KCS was recently invited to participate in a finals presentation for a small public defined benefit plan. We were one of six consulting firms to present that evening, and fortunately, the last firm to present on what turned out to be a very late evening.
As I predicted, each of the firms that preceded us talked about how they would go about achieving the prospect’s 7.5% return on asset assumption (ROA) through “superior” asset allocation strategies and manager selection. I attempted to throw cold water on their claims by stating that hitting the ROA was basically irrelevant, especially given the poor funding status of this plan, and that the only true benchmark / objective for a plan sponsor’s DB plan should be their plan’s liabilities.
According to Trust Universe Comparison Service (TUCS), the average public pension had a 6.8% return in 2014. This result fell slightly below most public pension return objective, but it wasn’t devastating on the surface, especially if one only focused on the asset side of the pension ledger. However, and in fact, 2014 was a bad year for Pension America, as a further decline in US interest rates exacerbated liability growth by more than twice asset growth.
In attempting to differentiate ourselves from the competition we stressed the need for plan sponsors to get an update on their liabilities more often that once every year or two, delayed 6 months, until they received their actuarial reports. It is our claim that asset allocation should be driven by the plan’s liabilities, funded ratio and contribution policies, and not the assets.
As one would expect, our claims were met with skepticism, since each of the firms that went before only spoke about assets and the ROA. We were told that asset consultants focus on the asset side because they are “tangible” and liabilities are not. REALLY? What is more tangible than a promise that has been made to a plan participant? Like assets, liabilities can be priced daily. They are bond-like in nature and are impacted by changes in the interest rate environment and benefit formula adjustments. The present value of future DB plan liabilities have grown substantially during the last 15 years, as US interest rates have plummeted.
What did plan sponsors do? They exacerbated the situation by creating a huge mismatch between their plan’s assets and liabilities by reducing exposure to traditional US fixed income. Why? The yield on US bonds declined to less than the ROA, and they argued (as did their consultants) that fixed income would become a drag on the portfolio’s return. Focusing on assets, and not liabilities, has had a devastating impact on the funded status of America’s DB plans (particularly multi-employer and public pensions).
As if that wasn’t enough, yesterday I spoke at the Opal Financial Groups “Investment Consultants Forum”. Notice that it wasn’t titled the “Investment and Liability Consultant Forum”. I spoke on asset allocation strategies with two others. Neither of my fellow panelists spoke about needing to understand the objective, and they certainly didn’t address a plan’s liabilities. In fact, one gentleman from a leading asset consulting firm talked about his firm using a model portfolio. Given that every client’s liabilities are different, how can there be such a thing as a model portfolio for a DB plan? This business never ceases to amaze me!
Pension America is in crisis due to the demise in the use DB plans. It will only get worse if we continue to support the notion that only the asset side of the pension equation is relevant. We better embrace a new approach before it is too late, as the same old, same old isn’t working and it won’t start now. There is nothing more tangible than a promise made. Not having the financial resources to meet that promise would be devastating for the participant.