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.

It was announced earlier this week that Janus and Henderson were merging their operations. Speculation around this transaction was that the active / passive trend favoring passive was putting pressure on the businesses of active managers, particularly in their ability to raise new assets.  We say hogwash!  The active / passive CYCLE has existed for quite some time, and it will always exist because of portfolio construction biases, which we’ve written about in a previous blog post.

We believe that the primary reason that active managers are having a difficult time attracting new clients and assets is because of the demise of the defined benefit plan! There are far fewer plans today (roughly 23,000) than there were 30 years ago (146,000 (DOL)), and many of those still in existence have frozen their plans to new employees or at a minimum have begun to de-risk their plans (see corporate America’s behavior).

We think that DB plans are superior to DC offerings, and have expressed those feelings many times before.  What is fascinating to us is the fact that although many small to mid-sized asset managers have little exposure to DC asset bases they haven’t spoken out in favor of DB. The trend favoring DC versus DB will only magnify, as more DB plans are shuttered because of deteriorating funded status and escalating contribution costs.

I suspect that there are many asset management organizations that believe a traditional DB plan is superior to a DC offering.  However, I don’t see them advocating for DB versus DC. Their silence may just be the death knell for DB, and consequently their own business.  Currently a hand-full of mutual fund companies dominate the DC space. Mutual funds still are the vehicle of choice for offering one’s product, although we see ETFs gaining traction.  However, most defined contribution plans are too small to have separate accounts as options within their plans.

Without a mutual fund or ETF platform, it is going to prove very difficult to penetrate the DC space. Think that the Janus / Henderson merger is an anomaly? Think again! DB plans need to be maintained, and if I were running an asset management organization, I would do what ever I could to be their advocate. Unfortunately, their silence is deafening!

For long-term readers of the KCS Fireside Chat series, you may recall that we dedicated one of our articles to Pension Obligation Bonds (POBs) (Pension Obligation Bonds:  Safe… or Sorry, July 2013).  Well, it seems that POBs are once again in the news.  I’ve seen reference in the last two days to Houston and Alaska considering using POBs to help close the gap between promises made and funded.

As a reminder, a Pension Obligation Bond is a debt that resides with the sponsoring entity (state, municipality, etc). It is basically a substitute for that entity making up the deficit through contributions, except that there is a carrying cost (interest payment) to the POB.

The hope is that the DB plan can generate a return on the POB’s proceeds that will exceed the borrowing cost.  Unfortunately, it doesn’t always work out that way.  In fact, a significant percentage of POBs were underwater following the great financial crisis.

Given where valuations are for equities and yields are for bonds. we would be very cautious about taking the proceeds from the POB and placing them into a traditional asset allocation with the HOPE that an excess return will be created.  We would prefer that a POB’s proceeds be used to immunize (cash flow match) the plan’s near-term liabilities, thus securing the funding for near-term benefit payments, while allowing the existing assets to benefit from an extended investing horizon.

We would be happy to discuss this approach to securing the victory, instead of subjecting the proceeds of the bond to the same excessive volatility witnessed in traditional asset allocation approaches.

Close to half of those who earn from $100,000 to $149,999 a year have less than $1,000 in their savings accounts. Some 18 percent of them have socked away absolutely nothing. This stat appeared in a Bloomberg article written by Polly Mosendz, titled “Make Six Figures? There’s a Decent Chance You’ve Got Almost Nothing in the Bank”.

The study was conducted by financial services website gobankingrates, which studied roughly 7,050 individuals. For those making between $25,000 and $49,999, 72 percent had either nothing or less than $1,000 in savings accounts.

We’ve been screaming that asking individuals to fund and manage their own retirement fund (DC) was bad policy.  This shows just how bad.  Individuals need to be saving roughly 15% of their income annually, if they expect to created a retirement account that will sustain them in retirement.  This data indicates what a pipe dream that is for most, but especially for those making less than the median household income (roughly $54,000).

We are pleased to share with you the next edition in the KCS Fireside Chat series (#51). This article speaks to the election issues that we feel need to be addressed in order to help mitigate the U.S. retirement crisis that is unfolding. The social and economic ramifications of our failure to preserve defined benefit plans will be devastating for our plan participants.

Click to access KCSFCOct2016.pdf

As you will read, we continue to be focused on those issues that we believe are necessary to stimulate economic activity to jump-start our anemic economy, such as jobs, wages, taxes, infrastructure, etc. We would encourage you to share with us your top 5 election topics.  We will report back on those issues that are of greatest import.

Please don’t hesitate to reach out to us with comments, questions, and / or concerns.

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?

Zerohedge is reporting in an article titled,

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

http://www.zerohedge.com/news/2016-09-20/dallas-police-pension-verge-collapse-record-number-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?