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Cash-flow driven investing and the American Rescue Plan Act

Multiple authors
2023-07-31
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only. 

The American Rescue Plan Act of 2021 (ARPA) provides special financial assistance to help multiemployer pension plans with weak funding positions. In this short paper, we outline how a cash-flow driven investment (CDI) framework, when supplemented with a glidepath, may further help by enhancing a plan’s benefit security, lengthening the investment horizon for a plan’s risk assets, and stabilizing its funding requirements. Though we are still awaiting guidance from the Pension Benefit Guaranty Corporation (PBGC) to clarify important questions on the new law’s provisions, the framework is flexible and can be adapted once we have regulatory clarity. 

Cash-flow driven investments

Much has been made — and rightly so — about the disconnect between the interest rate used to calculate the amount of special financial assistance and the actual yield achievable in the approved securities. The assumed interest rate is approximately 5.5% based on the law’s formula,1 but special financial assistance assets are required to be invested in investment-grade bonds, which currently only yield around 1.5% to 3.5% for corporates, depending on maturity and quality.2 Consequently, we estimate that the special financial assistance will cover roughly 15 years of gross benefit payments for a typical plan, assuming investment in a high-quality, corporate bond portfolio, versus the intended 30 years at the statutory discount rate.3 Though the specifics vary based on plan characteristics, we believe plans need to consider how to overcome this potential shortfall.

How can plans navigate this interest-rate disconnect and best use the special financial assistance assets to aim to maximize benefit security and stabilize funded status? In our view, plans should not view the discount rate as a return objective that must be met within the special financial assistance asset portfolio. We believe they should avoid stretching for yield through higher credit risk (e.g., BBB-rated bonds) or duration risk (via longer maturities). Instead, we think plans should construct a CDI portfolio that maximizes the length of time over which the special financial assistance assets are expected to reliably fund cash flows. 

A CDI portfolio is a tailored bond approach, constructed to align the portfolio’s income (coupons plus principal repayments) with the plan’s anticipated gross or net cash flows. In other words, a properly constructed CDI portfolio “self-funds” benefit payments. In our view, this offers several potential advantages to the plan sponsor:

  • A high degree of certainty of meeting cash-flow needs over the specified horizon, providing benefit security for participants and funding stability for contributing employers.
    We believe successful CDI strategies emphasize fundamental credit selection and robust portfolio construction to limit the risk of defaults, seek to enhance yield by serving as a liquidity provider, and minimize transaction costs via low turnover. They also incorporate sufficient flexibility to adapt to instances when actual cash-flow needs deviate from actuarial projections.

    Our earlier example estimated that the special financial assets may cover about 15 years of cash flows, but the horizon may be shorter or longer, depending on final PBGC regulations due in July.3 The coverage period under the CDI approach can be dialed up or down accordingly.
  • The ability to invest existing plan assets with a long-term horizon, given the low risk that these assets will need to be liquidated to fund outflows during the period of CDI coverage.
    We think that the long-term horizon afforded via the CDI strategy makes the existing asset portfolio the appropriate “bucket” in which to take risk, and that the level of risk should be influenced by the size of the funding gap net of expected contributions.

    Further PBGC guidance is necessary for plans to finalize investment strategy decisions, but a CDI strategy’s lengthened investment horizon may make more room for additional exposure to equities in existing assets. Equity strategies — despite high near-term volatility — have historically delivered compelling returns for investors who can hold them over a multi-decade period. Within equities, plans can look to thematic, opportunistic, and contrarian strategies whose managers often have a more “patient” mind-set. They can also consider illiquid asset classes such as private equity, real estate, and infrastructure.
  • A flexible glidepath framework for enhancing benefit security and funding stability.
    Over time, investment gains in the existing asset portfolio can be harvested and redirected to the CDI portfolio to extend the cash-flow coverage period, providing even greater benefit security for participants. Similarly, higher yields may present an opportunity to extend the CDI coverage period at a more attractive entry point. This “glidepath” approach helps enhance intergenerational equity by reducing the risk of higher deficits that then require plans to call on contributing employers to increase contribution rates to cover past accrued liabilities. 
Figure 1
cash flow driven investing and the american rescue plan act fig1

Bottom line

ARPA creates an exciting opportunity for plans in weak funded positions. In our view, a CDI strategy can enhance this opportunity and solve some of the potential issues presented by the disconnect between the new law’s assumed interest rate and the yield available in the market. We believe a flexible CDI framework can offer multiemployer plans the potential for improved benefit security, a longer investment horizon, and more stable funding requirements. 

1Plans must use the discount rate used in their most recently completed certification of plan status prior to 1 January 2021, subject to a minimum “interest-rate limit” equal to the third segment of the IRS 24-month average segment curve (unadjusted for 25-year corridor limits), no earlier than three months prior to application for special financial assistance, plus 200 basis points (source: H.R. 1319). Based on the June 2021 IRS segment rates, the interest-rate limit is 5.45%. The interest-rate limit is expected to apply for most plans, which typically use a discount rate of 6% to 8% (source: Milliman Pension Funding Study: June 2020). | 2BBG BC US Corporate index yields 2.18% as of 17 May 2021. | 3The approximate 15-year horizon estimate assumes that the special financial assistance is determined without regard to existing plan assets or anticipated contributions, that the PBGC does not expand the universe of allowable investments beyond investment-grade rated bonds, and that the PBGC does not alter the “interest-rate limit.”

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