Have We Stolen Future Return?

We hope that you had a wonderful Memorial Day weekend with family and friends, while remembering all those that gave the ultimate sacrifice to preserve and protect our freedoms.

It was during this past weekend that a couple of industry colleagues passed along a very interesting article written by John Hussman, who is one of the best financial analysts in the nation. Here is a link to his latest piece on the looming disaster of pension funds and what caused it:


John has a very interesting take on the ZIRP enacted by the U.S. Federal Reserve, and its potential impact on defined benefit pension plans.  John posits that equity and bond returns have been dramatically altered and accelerated due to near zero interest rates. As a result, we are paying much more now for the higher valuations that have occurred, which will lead to much lower returns during the next 10-12 years.

Furthermore, the “artificially” higher equity and bond returns in the most recent past (last 7 years) have kept pension contributions lower than they should have been under more normal returns.  As a result, pension plans (particularly public and Taft-Hartley plans) will incur greater funding risk in the coming decade when returns are low and the contribution expense escalates.

We can see John’s point, especially if we can’t get GASB moving closer to FASB  / IASB in marking-to-market pension liabilities.

In a WSJ article today “Pension Funds Pile on Risk Just to Get a Reasonable Return”, Christopher Ailman, CIO, California State Teachers Retirement System, laments the difficulty of building an asset allocation framework in this environment that will generate a return close to the funds 7.5% ROA.  Well, if we can’t get the return in this environment, just imagine how difficult it will be if John Hussman is proven correct!

Pushing Against A String?

I received in my email inbox the following update yesterday.

(Zerohedge) When Goldman warned on Friday that a “big drop” in the market is possible before the S&P hits the firm’s year end price target of 2,100, one of the bearish reasons brought up by the firm’s chief strategist David Kostin is that stocks are now massively overvalued. In fact, according to Goldman , while the aggregate market is more overvalued than 86% of all recorded instances, the median stock has never been more overvalued, i.e., it is in the 100% valuation percentile, according to some key metrics such as Price-to-Earnings growth and EV/sales.

This is what Goldman said:

Valuation is a necessary starting point of any drawdown risk analysis. At 16.7x the forward P/E multiple of the S&P 500 index ranks in the 86th percentile relative to the last 40 years. Most other metrics paint a similar picture of extended valuation. The median stock in the index trades at the 99th percentile of historical valuation on most metrics (see Exhibit 3).

Why is this important? Given that most public retirement systems and Taft-Hartley DB plans have dramatically reduced fixed income exposure during the last 15 years, while increasing equity and alternative exposure, an overvalued market such as the one described above could potentially set up these plans for dramatic underperformance relative to both the plan’s liabilities and the stated ROA.

With Funded Ratios low and falling, and the plan’s poor Funded Status large and growing, DB plans cannot afford (nor can the entities that fund them) to suffer out-sized losses. We believe that plans should undertake to transition a percentage of their portfolio to meet near-term benefit payments, which will improve liquidity, transform interest rate sensitive fixed income portfolios to more of a risk reducing tool, and importantly, extend the investing horizon for the riskier assets in the portfolio to weather stormy markets. Now is the time to begin to act and not after the red ink from the equity market losses has dried.

Seems A Little One-sided – Don’t You Think?

I happened across a P&I survey in a Tweet today. The survey was focused on state pension plan’s and future costs.  Here is the question and the potential answers:

What is the best change states have made to reduce future pension costs?

  • Raising age and tenure requirements
  • Change to a DC plan
  • Shrinking or stopping cost-of-living increases
  • Increasing employee contributions
  • Trimming salary calculation formulas

Most, if not all, state plans have enacted several changes during the last 6-7 years to try to reduce their plan’s liability, and many of those changes are part of the suggested answers above.  However, we continue to believe that the best approach to improving funding (reducing costs) is to manage the plans with a focus on that fund’s liability and not the return on assets assumption (ROA), which has been the singular focus for decades.

Regrettably, the potential responses cited above are all directed at the beneficiary (plan participant). Is that fair?  Remember, the benefits paid on a monthly basis provide excellent economic stimulus to the local economy.  With the demise in the use of DB plans in the private sector and the transferring of the pension liability from the sponsor to the individuals (DC plans), we are jeopardizing future economic activity.  Our economy is already struggling with <2.5% annual GDP growth. Any further reduction in the demand for goods and services could be severely damaging.

I think that P&I does a wonderful job of elevating and reporting on the critical issues for our industry.  In fact, I just spent 90 minutes at their office early this week discussing many of the issues plaguing our retirement system.  They get it! However, I think that the survey posted above should have included at least one item that focused on re-thinking the day-to-day management of DB plans, and not just the whittling of benefits or the escalation of employee contribution costs.

If you asked me how I would vote above, I would say definitely don’t move employees into a DC plan, as they were never intended to be anyone’s primary retirement vehicle, and they’ve proven to be ineffective as such. Many employees are already paying a significant chunk into the system, so that wouldn’t be my choice either, unless there exists a plan that doesn’t receive any contribution on the part of the employee.  Raising age and tenure may be doable for some employees, but there are a number of occupations where one is just not physically able to perform the task well into their 60s.

I would support the shrinking of cost of living adjustments if the plan is below a certain funded ratio / status – perhaps 80% funded.  Also, DB plans were once considered part of the overall retirement plan (along with personal savings, social security, home equity, etc.), and as such they were meant to replace a certain % of the employee’s compensation – not all of it!  We should get back to basing the benefit on an employee’s salary or lifetime average earnings, and not include elements such as vacation and sick pay, and over-time, when that liability hasn’t been known and couldn’t have been managed by the fund’s actuary.

Lastly, and before doing any of those possible strategies above, I would try to get plans to gain greater knowledge of the liabilities, build an asset allocation and investment structure that reflects those liabilities, and make sure that my asset allocation decisions are dynamic and responsive to changes in the funded ratio. This approach sets the plan on a derisking path that should stabilize contribution costs and begin to move the plan toward, and then beyond, full funding.

KCS Fireside Chat – May 2016

We are pleased to share with you the latest article in the KCS Fireside Chat series.  This article is our 46th in the series, and it deals with one of the most pressing subjects for DB pension plans.  As you will read, DB plans continue to singularly focus on the ROA as their fund’s primary objective.  Unfortunately, and despite meaningful outperformance, beating the ROA does not insure a well-funded plan. Just look at the 104 Massachusetts public funds.


In this article we discuss the need for sponsors and their consultants to focus more on a plan’s specific liabilities to drive investment structure and asset allocation decisions.  Are you ready to explore a different path to success?  Call on us to help you find your way.


RFI for Bank Loans

We, at KCS, will likely be doing a search in the next three months for a bank loan manager, and possibly more than one.  If you would like for your firm to be considered for this assignment, please send us an overview of your capability to handle a bank loan mandate of size (mandate likely >$50 million).  We would appreciate brevity as this is the first step in putting together a working universe.  Please provide information on the team, philosophy, process, performance and fees, but most import, please share with us how you are different from your competitors. Thank you!