Show Me The Money – The Fallacy of the Funded Ratio!

We’ve often spoken about the fallacy of the return on asset assumption (ROA), as not being the appropriate objective for a pension plan, but we’ve never introduced the idea that the funded ratio is not a good indicator of a plan’s financial health until today.  We think that a plan can hide behind the funded ratio, which can mask the true economics of that plan. How is that possible? Let us given you an example. But, first some facts.

  • During the last 5 years (ending 12/31/14) the average public pension plan (TUCS universe) has generated a 9.95% annualized return, which would be considered very good relative to most plan’s stated ROA (8%).
  • Also, during the last 5 years, liabilities (according to Ryan ALM) have grown by 10.14% annualized.
  • Given the fact that asset growth easily eclipsed the ROA, and kept pace with liabilities, one would think that the funded ratio would remain fairly stable, and you’d be right.  So what is the issue?

Let’s look at pension math. Let’s assume that your plan has $375 million in assets as of December 31, 2009, and a funded ratio of 75% (S&P stated that the average plan was 72% funded at that time). That would suggest that your liabilities amounted to $500 million.  If you grow assets by the 9.95% and liabilities by the 10.14%, your funded ratio only falls from 75% to 74.4%.

On the surface, everything seems to be stable, if not improving.  However, the funding gap in terms of the plan’s unfunded actuarial accrued liability (UAAL) has ballooned. In our example, assets grew to $602.6 million, while liabilities increased to $810.4 million. The UAAL went from $125 million, as of 2009, to $207.8 million in just five years, increasing by a whopping 65.8%.

So, do you still think that the ROA, which was easily eclipsed, and the funded ratio, relatively stable at roughly 74 -75%, are the key pension metrics? Managing a pension plan shouldn’t be about return, but about providing a stated benefit at the lowest cost possible. How many budgets can afford the volatility witnessed in our example? We suspect that few can! This is why a plan’s liabilities need to be at the forefront of asset allocation and manager structure decisions, and not a bit player, as they are today.

The POB – It’s Back! But, Is It A Wise Move?

The comeback of Pension Obligation Bonds (POB) shouldn’t surprise anyone. State and local governments are desperate for ways to address projected public pension deficits of >$4 trillion when liabilities are marked to market.

In one of the more recent examples, trustees of the Kentucky Teachers Retirement System, a DB pension plan funded at barely 50%, and with nearly $14 billion in unfunded liabilities, moved forward with a proposal to issue a $3.3 billion POB, passing the bill to the state Senate, where it is expected to be reviewed next week. With passage of the legislation, the $3.3 billion infusion into the plan would immediately bump the teachers’ funding level to 63 percent, according to KTRS trustees.

In Kansas, meanwhile, Gov. Sam Brownback is proposing Kansas sell $1.5 billion in POBs to help close the Kansas Public Employees Retirement System’s $9 billion funding gap.  We understand how tempting it is to issue bonds at these low interest rates to close huge funding gaps in these public pension plans, but does it make sense in this environment, especially after six years of an equity bull market?

In July, 2013 the KCS team published a Fireside Chat on the subject of POBs.  Here is a link to the original article

We weren’t thrilled with the idea of POBs at that time, and given how markets have continued to rally, we are less supportive at this time.  Please don’t hesitate to reach out to us with any thoughts related to this subject.

The Pension World’s Example of an Oxymoron

Oxymoron – “A rhetorical figure in which incongruous or contradictory terms are combined, as in a deafening silence and a mournful optimist.” (Yahoo dictionary search)

Well, we need go no further than most public DB plan’s actuarial reports to find a “perfect” example of an oxymoron – the “Schedule of Funding PROGRESS”! This schedule is truly a treasure chest of information, but to describe what has transpired in nearly all public plans during the last 10-15 years as “progress” would be an outrageous exaggeration.  Let’s take a look at the following information that I was able to grab from the web on a public pension plan, whose identity will remain anonymous.

As of year-end 1999, this plan had an actuarial value of assets in excess of $450 million and an actuarial accrued liability of $611 million, giving the plan an unfunded actuarial accrued liability (UAAL) of $161 million and a funded ratio of 73.7%.  The payroll supporting this plan was $178 million, so that the UAAL was 90.4% of payroll.  Let’s fast forward 13 years from 1999’s conclusion to December 31, 2012.  Unfortunately, the data that I am about to share with you doesn’t paint a happy picture.  The actuarial value of assets has grown nicely, net of contributions / benefit payments, and now stand at $667 million, but the actuarial accrued liability has jumped to $1.3 billion, for a UAAL of $653 million, representing an increase in excess of 400%!  Furthermore, the funded ratio has plummeted from 73.7% to 50.5%, and that isn’t on a mark to market basis. Lastly, the UAAL now represents more than 270% of payroll.

How did this happen?  The common practice in public DB plans is to focus on the return on asset assumption (ROA), as the plan’s primary objective, and not the plan’s specific liabilities. When attributing blame for the poor funding of public DB plans, most sponsors and their consultants regularly mention as the culprit the bear markets of 2001-2003 and 2007 – 2009.  In reality, it has been the massive decline in US interest rates that have exacerbated Pension America’s funding woes.

As the data above highlights, DB plans on average were much better funded in the late ’90s, with many plans being significantly over-funded. Had they adopted their plan’s liabilities as the primary objective and not the ROA, it is safe to say that these plan’s would not have significantly reduced their exposure to traditional fixed income, which only served to exaggerate the asset / liability mismatch, and lead them to seek more risky assets, including alternatives.

As 2014 will further highlight, liability growth continued to far outpace asset growth deepening DB Plan funding issues.  The benefits received from traditional retirement programs are too valuable to lose.  The communities in which these beneficiaries live derive great economic stimulus from the monthly annuity that is received.  We need, and can, do a better job.

For one thing, plan sponsors need to get a better handle on their plan’s liabilities.  Receiving an actuarial report every one to two years, delayed six months will not accomplish that objective.  Plan sponsors need to drive asset allocation decisions based on the plan’s liabilities and expected contributions, and not on some ROA, that is more of a Goldilocks number (it just “feels” right) than fact.  We believe that every plan should have a custom liability index (CLI) created using their specific liabilities.  It is only with a CLI that asset allocation can be responsive to changes in the plan’s funded ratio.  Let’s talk before contribution costs get so out of control that your DB plan becomes the next victim of the rush to DC alternatives.

Liabilities – the Cinderella of the DB world

There is lots happening in Pension America on both the asset and liability side of the equation.  As anyone who regularly reads our blog would know, the asset side of the equation gets all the attention, while liabilities are the poor stepchild, rarely being invited to the quarterly review table, if at all.  Why?  Liabilities aren’t fancy!  In fact, they are kind of boring, and so are the actuaries that calculate the benefits that are accruing within these retirement plans.  They’re math geeks.

The asset management side of the equation has a ton of excitement.  The various markets go up, down and sideways, and that may be in a single trading day or even an hour of the day.  Furthermore, you can invest anywhere in the world, and in an amazing array of strategies. Investment management professionals get to wax poetically (except for the math / quant geeks that live on the asset side) as to why they own a particular bond, stock, derivative, company, building, commodity, etc. Oh, what fun!  With glee usually reserved for children on Christmas morning, plan sponsors set out to hire many different shops to fill various asset class exposures and styles within those asset classes, conducting endless manager searches all with the HOPE that they will put together a combination of managers / products that will generate a total fund return at or above their return on asset assumption (8% for 49% of US public funds).

Plan sponsors have been told for years by their asset consultants, actuaries and the Government Accounting Standards Board (GASB) that earning or exceeding the ROA would “insure” solvency for their plans. But alas, something happened on the yellow brick road to the Emerald City.  Many plans generated returns that eclipsed the return objective, and over lengthy periods of time, only to have funded ratios plummet and contribution costs escalate.  This couldn’t happen said all the powers that be. But, it did, and there have been and will continue to be severe consequences.

We’ve witnessed the collapse of the DB plan as the primary retirement vehicle, replaced by the newer, shiny, employee controlled defined contribution plan.  Instead of a monthly payout that survives with you until you don’t, we get inadequate account balances, premature withdrawals, loans, inappropriate asset allocation decisions, greater cost, and lump sum distributions. Pandora’s Box is tame by comparison.

Well, continue to avoid liabilities at your peril.  Hosting a quarterly review meeting? You better think twice before you fail to invite liabilities to the conversation.  As you may begin to realize, 2014 was a lousy year for Pension America.  I know, assets were up, and in many cases the ROA was achieved, but liabilities, the ugly stepchild, generated a return that dwarfed asset growth, further depressing funded ratios and likely escalating contribution costs.

GASB 67/68 is upon us, and with the new legislation comes an opportunity to right a wrong.  Spend some time getting to know your liabilities. If you are too shy, we’d be happy to assist you with the introduction.  The new rules under this legislation require you to take some action (such as an asset exhaustion test).  In the case of NJ, the realization was an unfunded liability that more than doubled to a staggering $83 billion.  We need to preserve DB plans. At KCS we think that focusing on the liability side, as opposed to the asset side, will give your plan a greater probability of success. We stand ready to assist you.

NJ’s Singular Focus on the ROA is Misdirected

On Sunday, February 1, 2015, The Record (Northern, NJ daily) reported that NJ’s pension fund beat market expectations in 2014 with a 7.3% return. However, it was also highlighted that the return fell short of the 7.9% return on asset assumption (ROA) that NJ has established as their annual asset objective. Worse, and not mentioned, is the fact that liability growth (estimated at >20%) far outpaced asset growth in 2014, as long-term interest rates continued to plummet. Even if NJ’s pension plan had achieved the desired 7.9% ROA, the plan’s liabilities grew substantially larger, further exacerbating the plan’s underfunding.

It is truly unfortunate that plan sponsors of defined benefit plans continue to focus exclusively on the asset side of the equation, neglecting liabilities, which at the end of the day are the only reason that these plans exist. Understanding a plan’s liabilities will help with asset allocation decisions, and should lead to more stable funded ratios and contribution costs, which is imperative as the annual contributions become a larger percentage of NJ’s budget.

I am not opposed to the state sponsoring a traditional defined benefit plan. On the contrary, DB plans need to remain the backbone of the US retirement industry, as defined contribution plans (401(k)-type) have proven to be inadequate retirement vehicles for most of our private sector employees today. Why? According to a recently released household survey conducted by the Board of Governors of the Federal Reserve System, as of 2013, approximately 31 percent of Americans reported having zero retirement savings. Worse, the median retirement savings for those 55-64 years old is only $14,500. How do we expect that astonishingly low account balance to support anyone’s retirement, especially as we are on average living longer?

Public fund plan sponsors need to take a different approach to managing these plans. It is truly regrettable that the pursuit of the ROA, as if it were the Holy Grail, has lead NJ and other public entities to abandon traditional equity and fixed income investments in lieu of alternative investments, such as hedge funds, that have failed to generate commensurate returns. In fact, a simple (unrealistic) 60% US equity allocation (Russell 3000) / 40% US bond allocation (Barclays Aggregate index) would have produced a 10% return in 2014, far outpacing the 7.3% result highlighted in the article, and at substantially reduced fees.

Lastly, it was stated that NJ’s pension system was underfunded by roughly $37 billion, as of June 30, 2014. However, according to an analysis by Moody’s, New Jersey’s unfunded pension liabilities doubled to an astonishing $83 billion at the end of June. New more realistic accounting guidelines required by the Governmental Accounting Standards Board (GASB) require New Jersey, and other states, to use smaller discount rates (not the ROA) to determine the true liability. The Moody’s report — New Jersey Reports Surge in Unfunded Liabilities Under New Pension Accounting Rule — indicates New Jersey has limited time to fix its poorly funded public pensions.

KCS Fireside Chat – February 2015 – Pension America Struggles in 2014

We are pleased to share with you the February 2015 KCS Fireside Chat article on the continuing struggles for Pension America.  However, we are proposing a new approach to the management of DB plans that should help to stabilize funded ratios and contribution costs.  We look forward to your feedback.  Don’t hesitate to reach out with any questions that you might have regarding this article or others that have preceded it.

Here is the article: