In an industry as exacting as the investment industry where trading is measured in milliseconds, a penny miss in earnings can tank a stock, and where performance results are measured to a minimum of hundredths, it is shocking that we still have so much guesswork involved in managing a pension plan.

We were recently asked to create a Custom Liability Index (CLI) for a defined benefit plan.  Once that task was completed, we volunteered to do an Asset Exhaustion Test (AET) to help the plan sponsor calculate the return needed to ensure that the assets are not exhausted before all promised benefits were paid.

Unfortunately, the Return on Asset Assumption (ROA) that is used as a return objective and the discount rate in public and multi-employer plans, is nothing better than a guess. Given that it is nothing more than a guess, it is amazing that plans will have ROA targets as exact as 7.625%.  Really?

In the case to which I am referring, the plan had “determined” that 7.5% should be the ROA objective.  Why? Because! At KCS, we often refer to these ROAs as “Goldilocks” numbers because they are neither too hot nor too cold.  But in this case, their target return was too high for we calculated that 6.8% is the return objective needed to keep the fund going.

Why does this matter? First, the ROA is instrumental in determining contributions into the fund. A number that is too low will necessitate larger contributions and vice versa. In addition, striving for a number greater than what is needed injects unnecessary risk into the asset allocation process.  A plan with a 7.5% return target is likely going to have a lot more equity exposure than one needing only 6.85%.

As if this isn’t bad enough, because GASB allows public and multi-employer plans to discount their liabilities at the ROA, a significant majority (like all) are overstating their funded status.  But, we’ll save this little ditty for another KCS Blog post.

For years now, we’ve been hearing that U.S. interest rates MUST rise due to the aggressively easy monetary policy that will lead to inflation.  We’ll, glad that we weren’t holding our collective breath!  The following chart once again highlights how difficult it is to forecast interest rate changes.

Unfortunately, many plan sponsors and their asset consultants were forecasting higher inflation and interest rates.  The higher inflation guesses lead them to plow into commodities in 2009 and 2010 only to be significantly disappointed when inflation never reared its ugly head and commodities performed woefully as the S&P GS Commodity index is -10.0% for 10-years and -14.4% for 5-years through 9/30/17. Oh, my!

Furthermore, the premature forecast of dramatically higher interest rates lead them to significantly reduce domestic fixed income exposure. This has created the greatest mismatch ever between assets and liabilities within defined benefit plans.

At KCS, we’ve been encouraging (imploring) our clients and prospects to get out of the interest rate guessing game despite correctly forecasting that rates would NOT rise (please see a number of previous blog posts questioning the rising rate crowd).  We believe that managing a pension plan is a cash flow matching exercise and not a return game.

We encourage sponsors to transition their current fixed income allocation into a cash matching strategy that ensures near-term benefit payments will be met.  In the process, the plan has enhanced liquidity to meet those payments, removed interest rate sensitivity, while also extending the investing horizon for the balance of the assets that now benefit from more time allowing the liquidity premium to be captured.

Why continue to “guess” where rates will go when a strategy exists to get your DB plan onto a glide path toward full funding and more level contribution expense.

Living only on Social Security is a frightening thought, but it is the scary reality for millions of Americans.  In fact, nearly 20% of those 65-years-old or older count on their monthly social security check for 100% of their income in retirement.

According to a recent Washington Post article, 61% of Americans rely on Social Security for more than 50% of their post-retirement income.  Amazingly, 43% of single seniors rely on social security for 90% or more of their retirement income.

What does that mean in reality? According to the Social Security Administration (June 2017), the average annual payment is only $15,054.  Could you live on that sum?  It is highly unlikely if you are living in the NYC metropolitan area.  With the demise of the traditional DB pension plan, it is highly likely that these harrowing numbers will only get worse.

It has recently been reported that 63% of private industry participants in defined benefit (DB) plans were in plans still open to new employees.  Are we supposed to be impressed with that finding? Regrettably, only 18% (according to BLS data) of the private sector workforce are in DB plans at all. Given that, it isn’t impressive that 63% of 18%, which is only 11.3% of the workforce, are currently in an open DB plan.  Roughly 30 years ago, the U.S. had more than 146,000 DB plans covering 46% of the private workforce.

The move away from DB plans may be comforting for senior executives at public corporations who don’t want the volatility of contribution expense to impact their companies quarterly financials or the liability on their balance sheets, but it does little for the average American worker.  DC plans are not better than DB plans, especially when our industry and public education system have failed to provide adequate financial literacy for our workers.

On the Foxnews.com website, there is an article by Rachel Greszler, Heritage Foundation, discussing a potential bailout of the UMWA pension plan (coal miners).  She laments the potential federal taxpayer bailout of this plan, proclaiming that this could be the tip of the underfunded pension iceberg, which she estimates could result in trillions of taxpayer funds being used to prop up these plans.

Greszler also mentions a second proposed piece of legislation that is being considered at this time, which is a loan to the insolvent plan(s). She calls the loan a bailout because “there’s virtually no chance of repayment”.

She asks, “so what happens if Congress doesn’t step in to bail out the UMWA’s unfunded pension promises?” She mentions that the Pension Benefit Guaranty Corporation (PBGC) would step in just as it has for more than 50 other failed union-run pension plans. However, she doesn’t discuss that the PBGC’s solvency is on thin ice or the fact that union workers have benefits protected at roughly 20% of private sector workers ($13,000 annually).

You may recall that Ron Ryan, Ryan ALM, and KCS are working on the implementation that supports the “loan” proposal (see the August KCS Fireside Chat).  The process that has been created has been tested on the UMWA plan, as well as that of other large, poorly funded multi-employer plans, and the math works!  This legislation can protect the promised pension benefits despite the current poor funded status.

Does Ms. Greszler really believe that by allowing these plans to fail that the federal government won’t play a role in subsidizing the retirement plan’s beneficiaries? The potential collapse of these plans will thrust millions of union workers onto the welfare ranks, where neither they nor their fellow citizens want them to reside!

The fact that the implementation designed by Ryan ALM works, means that this process could be the foundation for a new direction for state and municipal plans, many of which are in dire shape, too. State and city finances are coming under significant pressure because of growing pension and OPEB liabilities.  Unfortunately, a significant majority of these plans continue to be managed as they have been for decades. A major rethinking is in order, and we have proposed a solution that should be given serious consideration.

The demise of the defined benefit pension system in the private sector has created social and economic issues that will be felt for generations. We shouldn’t be fooled into thinking that the elimination of these pension benefits for union and public employees could somehow be positive for our economy.

We are pleased to share with you the latest edition of the KCS Fireside Chat series.

We’ve taken a slightly different approach to this article by covering four topics, instead of one, while keeping the length to the normal four pages. Hopefully, our thoughts on these subjects will stimulate some interest. As always, we encourage you to reach out to us to challenge our thinking and engage in a deeper dive on each subject.

Thank you for your on-going support of KCS!

As reported in the WSJ, “two credit-ratings firms on Tuesday downgraded the city of Hartford further into junk status, citing an increased likelihood of default as early as November. S&P Global Ratings knocked down Hartford’s rating by four notches to CC. Moody’s Investors Service lowered its rating for Connecticut’s capital city by two notches to Caa3.”

The myth that public pension plans are perpetual has lead to misguided management and decisions. As we discussed earlier this year, just because something is perceived to be perpetual doesn’t mean it is sustainable. We are beginning to get frequent reminders of this fact, and Hartford, CT is just the latest example. Can cities and states truly continue to support contribution rates that are escalating unabated?

We (KCS) are huge proponents of defined benefit plans, but they need another path before most are shuttered. Stop focusing on the ROA as the primary objective despite the fact that GASB allows plan liabilities to be discounted at that rate. The use of the ROA as the discount rate has lead to the habitual underfunding of these plans. Had the true annual required contribution been made, these plans would be in much better shape.

In addition, so much energy is wasted in the day-to-day management of these plans by debating insignificant factors, such as active versus passive, ESG/SRI, minor asset allocation shifts, etc. These plans are failing because they haven’t focused on the true objective, and they will continue to fail until plans begin to focus on their specific liabilities first and foremost to drive asset allocation and investment structure decisions.

Older workers may think that a lack of retirement funding can be overcome by working longer, but that option isn’t always available to the employee.  Paula Aven Gladych recently reported in Employee Benefit Adviser on a recent study conducted by Transamerica’s Center for Retirement Studies that highlighted the fact that nearly three-quarters of employers think that they are “aging-friendly”, but unfortunately, most haven’t put in place procedures or policies to actually implement this objective.

According to the study, “only 39% of employers offer flexible schedules to pre-retirees, and even fewer allow pre-retirees to change from full-time to part-time positions or take on less stressful or demanding jobs with the company.”  Amazingly, only 27% of employers encourage pre-retirees to participate in succession planning, training and mentoring before they leave the company. What a waste of experience.

Why should an employee find this study disconcerting? With the demise of the traditional DB pension plan for the private sector, most employees will have to contribute earlier in the process, while also contributing more in order to actually generate a commensurate retirement benefit through a defined contribution offering.

Not surprisingly, this isn’t happening, and it isn’t likely to happen anytime soon, as higher paying jobs are hard to find in this economic environment, and our younger generation is often burdened with greater demands on their salaries from items such as student loan debt, higher medical insurance premiums, and greater housing expenses to name just a few.

So, if you find yourself a participant in a DC plan, please “pay” yourself first so that you can create a retirement account that might actually allow you to retire at a more normal age without having to count on the support of your employer to “permit” you to work longer.