The U.S. Federal Reserve raised the discount rate 25 basis points as expected.  But, was it warranted? Markets have certainly been going gangbusters, but the economy has been muddling along, and it appears that fourth quarter growth is likely to be more tepid than the third quarter’s >3% results.

The recent equity market reaction to President-elect Trump’s upset victory seems out-sized based on the underlying fundamentals of corporate America. Corporate investment is still lagging, and capacity utilization was estimated at 75% in November.  That is the same level that we were at during the market  correction in 2001. Regrettably, real wage growth has been stagnate for nearly two decades further tempering demand for goods and services.

Pension America, at least those that mark liabilities to market, should be happy that U.S. long rates have risen substantially.  The 10-yeat Treasury’s yield is at 2.55% today, up 25 bps from the beginning of the year, but a whopping 1.23% from the low of 1.32% established on 7/6/16.  Asset performance in the fourth quarter should be strong and liability growth should be negative.  The combination should help plans see meaningful improvement in their funded status.

But, if equity markets are ahead of themselves from a fundamental perspective, while bonds have sold off more rapidly than the economics dictate, plan sponsors may be sitting on a potential negative scenario.  The fact that most plans have little exposure to US bonds, which are highly correlated to plan liabilities, exacerbates this situation.

We believe that DB plans should de-risk when possible, even plans that are not well-funded.  We’ve written about this on many occasions.  Our preferred implementation is through a cash-matching strategy, as opposed to a duration matched program. With Treasury bond rates up, an implementation using Treasury STRIPS is cheaper today.

Interestingly, high yield bond rates have actually continued to fall making an implementation using high yield a little more expensive.  Although, there is still a huge advantage creating a cash-matched strategy using high yield and lower quality investment grade (BBB and A) bonds, but the advantage has been narrowed.

If a cash-matching strategy is not in the cards at this time we’d recommend that you review your current asset allocation versus your policy normal levels, especially in small cap value, which had an extraordinary result in November. Capturing profits is a good thing.

It has been a little more than 5 1/3 years that KCS has been in operation as an asset / liability consulting firm.  As we enter the holiday season I want to take this time to thank the many conference organizers for providing the KCS team with the opportunity to share our thoughts and views with the retirement community more than 50 times during the life of the firm.

We sincerely believe that we have something to offer the pension community, especially when one considers our diverse backgrounds spanning more than 200 years of collective experience for the six of us, but really who is KCS? Well, despite our lack of name recognition and size, we have been given an amazing opportunity to get our views into the marketplace, and we can’t thank you enough!

We don’t want to slight any organization that has provided us with an opportunity to speak, but there are several organizations that stand out in giving us the greatest opportunity to provide education and insight, including: Opal, IFEBP, IMI, FPPTA, and FRA.

We hope that those who have heard us present find that we bring a thoughtfulness to our views.  You may not always agree with our conclusions, especially since we often take a contrary view from more traditional providers of consulting services. However, they’ve been developed over many years observing what has and hasn’t worked.  Furthermore, we look forward to having our views / ideas challenged by the pension community.

As you’ve heard us say many times, our retirement industry is under great stress right now. We need to rally together to create change that will preserve defined benefit plans for the masses. It would be wonderful to think that perhaps some words of wisdom from a senior member of the KCS team has been a positive influence in that effort.

The following article appears in the WSJ today. It speaks to an issue that we, at KCS, have been discussing for years.  Specifically, with U.S. wages staggering, the ability to fund a retirement plan through a defined contribution plan is getting more and more difficult, if not impossible.

The American Dream is fading, and may be very hard to revive
http://www.wsj.com/articles/the-american-dream-is-fading-and-may-be-very-hard-to-revive-1481218911?emailToken=JRrzdvBzZH+Qh9c3Z8wg1FBtZ6wFEe6CT1WSIGrHM02JtWeQr+utxqM6wtKxrSaqTFc/7d1B8WMlVHjRiXBmGdOW3qRyj1a6djwE8sGdi1Tbax2C

According to several researchers at universities, including Harvard, Stanford and the University of California, 92% of 30-year-olds in 1972 out-earned their parents at the same age.  Regrettably, only 51% of 30-year-olds can say the same thing today.  Wages have stagnated since the late 90’s, and adjusted for inflation, they are actually below 1999’s level.

So, we repeat, who thought that it was smart policy to shift a significant portion of our private sector from company funded defined benefit plans to defined contribution plans? Many of our 30-year-olds are burdened with excessive student loan debt because of incredible increases in tuition expense.  At the same time, the companies that they work for have dramatically reduced their support of company sponsored medical insurance, the cost of which has also far outpaced inflation.  These increasing burdens further reduce one’s ability to fund a retirement plan – so they don’t!

It shouldn’t be a shock then to read about median DC account balances that are ridiculously low, while also learning that roughly 50% of our population hasn’t saved anything for retirement.  You are kidding yourself if you don’t believe that there is a retirement crisis unfolding in this country.  There will be grave social and economic implications as a result.  It is time to rethink this failed policy choice!

I must admit that I’m a pretty sappy guy when it comes to movie selections, and my choices often get me abused by my sons, although my daughters don’t hold back either.  The title of this post reminds me of a movie that I have watched more than a few times, “It Could Happen To You”, which is a Nicolas Cage and Bridget Fonda movie about a winning lottery ticket, and the subsequent troubles that follow. However, in the end all is just grand.

Unfortunately, what I am about to highlight for you does not have a fairy tale outcome, and it might just be the tip of the iceberg for cities around the country.  If you haven’t heard about the pension crisis in Loyalton, CA, you should make sure to get up to speed rather quickly.

Loyalton is a city in Sierra County, CA. As of the 2010 U.S. Census the population was 769, reflecting a decline of 93 from the 862 counted in 2000.  According to Wikipedia, many of the population are ranchers, loggers, former loggers, or suburbanites escaping from the San Francisco Bay Area, Sacramento, and the growing Reno-Tahoe area.

The trouble begins in 2013 when town officials decided to withdraw from CalPERS, upon the retirement of its last guaranteed pensioner. For council members, it just made sense — after all, the town had been fully paying its required annual contributions all along. What they didn’t count on was the $1.6 million termination fee demanded by CalPERS to cover unfunded liabilities that CalPERS had allowed to grow for the last 17 years. The fee amounts to a whopping $320,000 per each of Loyalton’s five retirees, an amount that is impossible for the town to pay. And now CalPERS has put the retirees on notice that their monthly checks will be cut.

I’ve been extremely fortunate to be in the investment industry for more than 35 years.  Because of my tenure in the industry, I’ve been spending much more time in the last several years sharing thoughts on various topics, especially those related to the U.S. pension industry, hoping to provide education and useful perspective.

I recently was asked by FundFire to weigh in on the passive versus active argument, which I was happy to do, as I think that there is a need for both, and factors / exposures that favor one versus the other at various times.

I received the following in my in-box today that also relates to passive indexing. I’m very skeptical of the conclusions in the original study that was the basis for the NY Times opinion piece.

I thought you might like this article from Seeking Alpha
Should Government Regulation End Indexing As We Know It?
by James Picerno

An op-ed in The New York Times today lays out the case for imposing new restrictions on how index funds operate. The rationale, according to the authors, is to prevent the reduction in competition in industries that is a direct consequence of indexing. If the proposal is implemented as outlined, the indexing strategy for equity investing that’s widely practiced could be headed for extinction.

http://seekingalpha.com/article/4028909-government-regulation-end-indexing-know?source=from_friend_readmore

I’m happy to discuss this in greater detail with you.  Please don’t hesitate to reach out, especially if you have an opinion that differs from mine.

Here is something from WSJ.com that might interest you:

Collapse of long-term care insurer reflects deep industry woes
http://www.wsj.com/articles/small-insurers-big-collapse-reflects-deep-industry-woes-1480852801?emailToken=JRrzdv1/Y3SVi9M1a8wn0VQsauwJDfSUXF7NNzXAO0eJv3vRpeu53Khwnda5pW6kWV0/690J9ys+QzHMm3ZwTYqOnLNk1A74KyEN88uUiVQ=

Could this happen to the insurers (Prudential, et al) that have acquired significant pension liabilities? If it does, don’t look for the PBGC to help, as once that liability is transferred from the corporate sponsor to the insurer, the PBGC is no longer on the hook.

According to the article, one of the primary reasons for the impending failure is the fact that “most actuaries badly underestimated costs, and the insurers then met resistance in many state insurance departments when trying to push the pricing miscalculation onto policyholders through steep rate increases.”

“Penn Treaty is the poster child for what happens if everything goes wrong—when key assumptions on…claims, morbidity and interest rates go wrong.”  Sound familiar? We know that pension liabilities for public entities aren’t being accurately measured under GASB, as liabilities are discounted at the return on asset assumption (ROA). We’ve seen public pension liabilities explode during the last 15 years on an actuarial basis despite this hocus pocus accounting.

We are pleased to share with you the latest edition in the KCS Fireside Chat series.  This article discusses the market reaction to Trump’s victory, while also exploring how the U.S. equity market has performed in the initial year of the 13 first terms for U.S. presidents dating to 1926 (there have been 22 elections).

Click to access KCSFCDec16.pdf

Please don’t hesitate to reach out to us if we can be of any assistance to you.  Furthermore, we wish for you and your family a joyous holiday season and a wonderful 2017.

I recently had the great pleasure to stop by the Asset TV studios to provide some perspective on DB versus DC and the DOL Fiduciary Rule, which may or may not survive under President-elect Trump.  Here is a link to that interview.

https://www.assettv.com/player/default-player/102724

As always, please don’t hesitate to reach out to us if we can be of any assistance to you. Happy Thanksgiving to you, your family and friends.

The following is an article that I wrote for eFinancialcareers on the potential impact of a Trump Presidency on the asset management industry.

For the U.S. institutional asset management industry that is already dealing with significant change, including the decline of traditional defined benefit (DB) pension plans to name just one, the election of Donald Trump is likely to create further disarray. First and foremost, there is great uncertainty as to his support – or lack thereof – for the Department of Labor’s fiduciary rule, over which the wealth management industry is divided.

Add this unknown to the impact on the financial services industry from changing demographics, new technology, consumer demands and a Trump presidency and we have a situation that is likely to shake traditional buy-side and less-nimble sell-side firms to their core.

You can find the remainder of the article at the following link to eFinancialcareers.com

http://news.efinancialcareers.com/us-en/265638/trumps-winds-of-change-are-blowing-across-the-asset-management-industry/

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.