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?

It wasn’t that long ago that the world was fixated on every economic development in China, and when China Sneezed the world caught a cold.  Well, as usual, our focus on a subject seems to last for a month or two, and then we are onto something else.  Well, we might just want to refocus our attention on the Chinese property market.

KCS friend and supporter, Kieth Jurow, has once again shared information with us that we feel warrants sharing with you. It seems to him (and us) that the property markets in China are nearing a top, and the last blow-off wasn’t pretty.  Here is what he shared.

Chinese Consider Home Prices “High and Hard to Accept,” but Buying Frenzy Surges

Chinese Consider Home Prices “High and Hard to Accept,” but Buying Frenzy Surges

Thanks, again, Keith for keeping us informed about developments in global real estate.

The U.S. economy is consumer driven! There is no arguing that fact, as nearly 70% of the U.S. economic output is driven by consumption.  Well, then, what happens to a consumer driven economy when its citizens don’t have the financial wherewithal to consume? It tanks! Get ready for some rocky times ahead, as our future retirees don’t have nearly the same spending power as the older Baby Boomers and previous generations have had.

The demise of the defined benefit plan will have a meaningful impact on U.S. economic growth.  Who says? We, at KCS do, but more importantly, the folks at the National Institute on Retirement Security (NIRS) do!  They have just released their latest study, which looks at the positive impact on spending from the roughly 24 million recipients of monthly pension checks from 2014. The results highlight the significant contribution to our economy from those receiving a pension benefit.  On the contrary, the loss of DB pensions being replaced by the underwhelming defined contribution account balances has the potential to depress economic activity.  Here are the NIRS findings:

The NIRS report, “Pensionomics 2016: Measuring the Economic Impact of Defined Benefit Pension Expenditures”, finds that economic gains attributable to defined benefit (DB) pensions in the U.S. are substantial. Retiree spending of pension benefits in 2014 generated $1.2 trillion in total economic output, supporting some 7.1 million jobs across the U.S. Pension spending also filled government coffers, with retirees paying a total of $190 billion in federal, state and local taxes on their pension benefits and spending 2014.

“Household spending drives the U.S. economy, accounting for more than two-thirds of U.S. economic output. In fact, American retirees’ pension spending supported one-tenth of such economic output nationwide,” said Diane Oakley, NIRS executive director. “So it’s clear that the growing number of retired Americans must have adequate income for consumer spending that continues to drive our economy.”

Pensionomics 2016 comes at a time when economists are predicting dramatic drops in economic growth in the coming decades. A recent McKinsey Global Institute study indicates that factors including an aging workforce and declines in population growth could reduce economic growth by one-third in the U.S. and 40 percent globally.

“A stable and secure pension benefit that won’t run out enables retirees to pay for their basic needs like housing, food, medicine and clothing. It’s good for the economy when retirees are self-sufficient and regularly spend their pension income. Retirees with inadequate 401(k) savings and fearful of running out of savings tend to hold back on spending. This reduced spending stunts economic growth, which already is predicted to drop by one-third as the U.S. population ages,” Oakley explained.

The study finds that in 2014:

Nearly $519.7 billion in pension benefits were paid to 24.3 million retired Americans including:
$253 billion paid to some 9.6 million retired employees of state and local governments and their beneficiaries (typically surviving spouses);
$78.8 billion paid to some 2.6 million federal government retirees and beneficiaries; and
$187.9 billion paid to some 12.1 million private sector retirees and beneficiaries.
Expenditures from these payments collectively supported:
7.1 million American jobs that paid $354.8 billion in labor income;
$1.2 trillion in total economic output nationwide;
$627.4 billion in value added (GDP); and
$189.7 billion in federal, state, and local tax revenue.
Pension expenditures have large multiplier effects: Each dollar paid out in pension benefits supported $2.21 in total economic output nationally.

The National Institute on Retirement Security is a non-profit, non-partisan organization established to contribute to informed policymaking by fostering a deep understanding of the value of retirement security to employees, employers, and the economy as a whole. Located in Washington, D.C., NIRS’ diverse membership includes financial services firms, employee benefit plans, trade associations, and other retirement service providers.

We are pleased to share with you the following article that was written by Keith Jurow, creator and author, Capital Preservation Real Estate Report. We’ve been very impressed with Keith’s many articles / reports, and we thought that you’d appreciate receiving his perspective, too.

“Fueled by institutional money and hot funds escaping from China, the US office market roared back – until the end of 2015. Now the hottest markets are showing signs of tanking and the smart money is getting out”, according to Jurow.

http://www.advisorperspectives.com/articles/2016/09/12/the-danger-in-office-market-reits

If Keith is correct in his assessment of the commercial real estate market, it further exacerbates a growing problem for plan sponsors and their asset consultants, who are struggling to find assets without significant over-valuations.  Given the current, and nearly impossible, challenge of cobbling together an asset allocation in pursuit of the ROA, we suggest that plan sponsors try a different approach.

Reach out to us if you ‘d like to hear how KCS can reduce your plan’s contribution volatility, while stabilizing the funded ratio.  Also, don’t hesitate to reach out to Keith with any of your real estate questions.  He’s an incredible resource.