What Is The True Objective?

The true objective for a defined benefit pension plan is to fund the liabilities (benefit payments) at stable and low contribution cost to the plan. Such an objective should be funded at reduced risk through time.  In order to accomplish this objective a plan sponsor and their ASSET consultant need to depart from the roller-coaster ride provided by pursuing the ROA. At KCS (an asset AND liability consultant) we focus first, and foremost, on the plan’s liabilities and funded ratio, which we use to drive the investment structure and asset allocation decisions.

Attached is an overview on the importance of having a custom liability index (CLI) measure your plan’s specific liabilities.  Let us know if we can build one for you.



Just Because You Can, Doesn’t Mean You Should!

I can’t tell you how many times I heard those words uttered by my mom when I was a youngster, and it usually pertained to my eating habits! For instance, did I really need to consume the whole quart of milk and the entire, newly-opened bag of cookies? Probably not, but invariably I did.  Well, if my mom understood what many (most) non-corporate DB plans were doing today, she’d chastise them, too, and with good reason.

Regrettably, GASB allows public pension DB plans to discount their plan liabilities at the ROA, and not at a “market rate” such as FASB (AA corporate) or the more conservative mark-to-market rate, such as US Treasury STRIPS.   As you’ve heard us mention on numerous occasions, liabilities and assets don’t have the same growth rate, so it makes no sense to discount liabilities at the ROA.  Why does this matter? It matters a heck of a lot, and it is leading to inappropriate asset allocation decisions that are being exacerbated in this market environment.

I attended the Tri-State Institutional Investor Forum today at the Harvard Club.  It was a well-attended conference, with very good presenters, but as usual, the singular focus was on the asset side of the DB equation.  In attendance were several representatives from a very large public pension plan from a state near and dear to my heart. Each of this state’s representatives mentioned that their fund had a 7.9% ROA. They also mentioned that they weren’t particularly focused on the liabilities given GASB’s ridiculous accounting methodology, and as a result they didn’t have much exposure to traditional fixed income, as the low yield environment would be a “drag” on performance, as if the only thing that mattered was the yield?

However, what they did do was to “equitize” their fixed income exposure by allocating to high yield, emerging market debt, preferred securities, and other more exotic alternative sources of fixed income exposure, betting that these securities would presumably benefit from rising equity markets.  Unfortunately, our equity markets are not cooperating, and instead of holding higher quality, more liquid fixed income (Treasuries) that have rallied significantly (the yield on the US 10-year has fallen by more than 50 bps so far in 2016), these equity alternatives are under significant pressure. UGH!

So, again, I ask, “just because GASB permits liabilities to be discounted at the ROA, should plan sponsors do this?  NO! Asset allocation decisions undertaken in an attempt to achieve a 7.9% ROA are accomplishing little in terms of generating return, but are certainly a breeding ground for volatility and uncertainty. Public pension plans should pay some heed to their liabilities.  They should use the current funded status to drive asset allocation decisions and not some generic ROA objective that has nothing to do with how liabilities actually perform. As a plan gets closer to full funding, the plan should de-risk, and not subject the entire corpus to unnecessary risk-taking.

Just like me when I was a kid, these plans need to pause before they continue to gorge unnecessarily! In the case of these DB plans they are choking on the risk associated with an asset allocation policy designed to achieve the ROA, with little likelihood of getting the benefit that they desire.

How Do you Know If You’ve Won?

Managing a pension plan is difficult!  Unfortunately, the task has been made more difficult by not having a complete picture of the plan’s true objective. What do I mean?

Well, as everyone knows, the big game is on Sunday, and much of the country will be glued to their seats watching Carolina and Denver play.  Just think what a different experience it would be if there was no scoreboard, and you didn’t know who was winning or losing. Can you imagine a team trying to run an offense without the knowledge as to whether they should become more aggressive (more passing) or conservative (3 yards and a cloud of dust)? How about a defense not knowing whether to blitz on every play or use 5-6 defensive backs to stop the big play?

Well, unfortunately for most of our plan sponsors this is what they experience all the time – at least 364 of 365 days (non leap years).  How is that possible? The most important piece of information that a plan sponsor can have is absent, missing, no where to be found! Plans only exist to meet a promise that has been made, yet that liability is only calculated once per year and usually received about 4 to 6 months in arrears.

Plans blindly manage asset allocation decisions versus a generic return on asset assumption (ROA), and I say generic because every liability stream is different, yet roughly 50% of public pensions use 7.5% as their objective.  How can that be?  Also, they assume that liabilities grow at the same rate as assets, but of course that isn’t correct. As we’ve seen during the last 15-16 years, liabilities have grown at nearly three times the rate as plan assets.  Wonder why we have a funding crisis?

By not knowing what the plan’s liabilities are it is impossible to adjust a plan’s asset allocation to reflect either improvement or deterioration in the funded ratio.  Plans experiencing improved funding should de-risk the portfolio (adopt that no hail Mary strategy), while plans struggling to improve funding might just need to get more aggressive.  Clearly, a one-size-fits-all ROA objective of 7.5% can’t be right.

The standard deviation associated with a combination of assets that might get you 7.5% in this environment is roughly 17.5%.  Are you comfortable living in an environment in which 68% of your annual observations ( 1 standard deviation) could have your plan up or down anywhere from 25% to – 10%? I don’t think so!  Yet that is exactly what is happening.

I encourage you to get greater clarity on your liabilities so that asset allocation and management structure decisions are based on fact and not some generic ROA that doesn’t have anything to do with liabilities. With greater clarity comes a more likely victory! Get a Custom Liability Index (CLI) so that you have a monthly view on your promised benefits.



KCS February 2016 Fireside Chat

We are pleased to share with you the latest article in the KCS Fireside Chat series. This article is titled “Greasing The Market Slide”.  We discuss what is currently happening within the Oil sector and what you should do as a DB plan sponsor and / or a DC participant.


As always, we hope that you find our insights helpful, and please don’t hesitate to reach out to us if we can be of any assistance to you.