is the Discount Rate Too Generous?

Sources say the new law dictates that stressed multiemployer plans filing for relief must use a specific discount rate when determining their precise level of underfunding. Namely, they must use what is called the “third segment rate” as defined under the Pension Protection Act (PPA), plus an additional 200 basis points (bps).

This raises a few concerns about the accuracy of the resulting shortfall projections, according to experts. Essentially, by choosing this third-segment rate, plans are performing their calculations based on a 20-plus year liability model. Sources say this could result in underestimates of the liabilities that have been promised by these stressed plans, and, as a result, such plans could again eventually fall 20% to 30% short on their stated liability.

“We need to watch out carefully and make sure the amount of money necessary to meet the promises these plans are supposed to meet will actually be there,” Kamp says.

Issue No. 2 – Withdrawal Liability

Equally, if not more concerning, is the second source of ambiguity, which relates to the lack of clarity about withdrawal liabilities to be assessed in the case that an employer wants to exit one of the stressed plans either before, during or after its relief application.

“What we need to avoid is incentivizing bad-faith actions by employers who could potentially see this relief program as an exit ramp,” Kamp says. “If I am a business owner and I want to sell my business, but I have this pension liability holding me back, what is to stop me from saying, ‘Hey, this plan is fully funded, so I’m going to walk, and I don’t actually have any liability, because the plan is fully funded.’ There is concern that this relief could in essence dismantle the union pension system in trying to save it.”

Issue No. 3 – Assistance Calculation Time Frame

According to Kamp, the stimulus law includes overly vague language about how plans should set the time frame (and other parameters) to calculate their relief requests.

“I can tell you that actuaries are already interpreting the relief calculation language differently,” Kamp says. “Some see the calculation as basically taking the current assets, adding any future contributions, subtracting expenses, adding the return you generate on the asset base, and then using this sum to define the gap between liabilities and assets. The issues with this interpretation is basically that it is assuming that you are going to use up every single dollar and have the plan be totally exhausted 30 years from now, leaving nothing left for future liabilities beyond that date.”

Other actuaries, seeing this issue, say this calculation should go differently.

“This second group is saying that you should basically segregate out the next 30 years and do a separate projection of liabilities, and then this is the amount of relief they are going to ask for, minus the appropriate discount rate,” Kemp says.

This would free the plans to grow their existing pool of money unencumbered in order to meet the open-ended liabilities of the long-term future.

“This is where I think and hope the consensus is coming down, because I don’t think it was Congress’ intention to close the multiemployer plan system with this relief package,” Kamp says. “At this point, I’ve seen as many as five different calculation methods being discussed. That’s a big unknown that we hope will be resolved by the PBGC.”

Issue No. 4 – Segregation of Assets

Sources say it will be challenging to keep any relief payments totally separate and distinct from existing assets, in part because of the investment requirements that come along with the money. Under current law, any special financial assistance that is given to these plans has to be totally separate and distinct from other funds. ARPA, however, directly states that the dollars should be invested in investment grade bonds or other assets the PGBC deems appropriate.

“This could prove to be challenging over the long-term future,” Kamp notes. “The original Butch Lewis Act required that money received through the program should be used in one of three ways. It could be used to transact a pension risk transfer [PRT], to enact a traditional LDI [liability-driven investing] approach, or to do a cash-flow management strategy. Such recommendations or requirements could be reflected in the PGBC guidance that remains forthcoming.”

Investing April 13, 2021

What DB Plans Can Learn From Endowment Investing

Alternative investments and private assets might help defined benefit plans diversify and generate more returns.
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The endowment model for investing suggests that long-term investors with access to illiquid investment opportunities, such as higher education institutions, should have relatively high allocations to alternative assets, which can help them earn greater returns.

Like endowments, defined benefit (DB) plans are also long-term investors, though many DB plans have different liquidity needs than higher education institutions. Still, sources say, DB plans can take some cues from the endowment playbook.

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Adam Levine, investment director of Aberdeen Standard Investments’ Client Solutions Group, says DB plans are very focused on their goals. They aim to have a good funded status relative to liability and to ensure they have enough funds to pay all obligations promised. “DB plans are very much oriented to a specific outcome and what they want to achieve for the plan. They are not just focused on generating returns,” Levine says.

He adds that DB plans invest a lot in fixed income and fixed income that matches liability, and they use hedge ratios to manage changes in liabilities. Endowments tend to focus more on maximizing returns, Levine says, and they also concentrate on their spending policy and making sure assets are growing to fulfill spending obligations. He says endowments tend to be a bit more creative or bold, using non-standard strategies and alternative investments. Corporate DB plans tend to be more conservative in terms of investing in alternatives.

Dave Keil, partner of Aon’s Corporate Defined Benefit Solution Practice, says endowments and corporate DB plans have different goals, so it makes sense that they have different investment strategies. He explains that endowments have extremely long, sometimes infinite, time horizons and seek to earn a rate of return above inflation—the consumer price index (CPI) plus 4% or 5%. They might seek higher equity returns by investing in private assets.

DB plans, meanwhile, are not big users of private assets, Keil says. They have adopted interest rate hedging techniques, which usually means investing in a small or medium amount of long-duration bonds.

According to the “2020 NACUBO [National Association of College and University Business Officers]-TIAA Study of Endowments,” the average investment allocation for all institutions in the study as of June 30 was 20% in marketable alternatives, 14% in private equity (PE), 13% each in U.S. and non-U.S. equities, 12% in fixed income, 11% in real assets, 9% in private venture equity and 7% in global equities.

Levine says DB plans are so driven by fixed income that, in general, they will not perform as well as endowments during market upswings. Corporate DB plans are much more defensive, focused on managing funded status and interest rate risk for liabilities.

Keil says that 10 years ago, it was easier to make comparisons between the average endowment and the average pension plan. But now, pension plans have adopted different investment strategies, and frozen plans use different tactics than ongoing plans, so it’s harder to correlate the two since DB plans are not as homogenous as they used to be. Since the biggest driver of returns is interest rates for DB plans—because of liability-hedging strategies—DB plans likely outperformed endowments last year, he says.

“Over time, I would expect endowments to start to outperform pensions,” Keil says, “because the average pension plan should get more conservative over time. The average DB plan should be on a path to taking less risk to become fully funded, to either maintain low risk or to move obligations to an insurance company.”

Chris Moore, chief investment officer (CIO) for not-for-profit at Mercer, which includes endowments and foundations and not-for-profit health care entities, says at a broad level, the performance of endowments and DB plans is consistent with the biases of the different types of capital. Endowments have more diversification, but that also means they have a higher risk profile.

In the past year, DB plans performed similarly to endowments because long-duration fixed income did so well in 2020, he says. It performed as well as some equity allocations. But the risk of inflation is higher going forward, so investing in alternatives will be more of a benefit, he notes.

Levine says he’s seen a trend of DB plans investing more in alternatives, which will help with diversification. “The traditional 60/40 portfolio,” which is a portfolio that’s 60% in equities and 40% in bonds, “is exposed to downturns,” he says. “Endowments, in general, have been more spread out across return drivers.”

The Endowment Index calculated by Nasdaq OMX increased 4.43% (on a total return basis) for the quarter ended March 31, compared with a gain of 1.02% for the same period for a global 60/40 index.

Keil adds that endowments tend to use a host of alternative investments, including hedge funds and insurance-linked securities, and some DB plans take advantage of those asset classes as well. “Two reasons to use alternatives are to lower risk through better correlation and to improve returns through a higher return stream than regular markets,” he says. “For example, a DB plan might invest in core conservative real estate as a diversifier to bring volatility down, or it might add private equity investments that would bring in a higher rate of return.

“With what’s been happening with interest rates, the performance of long bonds has driven pension performance up,” Keil continues. “To the extent that turns around, DB plans can use different strategies.”

Keil also says private assets could help DB plans. “There is a subset of DB plans where incorporating private assets makes a lot of sense: plans that are ongoing or for which the funded status has long way to go.”

Keil says this came into additional focus recently with the passage of new funding relief in the American Rescue Plan Act (ARPA). “Corporate DB plans can now amortize their unfunded shortfalls over 15 years rather than seven,” he explains. “For a DB plan taking advantage of the funding relief, it makes sense to invest in private assets.”

Moore says DB plans can learn from endowments to look outside of traditional fixed income for low-risk return drivers. Endowments consider a low-risk hedge fund strategy as a replacement for fixed income. “Today, traditional fixed income is low-yielding with a tight spread environment, so there’s no real income in fixed income,” he says.

However, Moore says, there are meaningfully different end goals for ongoing versus closed DB plans, so their portfolio strategies should be different. “For closed plans, the investment horizon is to match liabilities, so low-risk hedge funds are not a good fit. This investment horizon typically means they should buy more fixed income,” he explains.

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