Not Likely To See that Rate Bump Soon

Many DB plans are sitting with a fairly modest exposure to fixed income, as sponsors and consultants anticipate higher interest rates.  Unfortunately, the current economic environment isn’t cooperating with that thought process and asset allocation decision. Despite the Fed’s action in December to raise the discount rate by 25 bps, it doesn’t appear that there will be any follow through in the coming months.

Unfortunately, S&P 500 earnings are the weakest they have been since the great financial crisis, marking three consecutive quarters of negative earnings.  Couple this news with the fact that consumer sentiment has fallen and that home ownership is at a 48 year low, where is the catalyst for economic expansion and inflation, which would provide the thrust necessary to see rates lift off?

Furthermore, a significant percentage of global bonds are currently trading with negative real yields, making the US rate environment very attractive on a relative basis.  As such, both the fundamental and technical factors support rates remaining at or below these levels.  Neither scenario is good for pension liabilities, which change in value based on current interest rates (no they don’t grow at the ROA!).

DB plans should initiate a de-risking approach where current fixed income exposure is used to meet near-term retired lives, thus mitigating interest rate sensitivity, while enhancing liquidity and extending the investing horizon for the balance of the fund’s assets. Managing a DB plan is about providing the promised benefit at the lowest cost. Continuing to use the ROA as the primary objective injects too much risk / volatility into the asset allocation process.

KCS Quarterly for Q1’16

We are pleased to share with you the KCS quarterly for Q1’16.  As you will read, DB pension liabilities continue to outperform assets, exacerbating a trend that has lasted for more than 15 years. As a result, funded ratios continue to deteriorate. Also, learn what is new at KCS and read what our senior team has been doing during the quarter.

We hope that you find our insights helpful.  Please don’t hesitate to call on us if we can be of any assistance to you.


Hey Clara, “Where’s The Beef?”

Several large public pension funds have recently implemented a plan to or are in the process of reducing / eliminating their exposure to hedge funds.  Numerous reasons have been cited for this action, including size of the plan’s allocation, complexity, lack of internal resources, but given the less than stellar results achieved from within the hedge fund space, I can’t say that we are shocked by this action despite a good bit of challenge from many within the retirement industry.

As for the performance, for the 10 years ending March 31, 2016 the HFRI Composite Index has a +3.4% annualized return, while the S&P 500 (+7.0%) and the Barclays Aggregate Index (+4.9%) have beaten it handily.  The fact that the 10-year period encompasses all of the Great Financial Crisis (GFC) when hedge funds should have provided significant down-side protection speaks to the failure of many hedge funds to do what was expected of them. Fees of 2% and 20% or more is a hefty price to pay for perceived risk reduction because you are clearly not getting benefit from exposure to HFs on the return side of the equation.


For the record, we at KCS have been discussing for some time now the misalignment of plan assets and plan liabilities within DB funds.  Anyone who knows us has heard us speak about the importance of making sure that the correct bogey (plan liabilities and not the ROA) is being used.  DB plans have a relative objective, and not an absolute one.  Endowments and Foundations, as well as HNW individuals, have an absolute objective (positive spending policy), and the use of hedge funds in this space is perfectly reasonable, if you can select those that provide appropriate risk / return characteristics after fees.

Of course there are excellent hedge funds just as there are terrific managers of long-only equities, fixed income, real estate, etc. Unfortunately, our industry has a tendency to overwhelm the better investment firms / products with positive asset flows until the ability to add value has been arbitraged away.

DB plans don’t need expensive hedge funds in order to close their funding gaps.  They need to only outperform liability growth in order to accomplish that objective, and cheap beta strategies are more than capable of providing that excess return.  If we finally begin to see positive economic growth, here and abroad, a bit of inflation, and gradually rising interest rates, we could see asset growth easily exceed liability growth, which might actually be negative in that environment.

The last 15+ years have not been kind to plan sponsors and their DB plans. A return to the basics is what is needed at this time. We need to get refocused before it is too late.  Too many employees, both private and public, are losing the opportunity to participate in a traditional DB plan. The alternatives are just not cutting it, and the social and economic consequences may be grave!

The ROA Isn’t The Holy Grail!

Asset consultants and plan sponsors of DB pension plans continue to pursue the return on asset assumption (ROA) as if it were the Holy Grail!  Believe me, it is not! In fact, if one ever believed that achieving the ROA automatically brings funding success, the following statistics will debunk that thought, and quickly!

The following information is from the Public Employee Retirement Administration Commission (PERAC) website. PERAC was created for and is dedicated to the oversight, guidance, monitoring, and regulation of the Massachusetts Public Pension Systems. The professional, prudent, and efficient administration of these systems is the public trust of PERAC and each of the 104 public pension systems for the mutual benefit of the public employees, public employers, and citizens of Massachusetts.  A very admirable objective!

To PERAC’s credit, they annually publish a summary of performance results and the Funded Ratio for each of the 104 plans for which they have oversight.  As we’ve highlighted before, the “average” ROA objective for public funds nationally is about 7.5%.  According to the most recent performance report from PERAC covering periods through June 30, 2014 all 104 public entities achieved a 30-year return that exceeded the 7.5% average objective. Amazingly, only 6.7% of the funds failed to achieve a >8% return for 30 years! In fact, 45% of the plans generated a return for 30 years that eclipsed 9% – truly outstanding.

Since the ROA is the objective for most sponsors and consultants, and given the fact that most MA public plans have far exceeded that objective, it must be safe to assume that these plans are currently fully funded. WRONG! Despite the fact that 100% of the plans have exceeded the average ROA not one plan (0%) have a Funded Ratio above 100%.  How can that be?  In fact, only one plan had a Funded Ratio that exceeded 90%. It gets worse, as 81 of 104 plans have Funded Ratios that fall below 70%, with Springfield achieving a woeful 27% Funded Ratio despite generating a 30 year return of 8.53%!

Well, if beating your return objective doesn’t assure funding success, what does? DB plans will achieve success only when they outperform their liabilities. As a reminder, the plans only exist to fund a promise that has been made.  It doesn’t matter how well the assets perform as long as they exceed liability growth. Given the numbers cited above, clearly plan LIABILITIES do not grow at the ROA, and they have had a growth rate that has far exceeded the growth in assets.

Unfortunately, results for most of these plans in 2015 and 2016 will reveal underperformance to both the ROA objective and liability growth, as asset performance has been modest at best, while declining interest rates continue to inflate liabilities. If PERAC was created for and is dedicated to the oversight, guidance, monitoring, and regulation of the Massachusetts Public Pension Systems, then I would suggest that PERAC insist that a new approach be taken by the sponsors of these plans because what is being done currently is not working.

We need to preserve DB plans, but we are afraid that they will continue to come under greater public scrutiny as contribution costs escalate, while Funded Ratios plummet. That isn’t a formula for long-term success.  Liabilities need to be monitored more frequently, and the output from that exercise (review) should be used to drive the plan’s investment structure and asset allocation decisions. I would definitely describe myself as being stubborn, but even I would seek an alternate approach if what I’d been doing for 30 years failed to achieve my ultimate objective – full funding!


Lack of U.S. Growth Hurting DB Plans

The Atlanta Fed with the highly-tracked GDP estimator, slashed its Q1’16 GDP estimate to 0.1%. As a reminder, this number was as high as 2.7% two months ago – ouch!

The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.1 percent as April 8, down from 0.4 percent on April 5. The negative adjustment followed the wholesale trade report from the U.S. Bureau of the Census, the forecast for the contribution of inventory investment to first-quarter real GDP growth fell from –0.4 percentage points to –0.7 percentage points.

The U.S. economy’s on-going struggle to generate consistent and meaningful growth continues to negatively impact U.S. defined benefit plans (DB).  How? Actually the impact is felt in several ways, and it touches both assets and liabilities.  The lack of demand for goods and services is impacting the earnings and profits for corporate America, and it is highly anticipated that S&P 500 earnings will be negative for the third consecutive quarter. As we enter earnings season, it will be quite interesting to see how this unfolds.

Despite the tremendous rebound in equity prices that followed a deep sell-off earlier this year, stock prices do reflect growth in earnings and dividends over time.  A continuing struggle to generate earnings will eventually weigh heavily on stock price performance.

With regard to liabilities, they reflect changes in the interest rate environment, as they are bond-like in nature.  As a reminder, they DON’T grow at the ROA.  As plan sponsors and asset consultants continue to underweight fixed income for fear of rising rates (how long now?), assets and liabilities are heavily mismatched.  With U.S. GDP growth remaining quite low, it is highly likely that the Federal Reserve will work to keep rates low.

Even if we were to see a modest increase in the discount rate at some point this year, it is highly unlikely that longer dated US bonds would see an increase in their yields with the trillions of $s in negative real interest rates trading globally.  U.S. long bonds are quite attractive on a relative basis, and they are likely to generate tremendous interest as Japan and European central banks continue to drive rates lower.

2016 is once again shaping up to be a poor year for DB pension funded ratios and funded status following the difficult 2014 and 2015 years.  Isn’t it time to try something new? Stop focusing on the ROA and all the associated volatility, and begin to de-risk your plan through a strategy that focuses on your plan’s liabilities.  The only thing going up in this environment are contribution costs, and most plan’s can’t afford that reality!

Why I Prefer DB Plans To DC Offerings

Offering a retirement plan, whether DB or DC, is neither trivial nor inexpensive!  Thank you to the sponsors of these plans who are looking out for their employees (and our society)!  Unfortunately, a wide swath of the US population (mostly those in small companies) don’t have access to a retirement vehicle of any kind.

Since the founding of KCS, I have been an outspoken critic of what is transpiring in the US with regard to the retirement industry.  I much prefer DB plans to DC plans, but as most know, the DB plan is nearly extinct in the private sector, while public and Taft-Hartley plans continue to maintain their offerings, but are struggling in many cases to adequately fund them.

Why do I favor DB relative to DC? First, in many cases the employer is making the contribution or certainly the yeoman’s share of the contribution. Second, these plans are professionally managed.  Since we don’t do a great job of providing our students with adequate financial literacy, why should we expect them to manage these plans effectively? Third, the cost of administering / managing a DB plan is lower than that of a DC plan, although DC costs have come down.  Importantly, DB plans insulate the participant from market shocks that might alter one’s ability to retire with a DC balance and not a monthly check, if that balance has seen significant market losses (2007-2009).

In addition, DC plans have features that just don’t support the average participant.  If DC plans were truly retirement vehicles we wouldn’t allow loan features.  We would eliminate premature withdrawals when employees move from one job to the next.  Finally, we would insist that every 401(k) / 403(b) provide annuity features to minimize the use of lump sum distributions that come with significant management responsibility in retirement.

DC plans were initially used as supplemental savings plans for high income earners, and they are well suited for that use, but they are not retirement plans! I have never been a participant in a DB plan. Boy, do I wish that I had been.  I have only participated in DC plans since the early 1980s. Fortunately, as an investment professional for the last 35 years I have been able to handle this responsibility, but we are asking too much from those that haven’t spent their careers in the investment industry.

I know that many participants like the portability that comes with investing in a DC plan, but regrettably about 50% of the premature withdrawals from DC plans are related to movements among jobs in which the participant fails to rollover their balance.

We can do better as an industry, and we must! We are on the verge of having a significant percentage of our population retire without the means to remain participants in our economy.  The economic and social consequences of this development are potentially quite grave. We must do a better job of preserving DB plans for the masses in both the private and public sector.  This can happen, but they need new thinking with regard to how they are managed. The time has come!!


KCS April 2016 Fireside Chat

We are pleased to share with you the latest edition in the KCS Fireside Chat series.  This article titled, “Your ROA Won’t Be Impaired!”, reflects our thoughts on a new game plan for DB plan sponsors.

We remain concerned about the long-term viability of traditional defined benefit plans, and feel that it is increasingly necessary for sponsors to adopt a new strategy for managing them before they are permanently impaired. We hope that you find our insights helpful. As usual, please don’t hesitate to call on us if we can be of any assistance to you.