Glorified Savings Accounts

At KCS, we applaud any entity that provides their employees with a retirement vehicle! However, as we’ve written many times, we would prefer a defined benefit plan to a defined contribution plan for several reasons, including the fact that employees can take premature withdrawals and borrow from their accounts through loans. This access is crippling the financial future for many participants, and it will likely lead to significant shortfalls in retirement savings.

Fox Business is reporting on a PwC US study (2018 Employee Financial Wellness Survey), which tracks the financial and retirement wellbeing for 1,600 full-time employees. Not surprising, 42% of those surveyed expressed concern that they would have to tap their “retirement” account for everyday expenses associated with supporting their adult children, parents, and/or both. Furthermore, nearly 2/3rds of those polled anticipate delaying retirement for fear of rising healthcare costs.

There have been many significant improvements to defined contribution plans through the years, including such features as auto-enroll, auto-escalate, target-date funds as an approved QDIA, etc., but until we eliminate premature access to one’s retirement funds, these accounts will remain nothing more than glorified savings accounts.

Despite all the published accounts of how everything is just hunky-dory, we know that a significant percentage of our labor force are struggling to meet daily expenses let alone save for retirement. Student loans, healthcare, housing, etc., are all taking a bigger chunk of one’s income. As a result, we need to create true retirement vehicles for our employees, which are untouchable, that will permit them to retire at the appropriate time without ending up on the welfare ranks, as we expect many will.

 

 

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Would That Be True If They Used a Legitimate Discount Rate?

P&I is reporting on a Milliman study of the 100 largest U.S. public pension plans in which they calculate that the aggregate funding dropped to an estimated 71.4% as of March 31, down from 73.1% at the end of 2017.

Milliman is estimating that the challenging markets lead to a collective asset value drop of 1.7% during the quarter to $3.56 trillion, while liabilities increased 0.8% to $4.99 trillion. The first quarter’s investment returns caused six public pension funds to drop below the 90% funded mark, bringing the total number of plans with funding ratios of higher than 90% to 15. Of the remaining plans analyzed, 59 had funding ratios between 60% and 90%, and 26 were below 60%.

However, since these pension systems use a return on asset assumption (ROA) to discount their plan’s liabilities (under GASB), the liability growth described above may in fact have been negative in present value $s if a true mark-to-market evaluation had been conducted. The recent rising interest rate environment would have reduced the present value of a plan’s liabilities during the first quarter as opposed to what Milliman is reporting.

Not having done the analysis, we are not in a position to determine whether the falling level of liabilities would have made up for the collective lower level of assets, but it is doubtful that the funded status would have declined 1.7% during the quarter. Wouldn’t it be better for the plan sponsor community to have a more accurate and transparent evaluation of their liabilities from which appropriate asset allocation decisions could be taken?

 

Just In Case You Didn’t Believe Us

SOA projects 115 multiemployer plans to be insolvent in 20 years

The headline above appeared last week in Pensions & Investmants (P&I). As we’ve been reporting for nearly one year the solvency of many multiemployer plans is very much in jeopardy. We’re glad to see that the Society of Actuaries (SOA) confirms our belief that the problem facing these critical and declining plans are real.  It certainly is for the millions of Americans who may face a sharp reduction in the benefits that they paid into and were promised at the beginning of their employment.

Although the headline suggests a 20-year timeframe, a significant portion of these plans could be insolvent within 10 years. In fact, it is estimated that 21 plans will go kaput by 2023, while another 48 could evaporate by 2028. What we also know is that some of the plans facing more immediate uncertainty are the largest plans, including Central States Teamsters.

Based on various discount rates used to calculate the potential liability of this unfolding funding crisis the projected liability could be $57 billion (using a 6% ROA discount rate) to $107.4 billion when applying a 2.9% Treasury rate. These numbers mirror those that were calculated by members of the Butch Lewis Act team that recently presented to House and Senate staff members.

As a result of this unfolding crisis, Congress has established a Joint Select Committee to tackle this issue before it becomes a moot point. As we’ve reported in previous blog posts the committee has begun meeting with various industry experts. Select committee co-Chairman Sherrod Brown, D-Ohio, said Thursday that the panel will hold hearings until July, and then “we will have to start the process of negotiating a bipartisan solution to the crisis.” They are striving to have a “solution” established by a self-imposed deadline of November 30th. Obviously, we hope that the Butch Lewis Act will be the foundation for the legislation that eventually evolves from the Committee’s effort.

Why Pixie Dust Isn’t necessary

Yesterday we wrote about CalPERS, and the request by Dane Hutchings, legislative representative to the League of California Cities, imploring the CalPERS team to “think outside the Box” in order to generate a fund return that exceeded their 7% annual return on assets objective (ROA). We were wondering what magic potion they might discover that would altar the long-term return expectations for a variety of asset classes.

However, managing a pension plan isn’t about generating the highest return, but it is very much about providing the promised benefit at the lowest cost. As we’ve stated many times before, the true objective for a pension system is that plan’s specific liabilities, and not some made up ROA. We would like to further explain.

  1. Liabilities are highly interest rate sensitive. If rates go up (as most believe that they will) there is a good chance liability growth in present value dollars will be negative, just as the return on long bonds would be negative in that scenario, too.
  2. A pension plan’s true growth objective is to have asset growth exceed liability growth so the economic funded ratio/status is enhanced. Earning the ROA is not the goal here.
  3. The true economic funded ratio for a public pension plan is not currently known, as plans are not using a mark-to-market discount rate to value their liabilities. Yes, a discount rate of 4% (AA Corporate under FASB) or Treasury rate (3%) would increase the value of plan liabilities and reduce the plan’s funded ratio, but it would create the base case from which appropriate action can and then should be taken.

Let’s look at the scenario below. Clearly, assets do not need to achieve the 7.5% ROA objective to witness meaningful improvement in the plan’s funded status provided that asset growth exceeds liability growth. In our scenario, with liability growth of -2.56% annually, a 5% asset growth rate produces 7.6% annual alpha for assets relative to liabilities, and it improves the funded ratio from 60% to 87.8% in just 5 years. If markets cooperate, and the annual return achieved is 7%, then the funded ratio dramatically rises to 96.5%. Knowing the true economic reality of a plan’s liabilities can lead to better decision making, while eliminating the need for pixie dust to be thrown at the “problem”.

   5-year Scenario

                 What would happen to a plan’s liabilities if long U.S. Interest Rates were to rise 60 basis points per year for the next 5 years?

                 30-year Treasury at 3.00% going to 6.00%

                 Liability growth rate would be -2.56% annually or –12.81% cumulative

                 Note: duration of liabilities = 12 years

                                                 —– Annual Growth Rate —–

                  Assets                         5.0%      6.0%       7.0%      8.0%

                  Liabilities                – 2.6%     -2.6%   – 2.6%     – 2.6%

                  Alpha (annual)       7.6%      8.6%      9.6%      10.6%     

Funded Ratio starts at 60%:  87.8%   92.1%    96.5%   101.1%

Every DB plan, public or private, should use an economic set of books to value plan liabilities. Furthermore, every pension system should have a derisking plan in place. Just because a plan’s funded status is currently poor doesn’t mean that it can’t see dramatic improvement in a relatively short time frame. Improving transparency on a plan’s liabilities is an enhancement to the process. Without this honest evaluation how does a sponsor know if they are winning the game?

 

Oh, Okay – No Problem!

You Gotta love this one! CIO magazine is reporting that a “legislative representative to the League of California Cities urged the CalPERS Investment Committee Monday to think “out of the box” in finding a way to exceed its 7% investment return projections, saying that cities won’t be able to pay their monthly contributions to the pension plan if returns are that low.” No problem! I’m sure that they will be able to find a magic potion that will all of a sudden create new and exciting investment opportunities for this fund and all market participants!

Dane Hutchings cited a CalPERS September 2017 report, which showed that 180 of the 449 cities and towns that participate in CalPERS had an individual funding ratio of between 60% and 70% (on an actuarial basis).  Hutchings also warned that a significant number of those communities could fall between the 50% and 60% funded when new CalPERS data come out in August.

CalPERS is in the midst of a three-year plan to lower yearly expected investments to 7% from 7.5% because of diminished (more realistic?) return expectations. As returns expectations drop, CalPERS’s unfunded liability increases (under GASB accounting), therefore it must increase contributions from employers whose employees are in the pension plan, meaning the state, cities, towns, special districts, and school systems that makeup CalPERS must pay more.

How about valuing public pension liabilities using a more realistic discount rate and separating that rate (for contribution purposes) from the return on asset (ROA) assumption? DB plans used to be managed against their liabilities and not the ROA.  Trying to enhance a return will guarantee more volatility, but not necessarily an equivalent pick-up in return.

If plan sponsors began using a mark-to-market evaluation of their liabilities they would understand that the present value of those liabilities changes along with movement in interest rates.  A DB plan does not need to achieve its ROA objective in a rising rate environment given that the present value of the plan’s liabilities is falling. A 4-5% return would look heroic in a market environment, such as that! Have they conducted an asset exhaustion test to calculate the actual ROA needed to keep the plan solvent? Let’s apply some real solutions to this problem and not HOPE for unrealistic returns.

 

What’s Another 1% or So?

Recently the Federal Reserve Bank of Chicago unveiled a “solution” to the Illinois pension crisis, and according to those in attendance at the pension event the announcement drew an “audible gasp”! The speaker from the Chicago Fed proposed levying a special property assessment on ALL property owners across the state, which would amount to about 1% of actual property value each year for about 30 years.

Of course, this assessment falls on top of already ridiculous levels of property tax being paid by Illinois residents.  In fact, Illinois ranks #1 (not a good thing) in median property tax as a percentage of property value, and I thought that New Jersey was the worst! Don’t I feel just a little bit better. Ah, not really!

https://www.zerohedge.com/sites/default/files/inline-images/IL-highest-property-taxes-C.png?itok=jOpxyB5A

Incredibly, property taxes in many Illinois communities already exceed 3%-5% of home values. Given the impact that this would have on low-income residents a thought has been raised about making this new tax progressive, but if that were to happen the cost to others would be absurd.

The Chicago Fed recognizes that there will be a negative impact on current residents but they don’t seem to care one iota, stating “current homeowners would not be able to avoid the new tax by selling their homes and moving because home prices should reflect the new tax burden quickly.”  With regard to anyone moving into Illinois they said, “while they would have to pay higher property taxes, that would be offset by not having to pay as much for their new homes. But, the higher property taxes would be factored in every year for 30 years.

A homeowner buying a $500,000 house could expect that this legislation would levy an additional tax bill of $150,000 (next 30 years) on top of their normal 2.67% ($13,350/year) on their property value each year. The Illinois homeowner will pay $550,500 in taxes during the next 30 years, presuming no change in the 2.67% or the value of one’s home.  Property values will likely fall, but the declining revenue will likely lead to a higher percentage levied on each home. What a deal!

Furthermore, this proposed tax would only address the five state pension systems, and not the other 650+ pension plans in Illinois, just think about the impact of this action on those residents living in municipalities close to Chicago, whose plans are already terribly underfunded? According to the article, the Chicago Fed was asked at last month’s seminar how the other pension plans would be funded but “they, without explanation, said they didn’t bother to cover that.”

Illinois is already suffering mass migration from the state. According to a USA News article from earlier this year, Illinois is again #1 in this category:

  1. Illinois
  2. New Jersey
  3. New York
  4. Connecticut
  5. Kansas

Given the impact that these public fund pension systems are having on state and municipal budgets, one would think that a different strategy would be employed to manage this promised benefit. If not now, then when? Doing the same old, same old is just silly. Levying more taxes is not the answer and neither is trying to generate a greater return, which only increases volatility, but doesn’t guarantee success.

 

 

Let’s Stop The Guess Work

The Committee for a Responsible Federal Budget (CRFB) is out with an article titled, “Multiemployer Pensions: The Next Source of Budget-Busting Legislation?” We continue to be pleased with the fact that the multiemployer funding issue (and the Butch Lewis Act) is getting a lot of attention in Washington DC, but we would truly prefer unbiased reporting and less guesswork on the part of the CRFB.

As the article correctly highlights, there are roughly 1,400 multiemployer plans. There is a subset of this universe of defined benefit pension systems that are in “Critical and Declining” status.  They report 100 plans but by our analysis, there are 114 funds presently in this category. It is estimated by the Pension Benefit Guaranty Corporation (PBGC) that the present value of the multiemployer program’s liabilities at $65 billion, while the Congressional Budget Office (CBO) estimates that liability at $58 billion. Our analysis estimates the liability at roughly $68 billion.

Here’s where the reporting gets a little dicey. The CRFB claims that the CBO has “also projected a much greater shortfall of $101 billion on a fair-value basis that accounts for the risk of an unexpected economic downturn that causes more plans to claim financial assistance.” What about an unexpected upturn? What would the liability look like under that scenario?

When addressing the Butch Lewis Act (BLA) as one of the proposals from policymakers involved in solving this crisis the CRFB accurately describes that these critical and declining plans would receive low-interest 30-year loans “large enough to enable them to pay full benefits”.  However, they scoff at the idea of ensuring benefit levels at 100%, as the PBGC only guarantees benefits at 60% for plans that have failed. Why shouldn’t these pension beneficiaries be given their full pension?

Under the BLA, multiemployer plans would make annual interest payments, but they would not need to repay the principal until the 30th year. We think that this strategy makes great sense, as it buys time (extends the investing horizon) for the current assets and future annual contributions to meet future liabilities and the bond repayment. Unfortunately, the CRFB is assuming that the Treasury will have to revise repayment terms and/or forgive the loans of any plan unable to pay full benefits. Our analysis of the 114 plans does not forecast any plan failures.

The CRFB correctly points out that the proposed BLA legislation prohibits plans from making any reduction to accrued pension benefits, but they are absolutely incorrect when they state that the bill “does not require any contributions from employers.” The BLA specifically requires current contribution levels to be maintained by employees and employers. The BLA also requires no withdrawal liability once the loan has been accepted.

Another claim by the CRFB as to why the forecasted liability is understated has to do with the claim that the CBO would likely assign a significant cost to the loan program because MANY plans would likely require partial loan forgiveness or additional financial assistance. The analysis by our team has determined that only three plans need additional assistance from the PBGC and that all remaining plans actually have a return on asset assumption (ROA) annual performance objective of only about 6.5%, which is significantly lower and less risky than their current return objective.

The CRFB claims the “lawmakers three decades from now could simply forgive all loans to distressed plans if they judged repaying the principal to be too onerous.” Why? As we’ve reported on numerous occasions, the proceeds from the Treasury’s loans must be used to defease the retiree lives.  These plans all have substantial existing assets that will now benefit from time and future contributions that will be more than enough to meet future obligations.

The article concludes by stating that “multiemployer pensions face serious funding challenges, but so does the federal government”. We agree with the first point, but it is ridiculous to state that the U.S. government is facing a funding crisis. The U.S. enjoys the benefit of having a fiat currency, and as such we NEVER face the risk of not being able to meet our debt obligations. The CRFB should stop trying to compare the federal budget to a budget for either a U.S. state or individual household.

The nearly 3.5 million pension recipients in these multiemployer plans generate a tremendous amount of economic activity each month. It is foolish to believe that our economy is not negatively impacted by any action that significantly reduces their hard-earned benefits. We currently have an opportunity to preserve and protect these plans/benefits. We cannot afford to squander this moment in time!