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.

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.

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?

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.

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.

The WSJ published an article on Sunday that questions return assumptions by America’s pension plan sponsors and their consultants. The author, Jason Zweig, is particularly concerned given that U.S. stocks are currently at all-time highs.

Zweig references a study by professors Aleksandar Andonov of Erasmus University Rotterdam and Joshua Rauh of Stanford University who looked at expected returns among more than 230 public pension plans with more than $2.8 trillion in combined assets. The professors estimate that the average return on asset assumption (ROA) for these plans is 7.6%, which is roughly 4.8% above an inflation assumption. Almost 25% of these large plans still expect to generate a return in excess of 8%.

The study looks at the average pension plan’s investment profile by asset class.  The average plan has exposure to cash, bonds, both U.S. and international, U.S. and international stocks, real estate, hedge funds, private equity, and real assets (commodities). In order to achieve the 4.8% real return, plan sponsors were asked to forecast the returns that they would get over the long-term (10-30 years). The study reveals that plan sponsors expect to achieve a 3.2% return from cash, 4.9% from bonds, 8.7% from stocks, 6.9% from hedge funds, 7.7% from real assets, including real estate, and 10.3% from private equity.

Given that interest rates are substantially below the cash and bond expectations for future returns, a plan would have to make a dramatic switch into lower quality instruments in order to come close to those return targets.  Furthermore, corporate America has produced a roughly 6.3% annual growth in dividends and earnings for about the last 100 years, while the stock market has generated a 6.5% real return. How likely is it that stocks will achieve the forecasted 8.7% with valuations at these levels? Not likely.

As we’ve discussed in previous blogs, the U.S. pension game has morphed into a return seeking endeavor as opposed to the original mandate, which was one predicated on providing the promised benefits at the lowest cost. Pension plans can protect their funded status in this environment by adopting a bifurcated approach to asset allocation. By adopting this approach the pensino plan can reduce cost and volatility by cash flow matching near-term retired lives, while extending the investing horizon for the balance of the corpus, that now benefits from more time to capture the liquidity premium that exists in equities, real assets, private equity, etc.

Most U.S. defined benefit plans will not survive another major market crash.  The plans may be perpetual on paper, but that doesn’t mean that they are sustainable. Regrettably, we’ve already seen a move to alternative retirement structures among public pension sponsors, and that movement will only accelerate as contribution costs become a bigger share of a state’s or municipality’s annual budget.

DB plans need to be protected, but doing the same thing that has been done for the last 50 years is not the approach needed in this environment. Take the path less traveled, as you are less likely to get trampled when the rest of the plan sponsor community heads for the exits.

Yesterday the WSJ published an article highlighting the fact that several (they estimated roughly 12) corporations have announced plans to increase company matches into their 401(k) as a result of the benefits from the recent corporate tax changes. We are thrilled to read that this is occurring.

For many plan participants, the contributions into their 401(k)s from both themselves and their employer, are woefully inadequate.  We were surprised to see that many of the increases were going from 50% of the first 2-3% to perhaps 50% of the first 4%. This movement, although positive, is not earth-shattering. In order to ensure an adequately funded retirement program, the annual contributions should be in the 15% range. However, there are some companies, such as Visa, that do a great job with their benefits as they have announced that they will begin matching 200% of the first 5% that an employee contributes up from their current 200% on the first 3%. Now, that is significant!

We would prefer to read that these increases are permanent, but for many of the companies, it appears that this enhancement is a “bonus” payment for this year. On the other hand, we much prefer to see any additional employee compensation go into their retirement accounts instead of enhancing current take-home pay. It is ruly unfortunate that a majority of Americans are not prepared to fund a retirement, let alone a lengthy one.

One additional comment, we love the idea that SunTrust Banks is going to open accounts for the 8% of their workforce that has opted out of the company 401(k) with the aim to deposit the 1% bonus payment that they are planning to make for the 92% of their 24,000 employees who have opened 401(k) accounts at this time. Hopefully, this action will encourage that 8% to begin funding those accounts, even if it is just 1% of pay.

Roughly 12 companies is a start, but Corporate America is gaining a heck of a lot more from the tax law changes.  Let’s hope that their newfound windfall spurs on many other entities to engage in this positive corporate behavior.

As if this winter’s weather hasn’t been cold enough, the freeze announced by the corporate giant, Alcoa Inc., Pittsburgh, will surely chill its employees to the bone! Continuing a trend which began decades ago within the private sector, Alcoa announced Wednesday it will freeze its defined benefit plans for its U.S. and Canadian salaried employees, effective Jan. 1, 2021.

All salaried employees in the U.S. and Canada will cease accruing retirement benefits for future service under the current DB plans. It was announced that the roughly 800 affected employees will be moved to country-specific defined contribution plans.

In order to lessen the impact, Alcoa will contribute 3% of the affected participants’ eligible earnings to their DC plans in addition to its existing employer savings match.

Seniors seem to be getting whacked from all angles these days.  First, it was the reality for most that they would be retiring on Social Security alone, and now they are finding out that the long-term care insurance that they secured years ago may not be as secure as they thought, at least at the rate they thought that they were getting it. The WSJ published an article today regarding the state of the insurance market for long-term care in the U.S.

It appears that the industry is in deep trouble caused by financial turmoil that is causing angst among the roughly 7.3 million long-term policy owners.  According to the Journal, this cohort is equal to about 20% of the senior population (those over 65 years-old). Steep policy rate increases are forcing many to either pay up or pull out of the program.

At one time, there were about 100 firms selling long-term care policies.  Today that group numbers roughly 12, and many of them are not on steady footing.  In fact, GE has announced that it is taking a $9.6 billion charge that is mostly attributable to their long-term care business.  In addition, more than $10 billion in additional charges have been taken by insurance companies in this space since 2007.

Long-term care often costs more than $100,000 / year for an individual and it is estimated that long-term care was over $200 billion last year. Most individuals don’t have the resources to meet this expenditure, especially given the lack of a DB pension, anemic DC balances, and weak personal savings rates. A collapsing long-term care industry is just another sad event for many of our senior citizens.

This scenario just further solidifies for me the likelihood that we will have multiple generations living under the same roof sooner than later.

For a while now, we’ve speculated that the demise of traditional DB plans and the significant increase in student loan debt ($1.5T) would combine to adversely impact housing markets, as Seniors would not be able to remain in their homes, while those 18-30 would defer family unit creation and the purchase of their first homes. We believed that we could once again have a society with 3-4 generations living under one roof reminiscent of the late 1800s to early 1900s. The economic impact of that development could be startlingly negative.

Well, we just might be seeing this development materialize, and faster than we would have imagined. In an article published in Newsday, it was reported that Long Island’s housing costs are so high that four in 10 young adults live with relatives, and incredibly, seven in 10 say they’re likely to move to a less-expensive region within five years, a new survey shows.

Specifically, of Long Islanders 18 to 34 years old, 41 percent live with parents or other relatives, according to the survey to be released Wednesday by the Long Island Index, a project of the Rauch Foundation. These young adults are finding it difficult to find affordable housing and quality jobs that will permit them to stay in the region, and this is happening before the tax law changes take effect that will likely negatively impact long island’s real estate market.