Cities are broke. Pension plan promises are in the courtroom. Insurance companies are flying blind, unable to earn a yield. Liabilities have entered a boom market; inevitable, now that the interest rate cycle has turned. The liabilities (contractual promises) of cities, pension plans, insurance companies, and many other entities will be discounted, rediscounted, and discounted again.
This is a moment of great opportunity. Investment management has prospered through the expansion of financial assets over the past generation. Total debt in 1970 was $800 billion. Total world debt today is incalculable.
Investment management is consumed with earnings per share. Corporate finance concentrates on the income statement. Balance sheet analysis has atrophied. Yet, balance sheet commitments need to be managed, particularly when liabilities and leverage are growing in proportion to assets.
Similarly, financial firms are not organized for 2015. A quick historical detour explains why: Interest rates rose from 1946 to 1981. The final decade of this period was notable for its anomalies, only one of which was the evaporation of Wall Street. There were also precursors, little noted at the time, such as Drexel Burnham Lambert building the junk bond market in the late 1970s. Noteworthy is DBL’s “outsider” status. In the 1980s, establishment Wall Street firms played catch up to the much smaller DBL.
Today, investment firms are built for growth. That’s been the story, in the post-1981 period, when long-term U.S Treasury yields fell from above 15.78% to 1.40%. The most significant fact accompanying this period is financial and balance sheet expansion: with very few interruptions. Leverage grew, appetite for junk bonds blossomed, financial analysis loosened (EBIT was expanded to EBITDA), and risk management was homogenized (VaR, which evaporates when correlations converge, has now been imposed by federal regulators on banks). Access to funding has suffered only occasional depletion. Every such instance of famine has ended after central banks slashed interest rates. The rate that central banks control is now zero percent.
It is astounding, in 2015, after a generation of wind-to-their-backs, that so many of the institutions entrusted to meet long-term financial commitments are grasping for means to meet their obligations. Even if interest rates remain in the zero-range (improbable), liabilities have already swamped the parties’ assets. Pension plans, public finance, insurance companies (both life and P&C), universities, professional sports, and finance itself (a huge employer) are all in trouble. Most of us know this. The cashiers at Home Depot know it. But those in charge timidly look ahead, some in fear, some because their knowledge – including the advice they receive – is compartmental.
Comprehensive management demands the integration of assets and liabilities. One cannot get the right answers when the wrong questions are addressed. This is why a “bottom up” understanding of liabilities is needed. We will look at the management of defined benefit (DB) pension plans and municipal finance.
DEFINED BENEFIT PENSION PLANS.
There are three types of DB pension plans: corporate, public and Taft-Hartley (unions). There are differences. Only corporate plans will be addressed here so as to reduce the moving parts.
Long-term strategic planning is handicapped since pension asset values and liability levels are unpredictable. The difference between the two is calculated each year. Changes from the previous year alter earnings per share and the required plan contributions. Underfunded plans make additional contributions.
The coordination of pension plan management to corporate strategic planning should start with the most basic question: “What does the plan promise?” Yet, analysis is usually top-down.
Here is an example of how surprises may lurk without bottom-up analysis: A plan sponsor wanted to terminate its pension plan. An insurance company was willing to annuitize the benefits for $5 million. Before offering the quote, it hired a firm to analyze the plan in depth. This plan offered a “rule of 85” option: A plan participant with a combination of age (e.g., 60 years old) and service (e.g., 25 years on the job) that equaled 85 was fully vested. The worker could immediately start collecting full benefits. The insurance company changed its cost of annuitization to $10 million.
Pension plans (corporate, municipal/state, and union) receive advice on how to structure assets, particularly their fixed-income assets, to achieve specified objectives. But consultants usually do not integrate asset management advice to the specific design of the liability. Plan liabilities can be restructured (reduce lump sum options, change the benefit formula from final-salary to average-salary, split into dual plans, and many other possibilities to the particular promise and plan population). This is an iterative process. Restructuring liabilities then opens windows to supplemental asset strategies.
Integration of asset-liability management (“surplus management”) requires an understanding of pension plan design, actuarial calculations, accounting conventions, and regulation. Enrolled Actuaries calculate the liability and its relation to assets (the “surplus”). This is the source of news stories that “state pension plans are underfunded by $100 billion,” or whatever it happens to be.
Enrolled Actuaries are not hired to solve problems of underfunded plans. (They recommend levels of contributions. These were ignored by the headline pension plans.) Very few investment consultants to pension plans address the “bottom up” characteristics. Restructuring liabilities can be accomplished by looking between these two disciplines to address what the plan sponsor needs.
Actuarial conventions, for instance, are applied universally in all actuarial valuations. They calculate the surplus or deficit of plan assets in comparison to liabilities with company accounting statements in mind. CEOs and CFOs often state the pension is their biggest worry. Their adviser should analyze the liability to produce an economic solution (rather than an accounting figure).
The adviser must understand that parties place different values on liabilities: portfolio managers, security analysts, credit analysts, private equity firms, law firms, investment bankers (M&A), banks that lend to the entity, municipal lenders and bondholders, and distressed debt investors. Each has a particular interest. There is very little analysis addressed to these parties. Most do not know of the volatility within pension plans, which they already consider volatile. The “rule of 85” example above might be likened to an imbedded option that went unnoticed.
One final note: corporate pension plans are often manageable and not a hindrance to strategic planning. In one instance, a corporation that set itself up to go private never received an expected private equity bid. The private equity firm did not know how to analyze the pension plan. A bottom-up analysis (afterwards) revealed the plan was eminently manageable.
It is unfortunate that “pension deficits” overwhelm discussions of state, city and municipal deficits. The thinking seems to go: “If we can solve our pension problems, we’ll be OK.” Public finance problems are much deeper and not just the headline cases such as Detroit. It is notable that municipal finance is now drifting towards a more venturesome precipice than before the 2008 collapse.
Over 3,000 Florida municipalities defaulted in the 1930s. Pensions and benefits were not the reason. The problems of Florida municipalities are not that different from those today. Coral Gables was born in 1921, posted over $100 million in property sales in 1925 (over 1% of the United States’ GDP), was hit with a 125 mile-per-hour hurricane in 1926, was saddled with $29 million in creditor claims by 1929. “This speculative era also led many municipalities to institute costly internal improvement programs that were financed by bonds.” Miami’s municipal payroll rose 2,500 percent between 1921 and 1925. Quantitive-easing central banks did not yet exist.
Municipal spending has expanded for a generation, in both dollars and ambitions. Rising tax revenue and the ability to issue bonds has kept many a leaking vessel afloat. There is little reason a municipal oversight committee today would consider the fate of overambitious Florida cities and towns. Central banks have printed (digitally) several trillion dollars since 2008. There may not be 10 public officials in America who understand the municipal bond market still trades courtesy of Ben Bernanke, who departed a few months after long-term Treasuries hit their 1.4% bottom.
Rising interest rates will, at the most basic level, mean borrowing rates will also rise, reduce the availability of bond-market financing; defaults as well as bankruptcies will follow.
At the fundamental level, widespread sins of municipal borrowing and spending are known by enterprising “bottom-up” municipal bond analysts. They travel to cities and towns, meet with clerks, and examine their ledgers. The enterprising analysts are full of questions. Clerks often welcome the attention since “no one has ever asked me before” where the police payroll is hidden. It has become common for such current expenses to be paid out of bond proceeds. This is against the law. The Chicago Tribune, November 1, 2013: “General obligation bonds are intended to help governments achieve lasting public works, such as libraries and bridges, that are too costly to pay for all at once. But records show Chicago’s city leaders exploited a loophole in federal tax law and pushed the boundaries of Internal Revenue Service rules that prohibit using this type of borrowing for day-to-day expenses.”
Such eye-popping revelations are met with indifference: until it’s over. The bonanza ahead for law firms and “expert” testimony of a dozen different varieties offers a handsome working-lifetime income. These are the types of careers open to the “bond-yields rising” generation, possibly supplanting investment management careers of the interest-rate falling generation.
What about timing?
Enough dominoes have fallen to know the dam has burst. Not too long ago, it was difficult to conceive Teamster Central States, Southeast, and Southwest Areas Pension Plan reducing its pension benefit obligation by 22.6%. On October 2, 2015, the U.S. Treasury Department authorized this diminution.
On the public finance front, Public Private Partnerships (PPP) are gaining traction. PPP’s are agreements in which the responsible parent cedes some portion of management and revenues to a private company. This is notable. The public side, generally unions, have fought such concessions. Public employees and unions as a whole have only conceded when the alternative has been explicit, stark, and impoverishing. There have now been a number of high-profile transfers. It is understood that such arrangements are necessary. Where no alternative can be found, parking garages and highways are now in partnership with private enterprise. Momentum is building.
Liabilities are trudging to court where handicapping markdowns will be more valuable than the best race track touts. Even now, legal decisions have led to various and iterative developments. These will keep changing and change often. Handicapping judges will be at the center of valuing assets. Bottom up knowledge will carry weight at the courthouse.