From The Land Of Make Believe

Just where does the return on asset assumption (ROA) come from? Since plan sponsors, actuaries, and asset consultants live and die trying to achieve the ROA, and subsequently the DB pension plan, it must be derived through an incredibly elaborate evaluation of all the relevant data. At least you would think that, wouldn’t you?

At a recent conference, one of the KCS strategic partners asked an actuary how they derive the ROA. The actuary responded that they get it from the plan’s asset consultant.  Really? How then does the asset consultant get this number? Well, it seems that they make “assumptions” about future market returns, risks, and correlations based on previous results.  But, whether they believe that a 7% or 8% or 9% return is doable over some prescribed period have they looked at the liability side of the pension equation to determine if that is the correct number? No!

Plan sponsors will sometimes make adjustments to the ROA.  We’ve witnessed through the last 15 years a steady reduction in the ROA based on the belief that traditional asset classes would not provide enough return (beta or alpha) to generate an ROA-like return. However, in most cases, there has been a reluctance to move the ROA down substantially because of the impact that it has on contribution expense.

Because GASB allows public DB plans to discount liabilities at the ROA, there is a great reticence to lower the ROA, but would there be the same reluctance if the ROA only needed to be 5% in order to beat liability growth?  Probably not!  In fact, in a rising interest rate environment it is likely that liability growth could be negative.  The ROA certainly doesn’t need to be 7.5% in that environment.

GASB Statements No. 67, Financial Reporting for Pension Plans, and No. 68, Accounting and Financial Reporting for Pensions, which substantially improve the accounting and financial reporting of public employee pensions by state and local governments that apply U.S. Generally Accepted Accounting Principles (GAAP).

Statement 68 requires governments providing defined benefit pensions to recognize their long-term obligation for pension benefits as a liability for the first time, and to more comprehensively and comparably measure the annual costs of pension benefits. In order to meet this obligation, pension plan sponsors are expected to perform an asset exhaustion test on their plans.  It is through this analysis, and this analysis only, that a sponsor can truly understand what rate of return needs to be achieved in order to keep the plan functioning.

We would be willing to assist you in this effort. We think that you will be surprised to see what the output from this analysis will show.  Wouldn’t you like to know that the volatility associated with a traditional asset allocation can be substantially lowered in an environment where your objective is really 3%-5% because your assets (including contributions) are never exhausted?



A Pension System on the Brink of Collapse?

Zerohedge is reporting in an article titled,

“Dallas Police Pension On Verge Of Collapse As Record Number Of Cops Seek Full Withdrawals”

that the Dallas Police Pension system is possibly on the brink of failing.  As you will read in the article, it seems that the continuing pursuit of alternative investments in order to “beef up” returns has come back to haunt this particular plan, as it has so many.

Regrettably, the plan participants (benefit cuts?) and taxpayers (potentially huge tax bill) will once again suffer as a result of a continuing failure by plan sponsors and their consultants to focus on the correct objective, which is the plan’s liabilities and not the ROA!  We have already witnessed the incredible collapse of the traditional DB plan in the private sector.  Do we need anymore evidence that the continuing practices are failing these systems?

It is time to wake up to the fact that we are on the cusp of creating social and economic hardship for millions of pensioners.  I’ve seen enough!  Have you?

When China Sneezed…

It wasn’t that long ago that the world was fixated on every economic development in China, and when China Sneezed the world caught a cold.  Well, as usual, our focus on a subject seems to last for a month or two, and then we are onto something else.  Well, we might just want to refocus our attention on the Chinese property market.

KCS friend and supporter, Kieth Jurow, has once again shared information with us that we feel warrants sharing with you. It seems to him (and us) that the property markets in China are nearing a top, and the last blow-off wasn’t pretty.  Here is what he shared.

Chinese Consider Home Prices “High and Hard to Accept,” but Buying Frenzy Surges

Chinese Consider Home Prices “High and Hard to Accept,” but Buying Frenzy Surges

Thanks, again, Keith for keeping us informed about developments in global real estate.

Nature of Creativity

“The very nature of creativity is coming up with things that have never been tried before.”

If You Have A Consumer Driven Economy…

The U.S. economy is consumer driven! There is no arguing that fact, as nearly 70% of the U.S. economic output is driven by consumption.  Well, then, what happens to a consumer driven economy when its citizens don’t have the financial wherewithal to consume? It tanks! Get ready for some rocky times ahead, as our future retirees don’t have nearly the same spending power as the older Baby Boomers and previous generations have had.

The demise of the defined benefit plan will have a meaningful impact on U.S. economic growth.  Who says? We, at KCS do, but more importantly, the folks at the National Institute on Retirement Security (NIRS) do!  They have just released their latest study, which looks at the positive impact on spending from the roughly 24 million recipients of monthly pension checks from 2014. The results highlight the significant contribution to our economy from those receiving a pension benefit.  On the contrary, the loss of DB pensions being replaced by the underwhelming defined contribution account balances has the potential to depress economic activity.  Here are the NIRS findings:

The NIRS report, “Pensionomics 2016: Measuring the Economic Impact of Defined Benefit Pension Expenditures”, finds that economic gains attributable to defined benefit (DB) pensions in the U.S. are substantial. Retiree spending of pension benefits in 2014 generated $1.2 trillion in total economic output, supporting some 7.1 million jobs across the U.S. Pension spending also filled government coffers, with retirees paying a total of $190 billion in federal, state and local taxes on their pension benefits and spending 2014.

“Household spending drives the U.S. economy, accounting for more than two-thirds of U.S. economic output. In fact, American retirees’ pension spending supported one-tenth of such economic output nationwide,” said Diane Oakley, NIRS executive director. “So it’s clear that the growing number of retired Americans must have adequate income for consumer spending that continues to drive our economy.”

Pensionomics 2016 comes at a time when economists are predicting dramatic drops in economic growth in the coming decades. A recent McKinsey Global Institute study indicates that factors including an aging workforce and declines in population growth could reduce economic growth by one-third in the U.S. and 40 percent globally.

“A stable and secure pension benefit that won’t run out enables retirees to pay for their basic needs like housing, food, medicine and clothing. It’s good for the economy when retirees are self-sufficient and regularly spend their pension income. Retirees with inadequate 401(k) savings and fearful of running out of savings tend to hold back on spending. This reduced spending stunts economic growth, which already is predicted to drop by one-third as the U.S. population ages,” Oakley explained.

The study finds that in 2014:

Nearly $519.7 billion in pension benefits were paid to 24.3 million retired Americans including:
$253 billion paid to some 9.6 million retired employees of state and local governments and their beneficiaries (typically surviving spouses);
$78.8 billion paid to some 2.6 million federal government retirees and beneficiaries; and
$187.9 billion paid to some 12.1 million private sector retirees and beneficiaries.
Expenditures from these payments collectively supported:
7.1 million American jobs that paid $354.8 billion in labor income;
$1.2 trillion in total economic output nationwide;
$627.4 billion in value added (GDP); and
$189.7 billion in federal, state, and local tax revenue.
Pension expenditures have large multiplier effects: Each dollar paid out in pension benefits supported $2.21 in total economic output nationally.

The National Institute on Retirement Security is a non-profit, non-partisan organization established to contribute to informed policymaking by fostering a deep understanding of the value of retirement security to employees, employers, and the economy as a whole. Located in Washington, D.C., NIRS’ diverse membership includes financial services firms, employee benefit plans, trade associations, and other retirement service providers.

Are Things Slowing or Collapsing?

We are pleased to share with you the following article that was written by Keith Jurow, creator and author, Capital Preservation Real Estate Report. We’ve been very impressed with Keith’s many articles / reports, and we thought that you’d appreciate receiving his perspective, too.

“Fueled by institutional money and hot funds escaping from China, the US office market roared back – until the end of 2015. Now the hottest markets are showing signs of tanking and the smart money is getting out”, according to Jurow.

If Keith is correct in his assessment of the commercial real estate market, it further exacerbates a growing problem for plan sponsors and their asset consultants, who are struggling to find assets without significant over-valuations.  Given the current, and nearly impossible, challenge of cobbling together an asset allocation in pursuit of the ROA, we suggest that plan sponsors try a different approach.

Reach out to us if you ‘d like to hear how KCS can reduce your plan’s contribution volatility, while stabilizing the funded ratio.  Also, don’t hesitate to reach out to Keith with any of your real estate questions.  He’s an incredible resource.


It Is Time To Embrace Marked-to-Market Accounting For Liabilities

P&I reported in their September 6th edition that the Society of Actuaries and the American Academy of Actuaries Joint Task Force has challenged the practice of valuing liabilities at the ROA discount rate for public pension and Multi-employer plans. They, as do we, believe that liabilities should reflect economic reality, with the risk free rate (Treasuries) being used as the discount rate.

After much internal debate the Joint Task Force initially refused to release the draft report.  Fortunately, they changed their minds and recently released the paper.  It is being reported that NCPERS is trying to squash this movement.  It is truly unfortunate.

Given where the level of interest rates are at present, we believe that it is a great time to bite the bullet and mark plan liabilities at a true risk free rate.  Liabilities are bond-like, and they are likely not going to grow substantially from this level, and may in fact decline if the U.S. economy can generate a little growth and inflation that will lead to interest rates rising.  This may not occur in the immediate future, but it will happen eventually.

For more than 30 years, DB pensions have been under pressure from falling interest rates (liabilities have dramatically outperformed asset growth).  Regrettably, many, if not most, DB plans did not capture this great bull market for fixed income as plans anticipated that the lower bond yields would harm their ability to exceed the return on asset assumption (ROA). As everyone knows, bond values are not just determined by yield, and bonds, especially longer-dated issues, have provided outstanding returns during this period of falling rates.

Furthermore, pricing the liability at an inflated discount rate has artificially reduced annual contributions, while leading plans to take on much more risk in pursuit of the ROA through traditional asset allocation approaches. Given where equity and bond valuations are at present, it is highly unlikely that we are going to earn our way out of this underfunding.  We think that plans should initiate a different course in managing both assets and liabilities, and an honest accounting of the liabilities is a great place to start.

Just think what heroes plan sponsors and trustees will be when liability growth is negative in a rising rate environment and DB plans that were once assumed to be on their death bed are once again flourishing.  It won’t take heroic annual asset returns to close the funding gap in an environment in which liability growth is negative. Funded ratios could improve quite dramatically in this scenario. Your participants are counting on everyone to secure this incredibly important benefit.  The time is now to do something different!