Seeing “Double DB” in Your Future?

Seeing “Double DB” in Your Future?

The latest KCS Fireside Chat is attached for your review. This edition is the 24th Fireside Chat in our monthly series. This one addresses the development of a new hybrid plan called the Double DB. KCS is pleased to be involved in bringing this new pension plan design to the marketplace. We believe that sharing risk among both the plan sponsor and the participant is the better approach than one entity bearing all the risk. This exciting new pension plan design accomplishes this objective, while also bringing many additional attributes to the marketplace.

Please don’t hesitate to call on us if we can answer any questions that you might have about this exciting development.

Forget About Account Balances – Focus on Income Replacement

We have been coerced into thinking that wealth creation will provide for us in retirement, when in fact we should be focused on how we can create an income stream that will provide us with a meaningful income in retirement.  How many of you (us) focus too much attention on the month-to-month or quarter-to-quarter swings in the account values of our 401(k)s, 403(b)s, etc?

I believe that traditional DC statements need to be enhanced to reflect a projected income stream at various interest rates.  What does a $75,000 balance really mean to a 45-year-old?

Let’s create a profile of an average worker.  The employee is 65 years old, their final salary is $45,000, and they’d like to replace 75% of their final salary on an annual basis in retirement until demise (80 years old).  Social security (average payout) provides $1,294 / month, so we’ll say $15,500 per year.  How much would that individual had to have saved by the time they were a 45-year-old to replace $18,200 / year (($45,000 X .75) – $15,500)?  Well, that really depends on the interest rate (return) that was available to an investor at that time, and whether an annuity has been established that will carry her through to age 80.

For instance, at 45 years old, an account balance of $82,000 invested at 5% will provide upon retirement (age 65) an $18,200 annual income until age 80.  Since the “average” 401(k) balance is somewhere between $80,000 to $90,000, that person is on target.  Right? Perhaps, but maybe not.  Where can that investor get a 5% annuity at this time?  If for instance, they can only get an annuity that has a 3% interest rate, that same investor would need a $134,300 balance at age 45 to collect that same $18,200 / year until age 80.  God forbid rates continue to fall and the annuity is at 1% interest, that 45-year-old needs to have $224,000 accumulated.

So, focusing on the total value of the account and not translating that into an income stream can provide employees with a false sense of security.  We’ve all discussed the negative impact of falling rates.  Retirees and those nearing retirement are forced to save considerably more now than they would have 10-15 years ago, if they expect to replace a decent percentage of their final average salary. 

Finally, if one wants to maintain the purchasing power of their income stream throughout retirement (assuming inflation is at 3%), the account balances at age 45 have to be significantly larger.  In fact, that 45-year-old would have to have $166,100 in their account (and not $134,300) invested at 3% to accomplish their goals.  This balance is significantly greater than the average account today, and dramatically larger than the median account of only $13,000. We have a problem, and the lack of transparency into what our account balances can buy in the form of income isn’t helping.



Unintended Consequences

Unintended Consequences

Recently I had the opportunity to speak at the Financial Research Associates’ conference in NYC on non-traditional fixed income. I had the pleasure of participating on a panel with an industry icon – Ron Ryan, Ryan ALM  He and I presented on the topic “Taking a Close Look at the Liability Beta Portfolio”.  However, before presenting our views on the proper use of fixed income in a defined benefit plan, especially in a low interest rate environment, Ron and I addressed the unintended consequences from accounting rules, both GASB and FASB, that have lead to an under-reporting of plan liabilities and an overstatement of plans assets.  Given both, it is obvious that funded ratios are overstated, too.

The IASB (International Accounting Standards Board) has moved to a mark to market accounting of both pension liabilities and assets.  It isn’t too far fetched to believe that the US will adopt these same standards in the near future.  Unfortunately, since GASB uses the ROA to value plan liabilities, it becomes clear as to why the pension community continues to focus on the asset side of the equation instead of the liability side, which should be driving asset allocation and investment structure.

Attached for your review is our presentation.  We encourage you to reach out to us if you have any questions or challenges.



Where are the Economies of Scale?

Since its founding in August 2011, KCS has tried to highlight some of the issues facing the US retirement industry in the hopes that perhaps best practices could be identified and DB plans, as a result, SAVED.  I recently came across the “Status Report on Local Government Pension Plans” for Pennsylvania.  The report was released in December 2012, and it used information through calendar year 2011.

The following paragraph jumped out at me:

“Pennsylvania’s local government pension plans comprise more than 25 percent of the public employee
pension plans in the United States. There are now more than 3,200 local government pension plans in
Pennsylvania, and the number is continuing to grow. Seventy percent of the local government pension plans
are self-insured, defined benefit plans, and 30 percent are money purchase or other type plans. The pension
plans range in size from one to more than 18,000 active members, but more than 98 percent of the pension
plans can be characterized as small (less than 100 members). While 68 percent of the local government
pension plans have ten or fewer members, 32 percent have three or fewer active members.”

I find it hard to believe that anyone thinks that having more than 3,200 local government plans in PA is a good idea, especially when one considers that 98% of the plans have fewer than 100 employees. The local governments and their participants would be much better off pooling their resources into larger, more professionally managed DB plans that afford everyone the benefit or economies of scale. 

I suspect that there exist other states in the Union with a similar governance structure, but if we are to preserve the defined benefit plan as the retirement vehicle of choice, we need to reduce the cost of managing these plans.  Allowing thousands of defined benefit plans with fewer than 100 participants to exist is not sound governance.

Could This Hybrid Plan Revolutionize the Pension Industry?

As we’ve seen recently in NJ with Governor Christie’s decision to withhold the State’s annual required contribution, public and private pension funds are under extreme funding pressure.  As a result, traditional DB plans continue to be terminated / frozen in rapid fashion, with new employees being migrated to defined contribution structures. Unfortunately, the complete shift in risk from the sponsor to the employee is proving to be a disaster, with most employees incapable of funding and managing their own retirement (median account balance for a DC participant is slightly more than $13,000).

Importantly, KCS is pleased to announce that we’ve entered into an alliance with Ed Friend, a long-tenured and highly successful actuary, Ryan ALM and Longevity Financial Consultants to bring to the marketplace a patent pending hybrid DB structure that provides the plan sponsor with a fixed cost feature. The product is called Double DB, and as a hybrid, combines elements of both DB and DC. We think that this new design could revolutionize the pension industry by making the use of defined benefit plans more economical for the sponsoring organization.

Please don’t hesitate to reach out to us if you’d like to receive more information on Double DB. We think that both employers and employees are better served utilizing the Double DB design.