What Could Be More Important Than Fighting For Retirements?

Starting KCS in August 2011 provided me with an opportunity to return to my consulting roots, but it also gave me so much more.  By not having to commute into NYC each day, which I’d done since I was 18, provided me with several hours a day to dedicate to other endeavors. One of those was joining Rotary. I had little knowledge of what it meant to be a Rotarian, but it proved to be so much more than I could have ever expected.

For those of you that don’t know anything about Rotary, it is the world’s largest service organization with more than 1.2 million members in roughly 200 countries. The organization’s motto is “Service Above Self”, and it quickly became apparent that my fellow Rotarians are guided by that call each and every day.

In addition to meeting wonderfully caring individuals all focused on doing “good”, I’ve been extremely fortunate to be engaged in amazing projects, both locally and abroad, that have had a profound impact on the beneficiaries (and me, too). I bring this to your attention because one such project has recently brought fresh clean water to the village of Awhum, Nigeria.

There are roughly 30,000 residents in Awhum, and none of them had access to clean water.  The villagers were forced to walk miles to get drinking water, and I’m not sure if it was actually clean water.  I, for one, take for granted the availability of clean water.

How does a group of mostly middle-class suburbanites from Wyckoff and Midland Park, NJ get involved in a project in Nigeria? Well, we were extremely fortunate to have Father Felix Uguozor as a visiting priest from Nigeria join one of the local parishes for the past couple of summers.  It was Father Felix that brought to our attention this critical need.

Through the cooperation of a Rotary Club in Nigeria, Rotary International, Father Felix, Brian Murray (local entrepreneur) and members of our club, we were able to raise sufficient funds to provide a 700 foot deep well that finally provided clean water to those in desperate need of some. Unfortunately, the digging of the well proved to be phase one, as the electrical grid proved unreliable, and the frequent outages meant that water could not be pumped to the surface.

Fortunately, were able to raise additional capital for a generator, which has recently been installed at the site of the well in Awhum. Here is a video of the villagers benefiting from access to clean water. There are just a few things that I feel trump my work in trying to preserve defined benefit plans for the masses.  Being a part of our local Rotary Club, and helping to provide clean water to a village halfway around the world is certainly one of them. I would encourage each of you to get to know Rotary.  It is an amazing organization doing incredible work throughout the globe. My involvement has profoundly impacted me, and I suspect it would have a similar impact on you.

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Fireside Chat Follow-up – Question # 2

Are liabilities interest rate sensitive?

YES, the present value of pension liabilities is extremely interest rate sensitive if you use market interest rates as discount rates. This is certainly true for private pensions under FASB (ASC 715) accounting regulations. Unfortunately, GASB allows for the return on asset assumption (ROA) to be used as the discount rate for Public pensions, which is not interest rate sensitive.

However, GASB 67/68 opened the door to market rates by bifurcating the discount rate such that the ROA is used until assets are exhausted, and then you must use a 20-year AA muni index yield. The Society of Actuaries (SOA), in their 2004 white paper “Understanding the Principles of Asset Liability Management”, made it clear that GASB accounting rules can distort economic reality and, as a result, assets cannot function effectively vs. liabilities.

A current trend among public pension systems is to reduce the ROA, which increases the present value of liabilities. Just imagine that a 15-year duration public pension liability reduced its ROA by 50 basis points,  from 8.0% to 7.50%, while market rates for AA corporates went up 50 basis points from 3.50% to 4.0%. The ROA method would show a liability growth of  15.5% leading to lower actuarial funded ratio and higher contributions. The AA corporate method would show a liability growth of – 4.0% enhancing the true economic funded status. Which one is right? The proper discount rate is the one that can settle the liabilities, one that you can buy to defease the liabilities. The ROA is not purchasable and should be removed as a discount rate by definition.

But, What About The Stock Market Gains?

Two troubling items crossed my desk this morning that conflict with the tremendous gains that we’ve been witnessing from the U.S. equity markets. Bankrate has once again conducted their survey on the financial health of the American family, and the picture hasn’t improved from when we first reported on this topic several years ago.

Unfortunately, 61% of Americans would not be able to pay a $1,000 emergency expense with savings. Most would have to rely on credit, family/friends, or a personal loan to meet this unexpected outlay.  This analysis mirrors another conducted by the U.S. Federal Reserve that indicated that 44% of Americans would not be able to meet a $400 emergency payment.

The other piece of information that is troubling is the fact that the U.S. savings rate has declined (2.4%) to the third lowest level in recorded history, and it is now back to 2005 levels. The U.S. economy is consumer-driven with roughly 70% of GDP coming from individual consumption. We do know that revolving credit has exceeded the all-time record (8/17), and it now stands at more than $1.1 trillion. The previous record was established in April 2008. Notice that both “records” cited above either correspond with or just precede the great financial crisis.

The wonderful stock market returns are not enjoyed by a good chunk of the American public, and these stellar results mask what is happening in the broader economy.  According to Gallop, only 52% of U.S. adults owned stock in 2016. This is the second-lowest reading since Gallup started measuring this in 1998. These figures include ownership of an individual stock, a stock mutual fund or a self-directed 401(k) or IRA.

The Transformation of the U.S. Labor Force

There is much discussion related to the impact of technology on the future of jobs in America, and rightly so, but the magnitude is still to be realized. What hasn’t been discussed to the extent that it should have been is what is transpiring right now.  The migration to a contingent workforce (aka independent contractors, freelancers, on-call, contract, temporary help, etc.) has escalated dramatically.

Since 2005, it is estimated that the contingent labor force has grown by more than 9 million, while the number of workers in traditional full-time arrangements has fallen by 400,000.  This information comes from the Study “The Rise and Nature of Alternative Work Arrangements in the United States, 1995-2015” was conducted by Lawrence F. Katz Harvard University and NBER and Alan B. Krueger Princeton University and NBER in March 2016.  This contingent labor force now represents about 16% of all jobs in the U.S.

What’s the issue? Sure, individuals get more flexibility, but with that “benefit” comes inconsistent hours, more modest wages and little ability to influence wage growth, more difficulty getting mortgates, healthcare insurance falls solely on the employee’s shoulders, and saving for retirement becomes nearly impossible, since we know that most workers only save through an employer-sponsored plan.

As we digest news today of the U.S. Q4’17 estimated GDP, remember that roughly 70% of this growth comes from personal consumption. If our workforce has less disposable income available to consume, GDP has to take a hit.  We already have millions of Americans in “retirement” that are participating to a far lesser extent in our economy, which is certainly not helping growth.

Why Transparency On Pension Liabilities?

Since the firm’s inception, we, at KCS, have been encouraging for a variety of reasons plan sponsors and their asset consultants to embrace greater transparency of the defined benefit plan’s liabilities.  We still believe that with a greater transparency plan sponsors will be able to engage in a more dynamic and responsive asset allocation to changes in the plan’s funded status.

If plan sponsors don’t see the need for this improved insight, U.S. State Treasurers certainly should embrace this movement. Why? Moody’s Investment Service has recently modified their accounting methodology for measuring plan liabilities.  According to Moody’s in a December 2017 update, the most recent modifications replace the “Adjustments to US State and Local Government Reported Pensions Data methodology published in April 2013

Moody’s has updated the description of their standard balance sheet adjustment and included a description of the standard income statement adjustment. According to Moody’s, “both of these reflect the implementation of Governmental Accounting Standards Board Statement 68 accounting standards, which requires adjustments that were not previously necessary.”

What is the problem that they are trying to solve?

Under GASB standards, public pension plans with the same benefit obligations and similar asset values may report very different unfunded pension liabilities due to differences in assumed rates of investment return. Issuers may have incentives to use overly optimistic assumed rates of return, which have the effect of understating the unfunded pension liability.
Under governmental actuarial funding and accounting rules, discount rates are largely based on the plans’ assumed rates of investment return on assets. Governmental accounting standards set the reported single equivalent discount rate equal to a given plan’s assumed rate of investment return unless the plan projects that it will deplete its assets. Plans that project asset depletion apply their assumed rate of investment return as a discount rate to projected benefit cash flows up until projected asset depletion, and apply a municipal bond index to projected benefit cash flows thereafter. For these plans, the single equivalent discount rate represents a blend of their assumed rate of investment return and a municipal bond index.
Under these rules, public pension plans with the same benefit obligations and similar asset values may report different unfunded pension liabilities solely due to differences in assumed rates of investment return. Since assumed rates of investment return are linked to pension fund portfolio asset composition, plan funded status can improve under GASB accounting rules solely due to greater asset risk-taking.
Moody’s is using the net adjusted pension liability in their modeling of credit ratings for states and municipalities.  Using an inflated return on asset assumption will undervalue the pension plan’s future obligations, which might just impact the governing body’s credit rating. What state Treasury wants to see a credit rating down-grade under their watch. Don’t think it can happen? New Jersey has been impacted by multiple downgrades, and it currently lives with an A3 rating by Moody’s (July 2017).
“AAA is the best you can get, and here in Utah we won’t settle for anything less,” Governor Gary Herbert said in his January 2016 State of the State address. He later added in an interview with Pew, “It may not mean much to the average citizen, but it does have an impact on their wallet.” The higher a state’s credit rating, the lower the cost to repay its bonds.

 

KCS Fireside Chat follow-up – Question #1

As Promised, we will be posting answers to the questions that we posed in our most recent Fireside Chat, “Your Liability-Aware Cheat Sheet” during the next couple of weeks. Let’s begin:

  • Is the primary pension objective an absolute return (ROA) or a relative return (liability growth) goal?
  • Furthermore, is the ROA a calculated number?

The objective of a pension plan is not to generate the highest return, but to secure the promised pension benefit payments in a cost-efficient and prudent risk manner. When defined benefit plans first started, the current assets plus contributions were used to cash-flow match the plan’s benefit payments (i.e. liabilities).  It wasn’t until the development of the asset consulting industry in the late 1960s and early 1970s did pension plans migrate to a return orientation from one focused on funding cost.  Striving for a greater annual return ensures greater volatility of returns, but doesn’t ensure funding success, especially in an environment of stretched valuations for both equities and bonds.

What may come as a surprise to many in our industry is the fact that the return on asset assumption (ROA) is not a calculated number. The ROA is a discount rate for the plan’s liabilities and it determines the level of annual contributions that are required. Hitting the ROA objective does not guarantee funding success. A simple example proves the point. If you had assets of $60 and liabilities of $100 with an ROA of 7.50%, then don’t the assets need an ROA of 12.5% to earn $7.50, not the actuarial ROA of 7.50%! Performing an Asset Exhaustion test (an analysis of a plan’s solvency under GASB 67/68) will calculate the actual return needed to be generated by the fund that ensures that the fund’s assets will never be exhausted based on the contributions being forecast and will fully fund the benefits promised until the last participant has passed away.

 

KCS Fireside Chat – January 2018

We are pleased to share with you the latest edition of the KCS Fireside Chat series. This article, titled, “Your Liability-Aware Cheat Sheet”, encourages plan sponsors/trustees to have more on-going conversations regarding their plans specific liabilities.  We share with our readership some questions that we think will help start the conversation.

For the last 6+ years, we’ve discussed the importance of becoming more liability-aware, believing that with this greater awareness, plan sponsors can engage in a more dynamic and responsive asset allocation that responds to changes in the plan’s funded status.

During the next couple of weeks, we will be providing answers to the questions that we’ve proposed, so please check back to the blog.

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