We are pleased to share with you the KCS quarterly for Q1’16. As you will read, DB pension liabilities continue to outperform assets, exacerbating a trend that has lasted for more than 15 years. As a result, funded ratios continue to deteriorate. Also, learn what is new at KCS and read what our senior team has been doing during the quarter.
We hope that you find our insights helpful. Please don’t hesitate to call on us if we can be of any assistance to you.
Several large public pension funds have recently implemented a plan to or are in the process of reducing / eliminating their exposure to hedge funds. Numerous reasons have been cited for this action, including size of the plan’s allocation, complexity, lack of internal resources, but given the less than stellar results achieved from within the hedge fund space, I can’t say that we are shocked by this action despite a good bit of challenge from many within the retirement industry.
As for the performance, for the 10 years ending March 31, 2016 the HFRI Composite Index has a +3.4% annualized return, while the S&P 500 (+7.0%) and the Barclays Aggregate Index (+4.9%) have beaten it handily. The fact that the 10-year period encompasses all of the Great Financial Crisis (GFC) when hedge funds should have provided significant down-side protection speaks to the failure of many hedge funds to do what was expected of them. Fees of 2% and 20% or more is a hefty price to pay for perceived risk reduction because you are clearly not getting benefit from exposure to HFs on the return side of the equation.
For the record, we at KCS have been discussing for some time now the misalignment of plan assets and plan liabilities within DB funds. Anyone who knows us has heard us speak about the importance of making sure that the correct bogey (plan liabilities and not the ROA) is being used. DB plans have a relative objective, and not an absolute one. Endowments and Foundations, as well as HNW individuals, have an absolute objective (positive spending policy), and the use of hedge funds in this space is perfectly reasonable, if you can select those that provide appropriate risk / return characteristics after fees.
Of course there are excellent hedge funds just as there are terrific managers of long-only equities, fixed income, real estate, etc. Unfortunately, our industry has a tendency to overwhelm the better investment firms / products with positive asset flows until the ability to add value has been arbitraged away.
DB plans don’t need expensive hedge funds in order to close their funding gaps. They need to only outperform liability growth in order to accomplish that objective, and cheap beta strategies are more than capable of providing that excess return. If we finally begin to see positive economic growth, here and abroad, a bit of inflation, and gradually rising interest rates, we could see asset growth easily exceed liability growth, which might actually be negative in that environment.
The last 15+ years have not been kind to plan sponsors and their DB plans. A return to the basics is what is needed at this time. We need to get refocused before it is too late. Too many employees, both private and public, are losing the opportunity to participate in a traditional DB plan. The alternatives are just not cutting it, and the social and economic consequences may be grave!
Asset consultants and plan sponsors of DB pension plans continue to pursue the return on asset assumption (ROA) as if it were the Holy Grail! Believe me, it is not! In fact, if one ever believed that achieving the ROA automatically brings funding success, the following statistics will debunk that thought, and quickly!
The following information is from the Public Employee Retirement Administration Commission (PERAC) website. PERAC was created for and is dedicated to the oversight, guidance, monitoring, and regulation of the Massachusetts Public Pension Systems. The professional, prudent, and efficient administration of these systems is the public trust of PERAC and each of the 104 public pension systems for the mutual benefit of the public employees, public employers, and citizens of Massachusetts. A very admirable objective!
To PERAC’s credit, they annually publish a summary of performance results and the Funded Ratio for each of the 104 plans for which they have oversight. As we’ve highlighted before, the “average” ROA objective for public funds nationally is about 7.5%. According to the most recent performance report from PERAC covering periods through June 30, 2014 all 104 public entities achieved a 30-year return that exceeded the 7.5% average objective. Amazingly, only 6.7% of the funds failed to achieve a >8% return for 30 years! In fact, 45% of the plans generated a return for 30 years that eclipsed 9% – truly outstanding.
Since the ROA is the objective for most sponsors and consultants, and given the fact that most MA public plans have far exceeded that objective, it must be safe to assume that these plans are currently fully funded. WRONG! Despite the fact that 100% of the plans have exceeded the average ROA not one plan (0%) have a Funded Ratio above 100%. How can that be? In fact, only one plan had a Funded Ratio that exceeded 90%. It gets worse, as 81 of 104 plans have Funded Ratios that fall below 70%, with Springfield achieving a woeful 27% Funded Ratio despite generating a 30 year return of 8.53%!
Well, if beating your return objective doesn’t assure funding success, what does? DB plans will achieve success only when they outperform their liabilities. As a reminder, the plans only exist to fund a promise that has been made. It doesn’t matter how well the assets perform as long as they exceed liability growth. Given the numbers cited above, clearly plan LIABILITIES do not grow at the ROA, and they have had a growth rate that has far exceeded the growth in assets.
Unfortunately, results for most of these plans in 2015 and 2016 will reveal underperformance to both the ROA objective and liability growth, as asset performance has been modest at best, while declining interest rates continue to inflate liabilities. If PERAC was created for and is dedicated to the oversight, guidance, monitoring, and regulation of the Massachusetts Public Pension Systems, then I would suggest that PERAC insist that a new approach be taken by the sponsors of these plans because what is being done currently is not working.
We need to preserve DB plans, but we are afraid that they will continue to come under greater public scrutiny as contribution costs escalate, while Funded Ratios plummet. That isn’t a formula for long-term success. Liabilities need to be monitored more frequently, and the output from that exercise (review) should be used to drive the plan’s investment structure and asset allocation decisions. I would definitely describe myself as being stubborn, but even I would seek an alternate approach if what I’d been doing for 30 years failed to achieve my ultimate objective – full funding!
The Atlanta Fed with the highly-tracked GDP estimator, slashed its Q1’16 GDP estimate to 0.1%. As a reminder, this number was as high as 2.7% two months ago – ouch!
The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.1 percent as April 8, down from 0.4 percent on April 5. The negative adjustment followed the wholesale trade report from the U.S. Bureau of the Census, the forecast for the contribution of inventory investment to first-quarter real GDP growth fell from –0.4 percentage points to –0.7 percentage points.
The U.S. economy’s on-going struggle to generate consistent and meaningful growth continues to negatively impact U.S. defined benefit plans (DB). How? Actually the impact is felt in several ways, and it touches both assets and liabilities. The lack of demand for goods and services is impacting the earnings and profits for corporate America, and it is highly anticipated that S&P 500 earnings will be negative for the third consecutive quarter. As we enter earnings season, it will be quite interesting to see how this unfolds.
Despite the tremendous rebound in equity prices that followed a deep sell-off earlier this year, stock prices do reflect growth in earnings and dividends over time. A continuing struggle to generate earnings will eventually weigh heavily on stock price performance.
With regard to liabilities, they reflect changes in the interest rate environment, as they are bond-like in nature. As a reminder, they DON’T grow at the ROA. As plan sponsors and asset consultants continue to underweight fixed income for fear of rising rates (how long now?), assets and liabilities are heavily mismatched. With U.S. GDP growth remaining quite low, it is highly likely that the Federal Reserve will work to keep rates low.
Even if we were to see a modest increase in the discount rate at some point this year, it is highly unlikely that longer dated US bonds would see an increase in their yields with the trillions of $s in negative real interest rates trading globally. U.S. long bonds are quite attractive on a relative basis, and they are likely to generate tremendous interest as Japan and European central banks continue to drive rates lower.
2016 is once again shaping up to be a poor year for DB pension funded ratios and funded status following the difficult 2014 and 2015 years. Isn’t it time to try something new? Stop focusing on the ROA and all the associated volatility, and begin to de-risk your plan through a strategy that focuses on your plan’s liabilities. The only thing going up in this environment are contribution costs, and most plan’s can’t afford that reality!
Offering a retirement plan, whether DB or DC, is neither trivial nor inexpensive! Thank you to the sponsors of these plans who are looking out for their employees (and our society)! Unfortunately, a wide swath of the US population (mostly those in small companies) don’t have access to a retirement vehicle of any kind.
Since the founding of KCS, I have been an outspoken critic of what is transpiring in the US with regard to the retirement industry. I much prefer DB plans to DC plans, but as most know, the DB plan is nearly extinct in the private sector, while public and Taft-Hartley plans continue to maintain their offerings, but are struggling in many cases to adequately fund them.
Why do I favor DB relative to DC? First, in many cases the employer is making the contribution or certainly the yeoman’s share of the contribution. Second, these plans are professionally managed. Since we don’t do a great job of providing our students with adequate financial literacy, why should we expect them to manage these plans effectively? Third, the cost of administering / managing a DB plan is lower than that of a DC plan, although DC costs have come down. Importantly, DB plans insulate the participant from market shocks that might alter one’s ability to retire with a DC balance and not a monthly check, if that balance has seen significant market losses (2007-2009).
In addition, DC plans have features that just don’t support the average participant. If DC plans were truly retirement vehicles we wouldn’t allow loan features. We would eliminate premature withdrawals when employees move from one job to the next. Finally, we would insist that every 401(k) / 403(b) provide annuity features to minimize the use of lump sum distributions that come with significant management responsibility in retirement.
DC plans were initially used as supplemental savings plans for high income earners, and they are well suited for that use, but they are not retirement plans! I have never been a participant in a DB plan. Boy, do I wish that I had been. I have only participated in DC plans since the early 1980s. Fortunately, as an investment professional for the last 35 years I have been able to handle this responsibility, but we are asking too much from those that haven’t spent their careers in the investment industry.
I know that many participants like the portability that comes with investing in a DC plan, but regrettably about 50% of the premature withdrawals from DC plans are related to movements among jobs in which the participant fails to rollover their balance.
We can do better as an industry, and we must! We are on the verge of having a significant percentage of our population retire without the means to remain participants in our economy. The economic and social consequences of this development are potentially quite grave. We must do a better job of preserving DB plans for the masses in both the private and public sector. This can happen, but they need new thinking with regard to how they are managed. The time has come!!
We are pleased to share with you the latest edition in the KCS Fireside Chat series. This article titled, “Your ROA Won’t Be Impaired!”, reflects our thoughts on a new game plan for DB plan sponsors.
Click to access KCSFCApr16.pdf
We remain concerned about the long-term viability of traditional defined benefit plans, and feel that it is increasingly necessary for sponsors to adopt a new strategy for managing them before they are permanently impaired. We hope that you find our insights helpful. As usual, please don’t hesitate to call on us if we can be of any assistance to you.
Many corporate DB plan sponsors have have begun to de-risk their plans by adopting some form of a liability driven investing (LDI) approach. Despite this trend, there remains a significant subset of corporate plans, and most public and Taft-Hartley plans that haven’t begun to de-risk their plans.
According to Prudential the top 100 corporate plans saw their funded status decline by roughly 50% from 1999 to the present (135% funded to 83% today) while at the same time they contributed a collective $600 billion in contributions. Oh, my!
There has been significant volatility in both funded ratios and contribution costs in the last 15 years, and a lot of it has to do with plans trying to achieve an ROA objective instead of providing the promised benefit at the lowest cost possible. Traditional approaches to asset allocation inject significant risk into the process.
Adopting a cash flow matching strategy for near-term retired lives does not impair a plan’s ability to improve funding, as the yield on the cash matching portfolio will far exceed the yield on a Barclays Aggregate portfolio.
Don’t continue to live with the excessive volatility of traditional asset allocation approaches, which may compromise the stability of your DB plan, when successful, time-tested approaches exist that will stabilize your funded status on annual contribution costs.
KCS is in the process of searching for Global equity managers for one of our clients. The only requirement is that the fund be offered in either a mutual fund or commingled vehicle. We are not opposed to using smaller shops (small AUMs) with young track records (no minimum requirement). Interested firms should contact Russ Kamp at rkamp@kampconsultingsoultions.com. Thank you, and have a great day.
We are pleased to share the following link, which provides access to a recent interview of Russ Kamp by Asset.TV.
https://www.assettv.com/player/default-player/100435
The interview focuses on the US retirement crisis, and particularly the need to preserve DB plans or re-establish them if they’ve already been terminated. Why? We are asking too much from our untrained employees. These individuals aren’t investment professionals and this critical task should be left to those that are.
Ron Ryan, Ryan ALM, and the KCS team would like to encourage plan sponsors and their consultants to re-think the use of traditional fixed income in a defined benefit plan, especially given where rates are after a 3o+ year bull market for bonds. It is truly unfortunate that most plans have dramatically underweight fixed income during the last 15+ years, and as a result they’ve created a significant asset / liability mismatch, while missing one of the greatest performance periods for U.S. fixed income.
First, we’d like for you to ask yourselves what is the value in having Bonds in your portfolio? As mentioned above, yields are historically low suggesting below average potential returns. Historically, the PIPER study shows that active bond management adds little to no value versus their index benchmark based on the median bond manager versus the Barclay’s Gov/Corp index. But, it gets worse, as this comparison is shown “before fees”.
After fees the median manager would lose consistently to the index benchmark.
So, what is the value in bonds? Answer: Cash Flows. Bonds are the only asset class with a known cash flow. That is why bonds have been used for defeasance, dedication, immunization and de-risking strategies. The most cost effective way to de-risk a pension is “cash flow matching”, as opposed to duration matching liability driven investing. For example, a Liability Beta Portfolio (LBP) model (produced by Ryan ALM) will cash flow match liabilities at a cost savings of 4% on 1-10 year and 10% on 1-30 year liabilities given its yield advantage. That is tremendous savings on a $200 million portfolio ($8 to $20 million).
Second, pension liabilities are “Interest Rate Sensitive” just like bonds. Since they have on average longer durations than bond indexes they are more interest rate sensitive, and by a factor of 2, maybe 3 times. Since 1982 (the beginning of the great bond bull market) interest rates have been in a secular decline, which has created significant growth in the present value of DB pension liabilities.
When interest rates go up as a trend, the opposite effect will happen. The present value growth of pension liabilities will be very low, and importantly, perhaps even negative. This will provide the best chance for DB Plan Funded Ratios to recover to a fully funded status. Pension assets will need little positive growth to outgrow liabilities and create significant liability Alpha. As we’ve stated many times, the ROA isn’t the objective for a DB plan, but that plan’s liabilities certainly are!
By converting your current fixed income from a performance oriented portfolio to one that is used to cash flow match, we set the plan on a de-risking path, remove interest rate sensitivity, and begin to stabilize contribution costs. Let us know how we can help you!
Ryan ALM Blog 