P&I recently published a chart using data from that National Association of State Retirement Administrators (NASRA), which highlighted the fact that the once the holy grail 8% return on asset (ROA) target had moved from that level in 2001 to somewhere between 7.25% and 7.5%.  Although a full 50% of those using 8% in 2001 were still anchored there today.

We believe the data, but continue to shake our head at the foolishness of the ROA objective.  How is it that all these state plans, with a few exceptions, have a return objective that falls within 50-75 basis points of one another, especially when one considers the differences in current funding, contribution policies, workforces, economic environments, benefit structures, COLAs, etc.

As we’ve mentioned, if two plans have the same 7.5% objective they are likely going to have an asset allocation that is similar. But, does that make sense if one plan is 90% funded and the other one is 50% funded? Hell no! Given this example, one of these plans has an asset allocation that is either way to conservative or aggressive. The funded status and contribution policies should dictate asset allocation and investment structure – NOT the ROA.

A DB Plan should use cash flow (contributions) to meet benefit payments, where possible.  Why subject this important asset to the whims of the market? DB plans should also de-risk where possible.  The liability is known (promise made).  What isn’t known is how the markets will behave.  There are no guarantees, even with the benefit of time.  I suspect that most plan sponsors and their consultants would have assumed that the 8% was achievable over a 20 year horizon, but even the S&P 500 (7.7%) and the Russell 2000 (7.9%) failed to meet that objective for the 20 years ending October 31, 2016, and DB asset allocations aren’t only in equities.

It may be too much to ask of plan sponsors to completely flip the ROA switch off, but a portion of the assets should be se-risked in order to meet near-term obligations should the markets fall significantly from these levels.  Call us, we can help guide you on how to become more liability aware.

Regular readers of the KCS Fireside Chat series will know that 3-4 times per year we dedicate this monthly series to issues related to the defined contribution space, and November just happens to be one of those months.  Here is the link:

Click to access KCSFCNov16.pdf

In this article, Dave Murray, KCS’s DC Practice Leader, addresses such diverse topics as the IRS contribution levels for 2017, the DOL Fiduciary Rule, and a recent spate of lawsuits targeting small (not smaller) defined contribution sponsors.  DC lawsuits had once been relegated to the big corporate sponsors, but successful litigation at these firms has lead enterprising lawyers to pursue similar cases against much smaller sponsors.

Plan sponsors who felt that freezing and / or terminating their DB plan significantly reduced their fiduciary responsibility / liability are finding that they were kidding themselves.  Given that most private sector employees are in defined contribution plans, if they are in a retirement plan at all.  The DOL and IRS are getting much more aggressive in conducting audits of these plans.  We would be happy to provide you with a fiduciary review of your activities in order to make sure that you and your plan are prepared should you be contacted about an audit.

The following article appeared in the WSJ yesterday.

Slowdown in state, local investment in roads, other infrastructure dents U.S. economy
http://on.wsj.com/2eS7sKD

We are not surprised by this news, and would be shocked if you are, too, especially given growing claims on budgets to meet contributions for healthcare and pensions. Despite this growing claim on tax revenues, we believe that DB pensions must be preserved, not only for public workers, but for the private sector, too.

Can you imagine a future economy in which the only source of revenue for a significant percentage of its residents is Social Security?  We can, and the social and economic consequences from that happening will be grave. So, what needs to be done? First, DB plans need to begin to derisk.  A sponsor might ask “even if they are poorly funded?” Absolutely! As we’ve discussed on many occasions, managing a pension plan shouldn’t be about achieving the ROA, but about providing the promised benefit at the lowest risk and cost possible. Trying to achieve a 7.5% ROA in this environment is proving very problematic. Plans are getting much more risk, but not the commensurate reward.

These plans must begin to stabilize their funded ratios and contribution expense. It is through this enhanced discipline that municipalities and states will be able to more appropriately meet these liabilities, while providing the necessary resources to invest in their community’s infrastructure needs.  However, a new approach to the management of DB plans will need to be undertaken if they are to reduce funding volatility. The same old, same old is just not cutting it!

For regular readers of the KCS blog this is obviously not a subject that I often write or report about, but it is an area that I am passionate about as I’ve served on the WBMH Board and Foundation Board for the last 15-16 years.  As most of you probably don’t know, New Jersey is moving to a new funding system for mental healthcare organizations that will potentially hurt many of the neediest recipients of mental health services.

A fellow Rotarian of mine, Andrew Garlick, has written a blog post on this subject, which I share with you: please take a moment and read about it here: https://t.co/NoTyGQ9EJh

Ironically, I participated in a finance committee meeting at WBMH last evening, which touched on this very subject. It is frightening to me, and I’m sure to many others, that many mental health services that we take for granted may not be offered in the future, as fee reimbursement rates don’t cover the costs to provide those services.

The transition to the new funding mechanism occurs on July 1, 2017. As Andy is encouraging, we need to get our legislators to rethink this transition before it is too late. Your help is needed – thank you!

As we’ve discussed on many occasions, the purpose of a DB plan is to meet a promise (liability) that has been made to a plan participant.  Furthermore, this benefit should be provided at the lowest cost possible.  However, in order to do that plans need to stop focusing on the return on asset assumption (ROA) as the fund’s primary objective.  It isn’t!

We, at KCS, believe that DB plans, whether private or public, need to enhance their current actuary / generalist consultant model with a Liability Aware consultant.  The following link highlights the role that we are referencing.

Click to access KCSLiabilityAwareConsultant.pdf

In this role, KCS interfaces with both the actuary and the generalist consultant. We will help determine the appropriate ROA (it shouldn’t be a Goldilocks number) and advise on an asset allocation that reflects the funded status of the plan.  Plan’s should de-risk, especially as their funded status improves.

The current approach of focusing on the ROA has not improved funding, but it has increased cost, as the significant increase in the use of alternatives has been done in an attempt to jump-start returns.  That hasn’t worked!  Let us share with you how we can reduce cost, improve funding, and begin to de-risk your plan.  It is an approach whose time has come.

Click to access KCS3Q16.pdf

Attached for your review is the KCS Third Quarter Update. As you will note, we have been busy during the last few months, and the next three are nearly as packed. We thank you for your continuing support, and many others in our industry who have provided us with a forum to express our unique insights, as we attempt to alter the conversation regarding the day to day management of defined benefit and defined contribution plans.

We continue to believe in our firm’s mission, as we fear the adverse consequences of a failing retirement system. The statistics that are highlighted reveal a consistently ugly story, as fewer and fewer retirement participants are in a position to retire. In fact, only 1 in 7 contributors to a DC plan (only about 50% of the population actually fund a DC plan) are contributing enough to replace an appropriate portion of their current income.

Please don’t hesitate to call on us if you’d like to learn more about our approaches to working with DB, DC, E&F and HNW individuals. With a combined 191 years of relevant experience, we believe that our team can assist you and your team to navigate through these difficult challenges. But despite the choppy seas, they must be navigated.

Come on, folks. Let’s stop the silliness right now.  I can’t tell you how many times in recent weeks I’ve read about the demise of active managers versus passive offerings, but I can tell you that it has been too many times.  This discussion of passive versus active has been around since the creation of passive indexes, and it will remain a topic of conversation for a long time to come.

The KCS team has addressed this issue in prior blog posts, but given the recent fervor, we felt that it was necessary to discuss this topic again.  There are cycles throughout the capital markets, and it is no different for active equity managers versus their passive equity benchmarks.

There are portfolio biases that favor passive versus active and vice versus. Active managers tend to do better when small capitalization stocks and value-oriented stocks / sectors are in favor.  In addition, active managers tend to do better when markets are falling, as they often have cash reserves that help support portfolio performance.  These are portfolio construction issues given that most active managers build equal weighted portfolios, and have stock selection criteria that screens for value (price to something).

Passive portfolios, particularly larger cap indexes, benefit from momentum, rising markets, and large capitalization leadership.  These are the areas that have most recently been in favor (last 3 years), and so it isn’t surprising that active managers would be struggling in this environment.  Does this mean that something has changed that will always create this opportunity for passive investing?  Hell no!

There are certain segments of our capital markets that are more difficult to add substantial value add, but given the cycles in the markets there will always be opportunities.  We suggest that plan sponsors use both active and passive strategies to achieve their desired equity exposure and tilt to one versus the other when portfolio construction biases make sense to do so.

In addition, be careful what you pay in fees, and consider using performance fees to insure that you are only paying for value-added strategies.  Also, assets under management are an important consideration, too.  There are too many asset gatherers that have built asset bases that far exceed their product’s natural capacity to add value. Small can be a beautiful thing!

via Daily Prompt: Urgent

It was reported today that only 1 in 7 contributors to defined contribution plans (401(k) and 403(b)) are contributing enough to sustain a reasonable standard of living in retirement.  This is compounded by the fact that only about half of our labor force is participating in a DC-type retirement vehicle.

This is clearly an untenable situation for the individual, but equally important for our economy and social structure. Where will demand for goods and services come from if a significant percentage of our population don’t possess the financial wherewithal to be consumers?  Furthermore, this places a significant burden on our ability to manage the labor force through a natural evolution.

We urgently need to re-think the elimination of defined benefit plans (DB) in favor of defined contribution structures. In a DB plan the individual participant has little responsible for the ultimate outcome, which is the receipt of a monthly pension check. Regrettably, they possess the entire burden in a DC plan, from contributing, to allocating the assets, to managing the distributions.  Why do we think that untrained individuals will handle this responsibility?

The urgent need for education is clear, but the ability for most individuals to self fund these plans is still the greatest challenge. We live in an environment where real wages have stagnated for many years. In addition we have a significant percentage of our potential labor force on the sidelines (94 million age-eligible 16-65 year olds) who are not funding retirement programs.  Discretionary income is almost an oxymoron for a vast majority of our citizens.

via Daily Prompt: Clumsy

Sorry, but I don’t understand how our powers that be can support two different accounting standards for valuing a defined benefit plan’s liabilities.  The International Accounting Standards Board requires pension liabilities to be valued at a risk free market rate.  However, in the U.S. we have two governing bodies that oversee pension accounting with one supporting public and multi-employer plans (GASB) and the other supporting private sector plans (FASB).

In the case of GASB, a DB pension plan can value their liabilities at a discount rate equivalent to the return on asset assumption (ROA), which for most plans is in the 7.5% to 7.75% range.  Under FASB, a private sector plan must use a blended AA corporate rate, which will be much lower in this environment, but still significantly inflated versus the risk free rate (Treasury security). Why does this situation exist?  Not sure, but it seems to be creating a stir for actuaries, too.

The Society of Actuaries has been stating for a long time that liabilities should be valued at a true economic rate, and not one predicated on a guess as to how much a plan is going to earn (ROA) over time.  Having two different accounting standards is very clumsy, and it creates uncertainty in the marketplace.  At KCS, we remain strong advocates for DB plans, but we believe that these plans will only continue to be viable if there is an honest assessment of their liabilities.  Without this transparency, how can a sponsor truly know whether or not they are winning the pension game.

Original

The demise of the traditional defined benefit plan (DB) and the movement of most employees to defined contribution plans (DC) is creating a retirement crisis in the U.S.  According to the DOL, the U.S. pension industry has seen the number of DB plans go from nearly 150,000 in the 1980s to fewer than 24,000 today, and many of those plans have had benefits frozen for new employees.

Why has this trend unfolded? Well, there are multiple reasons, but for many private sector companies the carrying of the pension liability on their balance sheet and the volatility of contribution expense potentially impacting the income statement was just not acceptable. But the pension crisis isn’t just impacting private sector plans.  Public funds and multi-employer plans are also suffering under the weight of declining funded ratios and rising pension expense.

In addition, the capital markets have contributed significantly to this unfolding story, as interest rates have plummeted during the last 30+ years, while equity markets have witnessed two major corrections in the last 15 years. Declining asset values and rising liabilities have combined to create dangerously poor funding levels for many states, municipalities and union plans. Regrettably, this situation has been made worse by the reluctance of plan sponsors and their consultants to pursue a different strategy.

Many in the retirement industry continue to create investment structures and asset allocation strategies that are based on the return on assets assumption (ROA), as opposed to a plan’s true benchmark, which is that plan’s unique liabilities. Had these advisors chosen a more original approach they likely would have had greater exposure to fixed income assets during this 30 year bull market for bonds, which would have left them with less exposure to equities and the two major market declines for that asset class.

Institutional inertia continues to plague our industry, and unless we begin to consider a different path, I fear that our beneficiaries will not get the benefits that were promised.  The movement away from DB plans is placing an undo burden on many of our employees to fund and manage a retirement program without the necessary skills to successfully accomplish this task. The social and economic ramifications may be quite grave.