KCS Third Quarter Update


Attached for your review is the KCS Third Quarter Update. As you will note, we have been busy during the last few months, and the next three are nearly as packed. We thank you for your continuing support, and many others in our industry who have provided us with a forum to express our unique insights, as we attempt to alter the conversation regarding the day to day management of defined benefit and defined contribution plans.

We continue to believe in our firm’s mission, as we fear the adverse consequences of a failing retirement system. The statistics that are highlighted reveal a consistently ugly story, as fewer and fewer retirement participants are in a position to retire. In fact, only 1 in 7 contributors to a DC plan (only about 50% of the population actually fund a DC plan) are contributing enough to replace an appropriate portion of their current income.

Please don’t hesitate to call on us if you’d like to learn more about our approaches to working with DB, DC, E&F and HNW individuals. With a combined 191 years of relevant experience, we believe that our team can assist you and your team to navigate through these difficult challenges. But despite the choppy seas, they must be navigated.

Active Management Is Not Dead

Come on, folks. Let’s stop the silliness right now.  I can’t tell you how many times in recent weeks I’ve read about the demise of active managers versus passive offerings, but I can tell you that it has been too many times.  This discussion of passive versus active has been around since the creation of passive indexes, and it will remain a topic of conversation for a long time to come.

The KCS team has addressed this issue in prior blog posts, but given the recent fervor, we felt that it was necessary to discuss this topic again.  There are cycles throughout the capital markets, and it is no different for active equity managers versus their passive equity benchmarks.

There are portfolio biases that favor passive versus active and vice versus. Active managers tend to do better when small capitalization stocks and value-oriented stocks / sectors are in favor.  In addition, active managers tend to do better when markets are falling, as they often have cash reserves that help support portfolio performance.  These are portfolio construction issues given that most active managers build equal weighted portfolios, and have stock selection criteria that screens for value (price to something).

Passive portfolios, particularly larger cap indexes, benefit from momentum, rising markets, and large capitalization leadership.  These are the areas that have most recently been in favor (last 3 years), and so it isn’t surprising that active managers would be struggling in this environment.  Does this mean that something has changed that will always create this opportunity for passive investing?  Hell no!

There are certain segments of our capital markets that are more difficult to add substantial value add, but given the cycles in the markets there will always be opportunities.  We suggest that plan sponsors use both active and passive strategies to achieve their desired equity exposure and tilt to one versus the other when portfolio construction biases make sense to do so.

In addition, be careful what you pay in fees, and consider using performance fees to insure that you are only paying for value-added strategies.  Also, assets under management are an important consideration, too.  There are too many asset gatherers that have built asset bases that far exceed their product’s natural capacity to add value. Small can be a beautiful thing!

Funding Crisis

via Daily Prompt: Urgent

It was reported today that only 1 in 7 contributors to defined contribution plans (401(k) and 403(b)) are contributing enough to sustain a reasonable standard of living in retirement.  This is compounded by the fact that only about half of our labor force is participating in a DC-type retirement vehicle.

This is clearly an untenable situation for the individual, but equally important for our economy and social structure. Where will demand for goods and services come from if a significant percentage of our population don’t possess the financial wherewithal to be consumers?  Furthermore, this places a significant burden on our ability to manage the labor force through a natural evolution.

We urgently need to re-think the elimination of defined benefit plans (DB) in favor of defined contribution structures. In a DB plan the individual participant has little responsible for the ultimate outcome, which is the receipt of a monthly pension check. Regrettably, they possess the entire burden in a DC plan, from contributing, to allocating the assets, to managing the distributions.  Why do we think that untrained individuals will handle this responsibility?

The urgent need for education is clear, but the ability for most individuals to self fund these plans is still the greatest challenge. We live in an environment where real wages have stagnated for many years. In addition we have a significant percentage of our potential labor force on the sidelines (94 million age-eligible 16-65 year olds) who are not funding retirement programs.  Discretionary income is almost an oxymoron for a vast majority of our citizens.

GASB versus FASB – Clumsy

via Daily Prompt: Clumsy

Sorry, but I don’t understand how our powers that be can support two different accounting standards for valuing a defined benefit plan’s liabilities.  The International Accounting Standards Board requires pension liabilities to be valued at a risk free market rate.  However, in the U.S. we have two governing bodies that oversee pension accounting with one supporting public and multi-employer plans (GASB) and the other supporting private sector plans (FASB).

In the case of GASB, a DB pension plan can value their liabilities at a discount rate equivalent to the return on asset assumption (ROA), which for most plans is in the 7.5% to 7.75% range.  Under FASB, a private sector plan must use a blended AA corporate rate, which will be much lower in this environment, but still significantly inflated versus the risk free rate (Treasury security). Why does this situation exist?  Not sure, but it seems to be creating a stir for actuaries, too.

The Society of Actuaries has been stating for a long time that liabilities should be valued at a true economic rate, and not one predicated on a guess as to how much a plan is going to earn (ROA) over time.  Having two different accounting standards is very clumsy, and it creates uncertainty in the marketplace.  At KCS, we remain strong advocates for DB plans, but we believe that these plans will only continue to be viable if there is an honest assessment of their liabilities.  Without this transparency, how can a sponsor truly know whether or not they are winning the pension game.



US Retirement Industry Lacking Original Thought


The demise of the traditional defined benefit plan (DB) and the movement of most employees to defined contribution plans (DC) is creating a retirement crisis in the U.S.  According to the DOL, the U.S. pension industry has seen the number of DB plans go from nearly 150,000 in the 1980s to fewer than 24,000 today, and many of those plans have had benefits frozen for new employees.

Why has this trend unfolded? Well, there are multiple reasons, but for many private sector companies the carrying of the pension liability on their balance sheet and the volatility of contribution expense potentially impacting the income statement was just not acceptable. But the pension crisis isn’t just impacting private sector plans.  Public funds and multi-employer plans are also suffering under the weight of declining funded ratios and rising pension expense.

In addition, the capital markets have contributed significantly to this unfolding story, as interest rates have plummeted during the last 30+ years, while equity markets have witnessed two major corrections in the last 15 years. Declining asset values and rising liabilities have combined to create dangerously poor funding levels for many states, municipalities and union plans. Regrettably, this situation has been made worse by the reluctance of plan sponsors and their consultants to pursue a different strategy.

Many in the retirement industry continue to create investment structures and asset allocation strategies that are based on the return on assets assumption (ROA), as opposed to a plan’s true benchmark, which is that plan’s unique liabilities. Had these advisors chosen a more original approach they likely would have had greater exposure to fixed income assets during this 30 year bull market for bonds, which would have left them with less exposure to equities and the two major market declines for that asset class.

Institutional inertia continues to plague our industry, and unless we begin to consider a different path, I fear that our beneficiaries will not get the benefits that were promised.  The movement away from DB plans is placing an undo burden on many of our employees to fund and manage a retirement program without the necessary skills to successfully accomplish this task. The social and economic ramifications may be quite grave.

Where are the Advocates?

It was announced earlier this week that Janus and Henderson were merging their operations. Speculation around this transaction was that the active / passive trend favoring passive was putting pressure on the businesses of active managers, particularly in their ability to raise new assets.  We say hogwash!  The active / passive CYCLE has existed for quite some time, and it will always exist because of portfolio construction biases, which we’ve written about in a previous blog post.

We believe that the primary reason that active managers are having a difficult time attracting new clients and assets is because of the demise of the defined benefit plan! There are far fewer plans today (roughly 23,000) than there were 30 years ago (146,000 (DOL)), and many of those still in existence have frozen their plans to new employees or at a minimum have begun to de-risk their plans (see corporate America’s behavior).

We think that DB plans are superior to DC offerings, and have expressed those feelings many times before.  What is fascinating to us is the fact that although many small to mid-sized asset managers have little exposure to DC asset bases they haven’t spoken out in favor of DB. The trend favoring DC versus DB will only magnify, as more DB plans are shuttered because of deteriorating funded status and escalating contribution costs.

I suspect that there are many asset management organizations that believe a traditional DB plan is superior to a DC offering.  However, I don’t see them advocating for DB versus DC. Their silence may just be the death knell for DB, and consequently their own business.  Currently a hand-full of mutual fund companies dominate the DC space. Mutual funds still are the vehicle of choice for offering one’s product, although we see ETFs gaining traction.  However, most defined contribution plans are too small to have separate accounts as options within their plans.

Without a mutual fund or ETF platform, it is going to prove very difficult to penetrate the DC space. Think that the Janus / Henderson merger is an anomaly? Think again! DB plans need to be maintained, and if I were running an asset management organization, I would do what ever I could to be their advocate. Unfortunately, their silence is deafening!





POBs In The News Again!

For long-term readers of the KCS Fireside Chat series, you may recall that we dedicated one of our articles to Pension Obligation Bonds (POBs) (Pension Obligation Bonds:  Safe… or Sorry, July 2013).  Well, it seems that POBs are once again in the news.  I’ve seen reference in the last two days to Houston and Alaska considering using POBs to help close the gap between promises made and funded.

As a reminder, a Pension Obligation Bond is a debt that resides with the sponsoring entity (state, municipality, etc). It is basically a substitute for that entity making up the deficit through contributions, except that there is a carrying cost (interest payment) to the POB.

The hope is that the DB plan can generate a return on the POB’s proceeds that will exceed the borrowing cost.  Unfortunately, it doesn’t always work out that way.  In fact, a significant percentage of POBs were underwater following the great financial crisis.

Given where valuations are for equities and yields are for bonds. we would be very cautious about taking the proceeds from the POB and placing them into a traditional asset allocation with the HOPE that an excess return will be created.  We would prefer that a POB’s proceeds be used to immunize (cash flow match) the plan’s near-term liabilities, thus securing the funding for near-term benefit payments, while allowing the existing assets to benefit from an extended investing horizon.

We would be happy to discuss this approach to securing the victory, instead of subjecting the proceeds of the bond to the same excessive volatility witnessed in traditional asset allocation approaches.