Who Is Kidding Whom?

I had the opportunity during the weekend to read the Comprehensive Annual Financial Report (CAFR) for a municipality, which will remain unnamed. These reports provide a lot of really good information.  I always find the Retirement Systems and Deferred  Income Plans section to be particularly interesting, and this report didn’t disappoint.

I was heartened to see that this municipality was participating in a state-sponsored defined benefit system that was actually using a discount rate of their liabilities (5%) that wasn’t equal to the state’s return on asset assumption (7%), and was truly more representative of a legitimate discount rate in today’s interest rate environment.

Where I take umbrage with this analysis is in the long-term “forecast” of asset class returns by either the asset consultant or actuary or both.  I had to laugh when reviewing the data because this (or these) entity (entities) had used 10.63% to represent the expected return for “debt-related private equity”. Buyouts/venture capital had a forecasted long-term estimate of 13.08%. In fact, 13 of the 15 asset class return forecasts were to the second decimal. Are you serious?

It is highly unlikely that these forecasters will get the first number to the left of the decimal place correct let alone get their prediction anywhere close to two decimal places to the right! Was the use of two decimal places supposed to make this a more legitimate exercise to prove that they had some mystical power to forecast what others couldn’t?

Again, managing a pension plan shouldn’t be about creating a return that exceeds some return on asset assumption (ROA), and in this case 7%. Managing a DB plan should be about exceeding liability growth, as that is the only reason why a plan exists in the first place. But, the industry spends nearly all of its time trying to build a better mousetrap when allocating assets and creating an investment structure. Everyone would be much better off in the long run, and there would be far less guesswork if the plan’s primary objective was the plan’s specific liabilities.

Furthermore, the return forecasting exercise, which was for the periods ending both June 30, 2017, and June 30, 2016, had the consultant/actuary use Global Debt ex U.S. as one of the asset class categories that had a 5% target allocation. The long-term forecasted return was -2.5%. Why then would you have this “asset” in your fund?

Finally, can we please stop making this process much harder than it needs to be? Can we stop playing games with long-term forecasted returns to two decimal places as if we have real knowledge of how markets will perform during the next 10-, 20-, or 30-year period? Can we finally agree that the only reason a pension plan exists is to fund a promise that was made to that entities employees? If we can agree to that, can we agree then that the true objective shouldn’t be a made up ROA, but that plan’s specific liabilities?

 

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Deja Vu All Over Again?

We have occasionally highlighted the insights of real estate expert Keith Jurow, who provides a unique perspective on many aspects of the general real estate environment, but mortgages in particular.  He has recently produced an outstanding analysis/article on the current environment of mortgage REDEFAULTS. The media and other real estate analysts would have you believe that the worst is far behind us and that our real estate markets have recovered following the Great Financial Crisis (GFC).  According to Keith, they haven’t and things may actually be deteriorating further!

Fannie Mae and Freddie Mac have saved 4.1 million homeowners from default, including another 68,000 in Q1’18, since the GFC. But, according to Jurow, this effort has been a massive failure, as homeowners across the country are redefaulting again once, twice, and in some cases, three times. According to Jurow’s analysis, 37% of homeowners who had received a loan modification from Fannie Mae had redefaulted by Q4’17. Incredibly, 30% of homeowners who received a loan modification in 2017 had redefaulted in three months!

“Even mortgage pros don’t really know that there is a problem. How could they? The re-default numbers … have been buried where few people can find them, said Jurow. At Bank of America, the redefault rate on “troubled debt restructurings” is 45%. At PNC, it’s 57%. At Wells Fargo, it’s 35%. These and other lenders, loan servicers, and Fannie and Freddie “have been able to pull off this charade because hardly anyone knows how bad the re-default situation really is,” Jurow said.

I highly recommend that you take the time to read his article. Furthermore, Keith’s work is worthy of a visit to his website, which can be found at http://www.keithjurow.com. You will not be wasting your time!

 

I Got Excited For A Second

I happened to catch an AP note titled, “New Mexico Lawmakers Take Stock of Pension Liabilities”, and my heart began to flutter, as I thought that FINALLY, a pension system was going to manage their fund through a more transparent liability lens. Silly me!

When I read the note it mentioned that members of a legislative committee are just taking stock of mounting liabilities at New Mexico’s two major public pension funds in the wake of a downgrade of the state’s credit rating by Moody’s Investor Service, which cited large pension liabilities as the reason for the downgrade. Shocking.

It really shouldn’t have come as a surprise to that governing body, or any other public entity, that those pension liabilities are burgeoning, and the impact on state budgets is becoming more onerous. Plan sponsors can and should begin to tackle this issue by becoming more liability aware and using the output from liability modeling to drive investment structure and asset allocation decisions that will help to stabilize the plan’s funded status and contribution expense.

As we’ve mentioned numerous times, public pension systems need to be preserved for the millions of participants counting on the promised benefits but managing them with only an asset-focused approach hasn’t worked and we don’t believe that it will work in the future. New Mexico’s legislators and the plan sponsors need to understand the liability’s term structure, growth rate, and interest rate sensitivity as the first step in managing the pension system and not the last step after a downgrade.

 

And Another One Bites The Dust

According to P&I, Avery Dennison Corp will terminate its defined benefit plan. In addition, they will make a $200 million contribution prior to August 15th in order to claim a tax deduction on their 2017 taxes.

The U.S. DB plan has a funded ratio below 70%. The company is looking to settle its liability, estimated to be $950 million, through a combination of lump-sum distributions and an annuity contract (which is not inexpensive). There is no mention on the path going forward for Avery Dennison employees.

I suspect that Avery Dennison shareholders have benefited from recent federal tax law changes. I guess it is too much to ask that their employees also receive some of that largesse.

Sound Familiar?

According to a recent study by Irish Life, one of the largest participants in the Irish retirement industry, 90% of Irish workers are not on track with their retirement savings. Boy, if that doesn’t sound familiar.  Here’s the scary part – Irish Life is advising clients that they need to have saved enough to replace annually one-third of their salary, which doesn’t seem nearly enough for the average worker, as the “rule of thumb” in the U.S. is to replace at least 50% of one’s final salary.

The fact that 90% of Irish workers can’t replace even 30% of their compensation should truly concern the powers that be in Ireland, as the lack of financial wherewithal will negatively impact Ireland’s economy going forward. One of the key findings by Irish Life was the fact that the average worker only begins saving for retirement at age 37, and this delay is significantly reducing the potential accumulated wealth.

Auto-enroll and auto-escalate features would certainly help the average worker but in many cases, it is the lack of wage growth that is restraining employees from participating to the extent that they should. We are certainly seeing that in the U.S.

Is Now The Time?

The Active versus Passive debate rages on, but the results would suggest that large capitalization active managers are about to lose on a 10-count! According to a SPIVA study of large-cap managers versus the S&P 500 through December 31, 2017, 89.5% of managers failed to beat the index for the 10-year period.  Results are slightly better for the 3- and 5-year periods at 80.6% and 84.2%, respectively, but the slight improvement shouldn’t give anyone too much confidence that the tide is about to change.

However, I believe that the percentage of large-cap U.S. equity managers will begin to outperform.  Why? At KCS, we think that there are three environments that favor active managers versus the S&P 500, including markets that favor value, smaller capitalization stocks, and bear market environments. The last 10 years have been dominated by large-capitalization growth stocks, as the Russell Top 200 Growth Index has bested the Russell Mid Cap Value index by 2.3% per annum.  The margin of outperformance has continued to grow substantially in recent periods, peaking (?) at 18.6% in 2017 (31.9% versus 13.3%).

So, what gives us reason to believe that value-oriented, smaller capitalization securities will once again have their day in the sun? History! History has a way of repeating itself, and so do market cycles. Mid-cap value ate large growth’s lunch for the 20 years ending 12/31/17 (9.5% versus 6.6%) despite the significant underperformance during the last 10+ years.  Also, valuations and fundamentals ultimately matter, and there is little justification for the valuations currently attributed to the top 200 growth stocks.

We believe that there is a role for both active and passive management in a well-diversified equity portfolio, but the large growth versus mid value cycle should be used to “tilt” one’s portfolio within appropriate asset allocation bands. If you aren’t prepared to bet that large growth will continue to significantly outperform mid value then you should act sooner rather than later before the next cycle is well underway.

 

 

 

We Believe That They Are

A new study released by Georgetown’s Center for Retirement Initiatives questions whether defined contribution participants invested in target date funds (TDFs) are being negatively impacted by the the lack of alternatives in these products. We agree with their concerns/conclusion.

As a reminder, individuals should have an absolute return objective similar to that of endowments and foundations, which differs from defined benefit plans that have a relative objective (the plan’s liabilities). Unfortunately, only 8 of 41 target date fund managers tracked by Morningstar have any exposure to private equity, hedge funds, and/or real estate. For the most part, those products without any alternatives saddle their participants with mostly traditional fixed income and equity exposures.

The study suggests that the dearth of alternatives has its roots in the lack of internal expertise, poor liquidity (need to have mark-to-market capability), and higher fees associated with these products in an era of growing litigation related to expenses.

Given equity valuations and the current interest rate environment in the U.S., we, too, are concerned that defined contribution participants may be saddled with an inferior product in this environment. Given that DC participants (on average) are already facing a retirement funding shortfall, the last thing that we need is another market correction in a rising rate environment that would adversely impact fund balances.

We think that the inclusion of TDFs in a fund lineup has been a very positive development for the average DC participant, just as auto-enroll and auto-escalate features have enhanced the participant’s experience. However, let’s strengthen these product offerings in order to maximize the benefit.