aiCIO: Have you done the math on [what would happen] if public plans were held to PPA standards?
Wilson: Yes, we selected a highly representative public plan—75% funded using a 7.65% discount rate—and recalculated their funded ratio using different discount curves. First, we estimated the impact of the pending GASB Statement No. 68, where public plans will be required to discount their unfunded liabilities using a high-quality municipal rate. This new methodology would lower their funded ratio to about 65% because their discount rate would blend down to 6.40%. Then, we quantified the impact of discounting the liabilities using the PPA Spot Curve, and the funded ratio dropped further, to 50%, because their discount rate dropped to 4.10% at the time. Finally, we discounted their liabilities using a Treasury curve, which some are calling for, and found their funded ratio would be less than 40%.
aiCIO: Are public plans utilizing LDI?
Wilson: Under the current regulatory framework and given their economic situation, public pension plans have no real motivation to pursue LDI. Many plans are massively underfunded on an economic basis, using significantly higher discount rates than their corporate counterparts. They have three tools in the shed to improve their economic condition: contributions, investment returns, or plan reform.
Plan reform has been enacted by at least 30 states across the country, but it doesn’t have much of a near-term impact. Also, since many municipalities are budget constrained, making outsized contributions is a difficult proposition. So, large contributions will have to come from higher taxes or the issuance of pension bonds. Pension bonds are essentially a back-door way to raise taxes, so that’s very difficult.
That leaves investment returns. We’ve seen significant re-risking by some public plans in an effort to dig out of their holes. Public plans currently have about 70% of their portfolios invested in return-seeking strategies, such as equities and alternatives, and 30% in fixed income. Furthermore, given the consensus view that rates will continue to rise, we’ve seen a significant flight from core fixed income in favor of higher octane strategies such as high yield, bank loans, emerging market debt, and other “non-traditional” or “opportunistic” strategies.
On the contrary, we believe the primary role of the fixed income portfolio for public plans is to reduce portfolio volatility or immunize the liabilities. We’ve developed such strategies, which are “LDI-like” in that they seek to hedge liability payments over a defined time horizon and on a rolling basis. For example, a public plan sponsor can seek to immunize the next five years of plan payments, net of contributions, on a rolling basis with a high-quality fixed income portfolio. This strategy allows time for the return-seeking strategies to achieve their long-term expected returns and avoids the potential for a forced sale of assets to meet plan obligations, a situation we refer to as the “Black Hole Scenario”.
However, in our opinion, many public plan sponsors are increasing the risk profile of their fixed income allocation significantly, leaving themselves very overexposed to risk, with very little hedging properties left in their portfolios.
aiCIO: Going forward?
Wilson: We believe that LDI for public plans will be just as big as LDI for corporate plans—in a decade or so. Last summer, GASB issued Statement No. 68, which I believe is the first step towards a full blown PPA-like mark-to-market framework for public pension plans. GASB 68 says they can continue to discount their funded liabilities using an expected rate of return, but their unfunded liabilities need to be discounted using a high-quality municipal bond rate. If public plans, like their corporate counterparts, are “punished” for funded ratio volatility in the form of higher required contributions, LDI will emerge as an attractive solution.
Moody’s is also piling on by changing the way they evaluate the impact of the pension plan on the public sponsor’s credit rating. Essentially, they re-value the liabilities using the same discount curve as corporate plans, amortize the adjusted unfunded liability over a 20-year period, and include the new metrics in their ratings determination. Any resulting downgrades will likely increase the borrowing costs for the public entity. It is unclear if this particular development will motivate de-risking at some point in the future, but the trend towards more regulations and oversight is quite clear.
