I don’t think that I’d get too much of an argument for making the claim that experience matters in all industries. One should want to work with an individual or team that has experienced a variety of markets and environments.  To be able to recall how one reacted previously to similar events should provide a level of confidence relative to someone experiencing a situation for the first time.

Because the financial industry produces many cycles, having the ability to draw on one’s knowledge of how those cycles played out is extremely important. I once heard that the investment management industry was a young man’s (or woman’s) game.  I’m sorry, but I totally disagree with that thought.

At KCS we’ve built a team of 8 senior consultants that has a combined 285 years of industry experience, which equates to 35.6 years of average service per consultant. That means that the “average” consultant has been in the investment/pension industry since 1981’s bear market.  How many of you remember the bear market from 1980 through July 1982?  In fact, both Larry Zielinski (48 years) and Ivory Day (45 years) have been working with their clients’ issues since before ERISA. Wow!

The good thing about the years of experience that we’ve accumulated is the fact we’ve already made a lot of mistakes and have learned from those.  For instance, we, too, were focused on the return on asset assumption (ROA) as being the primary objective for managing a pension plan, only to realize many years into the game that achieving the ROA didn’t guarantee funding success.  As a result, we’ve built KCS with the knowledge that a plan’s primary objective is to fund the promise (benefits) at the lowest cost possible.

In order to accomplish this objective, sponsors must have greater knowledge of what that liability looks like on a more frequent basis. We’d appreciate the opportunity to share with you some of what we have collectively learned during our 285 of managing pension issues.  I think that you’ll find we have a lot to offer.

How are your defined benefit plan’s liabilities performing?  If you are a public fund plan sponsor this simple question might be very difficult to answer.  Why? Well, for one reason, you are only receiving an update annually, perhaps 4- 6 months dated, when your actuary delivers their annual update.  Second, the totally arbitrary discount rate being used under GASB is understating the plan’s true liability in this low-interest rate environment.

As a reminder, the DB plan only exists to fund a promise (liability) that has been made to the plan’s employees/participants. It is funding this promise at the lowest cost possible that should be the ultimate objective.  Regrettably, that is not the case for most plans, as they’ve been inappropriately convinced (hoodwinked?) that achieving the return on asset (ROA) assumption is all the matters.

I suspect that you know the current market value of assets in your plan down to the penny.  If not today’s valuation then you certainly know the value as of January 31, 2017.  Why is it more important to know the asset side of the equation than the liability side?  If I were running a pension plan, I’d certainly want to know the following:

1. What is the current value of the promise (liability) that has been made?
2. What are the current funded ratio and funded status of the plan?
3. What do the benefit payments look like on a monthly basis?
4. Do I have the liquidity to meet those payments?
5. Will the plan run out of money prematurely? If so, when?
6. Are the estimated contributions enough to narrow the funding gap?
7. What happens to the plan’s long-term funding if only a fraction of the contribution is made?
8. Can I “safely” award a COLA or benefit enhancement?
9. How much alpha do I need relative to liability growth to begin to whittle away at my unfunded liability?

I would suggest that without greater knowledge of the plan’s liabilities, you will not be able to answer the questions above.  In fact, without a custom liability index (CLI) being produced for your plan’s specific liabilities it would be impossible to answer those questions.

Investment structure and asset allocation should be driven by the liability side of the equation. It makes no sense that trying to achieve an arbitrary ROA would be the plan’s primary objective. As we reported earlier today, the average public DB plan has a 7.6% ROA target with only 7 of 132 large public funds having a ROA < 7%. How is it possible that all these plans have roughly the same ROA objective?

One would think that a plan that is 90% funded would have a much more conservative asset allocation than one that is 50% funded. But if both plans are striving for the same 7.6%, they are going to get a very similar asset allocation from their generalist asset consultant. DB plans should be removing risk from the process as funding improves. But, if you don’t know how the liabilities are performing, then you can’t possibly know when to take risk off the table.

If you’d like to be able to answer the questions posed above, please reach out to us to construct a CLI for your plan.  It isn’t prudent to perform surgery without a set of X-rays.  Why engage in the management of a DB plan without the appropriate x-rays being made available for your plan’s liabilities?

According to a recent Barron’s article written by Thomas Donlon, there are 23 U.S. States whose inflation-adjusted revenues remain below pre-recession levels.  This is shocking to me given that we are in year eight of the “recovery”. Unfortunately, there also remain 18 U.S. States that have lower employment levels than they had in 2007, further stressing state budgets, as tax revenue declines.

This unfortunate combination of lower revenue and weaker economic growth will make funding public DB plans even more challenging than it already has been.  Contribution costs continue to escalate for many public pension systems despite the 8-year recovery in equity markets and the use of a discount rate that averages 7.6%.

Given current valuation levels for both bonds and stocks, it is unlikely that we can expect outsized gains from the capital markets.  Furthermore, given the pressure on state budgets, it is unlikely that our public pension system will be cured of its underfunding by just allocating more of the state budget to the problem through contributions. We have seen most, if not all, state plans address their troubled systems with changes to contribution rates for employees, new tiered benefits, longer required retirement ages, elimination of COLAs, etc., and in many cases, funding levels continued to deteriorate.

As we’ve frequently said, these plans are much too important to the individual participants and their local economies to subject them to undue risk. Pursuing the ROA in this market environment is adding considerable risk to the traditional asset allocation process.  At KCS we espouse a much different approach: one designed to stabilize both contribution costs and the funded status.  Once those objectives have been met, a plan can begin to de-risk.

I don’t believe that most public pension systems can survive another 2000-2002 or 2007-2009 equity market decline, especially if is accompanied by declining U.S. interest rates.  Putting in place a lower risk investment structure and asset allocation will reduce the risk of such an occurrence.  DB plans need to get a better handle on their plan’s liabilities.  With this greater knowledge, more informed asset allocation decisions can be taken.  We are ready to assist you.

We receive a daily email from Pensiontsunami.com that contains recent pension crisis headlines.  Most of the articles talk about the unsustainability of public pension plans.  Here are a couple of examples from today’s list:

PENSION CRISIS HEADLINES POSTED FEBRUARY 9, 2017

• California Taxpayers on the Hook for Skyrocketing Teacher Pension Contributions (Kevin Truong / San Francisco Business Times)
• CalSTRS’ Reduced Goal Will Hit These Districts Most (Romy Varghese / Bloomberg)
• Public Pension Pilfery (Larry Sand / UnionWatch)
• Dallas Council Members Sue to Wrest Control of Pension Assets From Board (Matt Goodman / D Magazine)
• Illinois Budget Deal Hits Snag After Key Pension Bill Fails (Karen Pierog & Dave McKinney / Reuters)
• The Man Behind the Fiscal Fiasco in Illinois (Dave McKinney / Reuters)

Clearly, some of the more notable state plans are in big trouble from a funding standpoint, but the entire industry surely isn’t.  Furthermore, there are strategies that can be employed to begin to improve the financial health of public pensions. However, it will take a different path than the one that has been traveled for the last 50+ years.

As we’ve said before, managing a DB plan isn’t about generating that greatest return.  It is about meeting the promise at the lowest cost possible. The pursuit of the return on asset assumption (ROA) has forced plans in this low-interest rate environment to inject greater volatility into the asset allocation process.  DB plans should be looking to take risk out of the equation.

Furthermore, we are discouraged by the continuous publication of headlines that predict that all DB public plans will fail (not to mention multi-employer plans, too), without offering meaningful solutions.  Defined contribution plans certainly aren’t the answer, but that seems to be the only remedy being proposed.  Have you seen the results of this failed model?

We, at KCS, have created a five-point de-risking solution that will stabilize a plan’s funded status and contribution expenses while beginning to return these plans to a healthier state.  It starts with understanding what the promise you made looks like.  Once a sponsor has their arms around that promise they can then use the output to drive investment structure and asset allocation decisions.

We know that not all DB plans have been managed appropriately, as contribution holidays have been taken, COLAs awarded and benefits enhanced without a true understanding of the long-term implications of these actions.  But, with a little more discipline and a new approach, DB participants will once again be able to count on having the retirement benefit that was promised to them, and one to which they have been contributing.

Reuters has published an article, titled “Despite risks, public pensions put faith in long-term returns” As usual, the article stresses return as the savior of defined benefit plans.  But, achieving the return on asset assumption (ROA) has not guaranteed success. We’ve illustrated this point before. But, it has guaranteed much more volatility in the returns achieved.

We understand that the lowering of the ROA target likely increases contribution costs as GASB allows for plan liabilities to be discounted at the ROA.  This practice is leading to the habitual underfunding of DB plans.  Both the IASB and FASB require plan liabilities to be discounted at substantially lower rates (mark-to-market and AA corporate, respectively).

DB plans can earn substantially less return than the ROA target and still come out ahead.  How? Liabilities are bond-like in nature. The present value of a liability rises and falls with changes in interest rates.  Liability growth has been fueled in large part by the collapse in U.S. rates. If rates begin to rise, we could see negative growth rates for plan liabilities.  In this case, a 4% asset return will look very strong versus a -3% liability growth. You need fewer assets in a rising rate environment to meet your future liability.

Even if plans continue in their attempt to beat the ROA, their targets are still too aggressive. The average ROA for a public plan is estimated at 7.5% to 7.6%. Since 1926, the S&P 500 has produced an average 30-year return of 7.81%.  Most plans will not have a nearly 100% allocation to the S&P 500.  How are they going to achieve the ROA?

Stop the singular focus on assets, and begin to focus on your plan’s liabilities. Managing a pension plan should be about meeting the promise (liability) at the lowest cost possible.

We are pleased to share with you the latest edition of the KCS Fireside Chat series.  In this article we share our opinion on the top 10 retirement and market-related stories of 2016.  We look forward to hearing from our readers regarding their thoughts on the major stories that shaped our industry.

I’m taking a few moments to depart from my nearly singular focus on preserving DB plans for the masses to comment on something that I read this morning.  The following came across my desk, and it echoes a claim that I hear frequently, but one that isn’t based on fact.

“We basically have gone from $8 Trillion to $20 Trillion in Government Debt since 2008, and it is the rate of change of this debt spending that is the real elephant in the room, and we are just coming up on the entitlement’s impact curve on our government debt obligations.

I feel for Trump because he has inherited a boxed in economic situation here. He actually wants to stimulate the economy through growth projects; but the previous wars, financial crisis, bailouts, and unwise and inefficient spending programs have made borrowing any more money at these levels impossible, and Congress knows this fact!

They may try to go down this borrow and spending road, but it will backfire bigtime on the Republicans. By my calculation, the Democrats are going to benefit immensely from the fact that the s*t is going to hit the fan during the Trump presidency and Republican-controlled Congress from past bad governmental practices of what I call “Can-Kicking” and “Short-Termism.””

This constant chatter about unsustainable levels of U.S. debt has been occurring since at least the 1930’s.  My friend and former colleague, Charles DuBois, shared the following quote with me:

“Everyone knows if we continue the present financial program of borrowing billions upon billions of dollars, with an unbalanced budget, piling up debt upon debt, sooner or later, the day of reckoning will come. None of us are prophets. We cannot predict when that time will be. All we know is that if we continue on this road, with no financial policy and an unbalanced Budget we are going down the road to bankruptcy, repudiation and financial chaos.” Rep. Hamilton Fish III (R- NY) on the floor of the House of Representatives – November 1937

Those words were uttered 80 years ago, and we are still waiting for the great bankruptcy to occur.  What we do know is the U.S. will always be able to pay its bills.  Why? Because we possess a fiat currency, and a country with its own free-floating currency and no foreign debt can always meet all of its obligations – including Social Security, so please stop worrying about that political football!

One of the potential consequences of printing money is the possibility that it creates excess demand that exceeds our economy’s ability to produce the goods and services to meet that increased demand, which will lead to inflation. However, we have tremendous slack in our economy currently, and our ability to meet increased demand should not be an issue in the near-future.

Let’s hope that President Trump’s goal of increasing infrastructure spending to spur economic growth, job creation and enhanced wages is successful.  The last time the US produced an annual GDP growth rate in excess of 3% was 2005.  That is just not acceptable.

I just penned the following article, “How Defined-Benefit Pension Plans Can Be Saved” for publication on the Investopedia.com website.  We, at KCS, hope that you find our insights beneficial, and we look forward to having the chance to discuss with you some of our ideas on the subject. We believe that DB plans are too important to see them disappear.

Usually, congratulations are in order for finishing first, but in this situation, I will hold back on my celebration. Why? I am not inclined to applaud the Treasury Department’s decision to approve the rescue request for Iron Workers Local 17 Pension Fund, Cleveland. See, this plan becomes the first multiemployer pension plan to win approval to reduce benefits under the Kline-Miller Multiemployer Pension Reform Act (MPRA) of 2014.

According to a December 26, 2016, article in P&I, the benefit reductions can not be lower than 110% of the PBGC’s guarantee, which is presently just under $13,000 per retiree, per year for someone with 30 years of service.  Little consolation as far as I’m concerned for a retiree who may have been receiving $20,000 per year and now has to make due with a 35% reduction.  If only this worker had been in a corporate plan as opposed to a multiemployer pension for that individual’s benefits are protected to nearly $60,000 per year by the PBGC!

Regrettably, Local 17 isn’t the only plan seeking to reduce existing benefits, as there are an additional 60 multiemployer plans that have notified the Department of Labor of “their critical and declining” status, which makes them eligible to consider applying for benefit reductions.

There were several reasons that were cited in the P&I article as to why Local 17 gained approval when four other plans, including the $17.8 billion Teamsters Central States plan were rejected.   Two of the primary reason were the plan’s small size (roughly $90 million in assets) and its reduction in the return assumption from 7.5% to 3.75%.

We do want to recognize that trying to save the plan is better than having it end up being the responsibility of the PBGC as retirees who worked a minimum of 30 years will get at least 10% more from this plan.  However, we continue to worry that this is just a band-aid for an industry that continues to focus on the wrong objective – the return on asset assumption (ROA).

As this situation is proving, the fund only exists to meet a promise that was made to the employee.  The promise is the plan’s liabilities, and meeting that liability should be the main objective, not an arbitrary return target that doesn’t guarantee a plan’s success. Furthermore, with the potential for interest rates to back up in the near future, the present value of that liability declines.  We could witness improved funding without the need to reduce some poor retiree’s benefits.

Instead of granting permission to reduce benefits for all those multiemployer plans currently in the queue, let’s help them change their focus from managing the return side of the equation to finally using the promise that they made to drive asset allocation and investment structure decisions.

We are pleased to share with you the KCS Fourth Quarter 2016 update. As you will read, 2016 was a good year for DB plan funded ratios, as U.S. long rates backed up marginally from the beginning of the year, and assets performed well despite a troubling beginning to the year and a hiccup following Brexit. Will the “Trump Rally” continue? Will interest rates continue to back up? If they do, plan liability growth will likely be negative, and in that scenario, DB plans do not need to generate outsized returns to begin to see improvement in fund ratios and contribution expense.

2017 should be the year that plan sponsors become more liability aware. What does this mean? Asset allocation and investment structure should reflect a plan’s funded status and not some arbitrary return on asset assumption (ROA). As plans see improvement in their funding they should begin to de-risk. Why continue to live with the volatility associated with pursuing the ROA when achieving said ROA doesn’t guarantee anything. Most DB plans were fully funded in the late 1990’s only to see that funded status get crushed under two significant market declines.

History has a way of repeating itself. Let’s see if we can alter the future for DB plans, by trying a new approach.

All the best in 2017,

The KCS Team

Dave, Ivory, Larry, Lillian, Russ, and Russ