We remain concerned about the singular focus by plan sponsors on the return on asset assumption (ROA) to drive asset allocation.  Why? First, the ROA is not reflective of a plan’s liability growth.  Second, trying to create an asset allocation that achieves a 7.5% (average ROA) objective in this market is leading to excessive volatility.

It was once a fairly easy objective when interest rates provided a healthy 5%-6% return.  However, in this low interest rate environment the standard deviation of returns around a 7.5% objective is roughly 17%-18%.

What does that mean for the plan sponsor and their asset consultant? It means that 68% of the time (1 standard deviation), the annual return for a DB plan will be anywhere from 25% to -10% (using 17.5% as the standard deviation).  It also means that 95% of the time (19 out of 20 years) the return to the pension plan could be 42.5% to -27.5%.  WOW!! You can drive multiple trucks through that gap.  Is this range of results comforting to you?  It shouldn’t be!

What is particularly troubling is the fact that there are well funded and less well funded plans using the same 7.5% objective and roughly the same asset allocation.  How does this make sense?  One would think that a plan with a 90% funded ratio would remove a significant portion of the above mentioned volatility from the asset allocation process.  Either one plan’s asset allocation is too conservative or the others is way too aggressive.

We need to protect and preserve DB plans as the primary retirement vehicle.  Injecting too much risk into the asset allocation process is destabilizing these plans.  We need to rethink this approach before it is too late.

We are pleased to provide you with the latest edition of the KCS Fireside Chat series. This article is titled, “DC Plan Participants Speaking Up”, and boy are they! Just when corporate America thought that they were reducing the company’s liability by freezing / terminating the DB plan, plan participants in defined contribution plans are reminding them that there is still significant liability to be had. Don’t be fooled into thinking that these DC lawsuits and DOL audits only occur in large entities. DC audits have been know to be taken on plan’s as small as $1 million in AUM.

Click to access KCSFCMar16.pdf

If you haven’t rebid your platform provider / record keeper within the last 5-7 years, you are a prime candidate for an audit.

We hope that you find the thoughts from Dave Murray, KCS’s DC Practice Leader, useful and compelling. Please don’t hesitate to call on us if we can assist you in making sure that you and your DC plan are prepared for an audit. A little time and money invested today, can save you a lot of both in the near future.

Be well, and thank you for your on-going support.

The true objective for a defined benefit pension plan is to fund the liabilities (benefit payments) at stable and low contribution cost to the plan. Such an objective should be funded at reduced risk through time.  In order to accomplish this objective a plan sponsor and their ASSET consultant need to depart from the roller-coaster ride provided by pursuing the ROA. At KCS (an asset AND liability consultant) we focus first, and foremost, on the plan’s liabilities and funded ratio, which we use to drive the investment structure and asset allocation decisions.

Attached is an overview on the importance of having a custom liability index (CLI) measure your plan’s specific liabilities.  Let us know if we can build one for you.

Click to access KCSPensionAmericaCLI.pdf

I can’t tell you how many times I heard those words uttered by my mom when I was a youngster, and it usually pertained to my eating habits! For instance, did I really need to consume the whole quart of milk and the entire, newly-opened bag of cookies? Probably not, but invariably I did.  Well, if my mom understood what many (most) non-corporate DB plans were doing today, she’d chastise them, too, and with good reason.

Regrettably, GASB allows public pension DB plans to discount their plan liabilities at the ROA, and not at a “market rate” such as FASB (AA corporate) or the more conservative mark-to-market rate, such as US Treasury STRIPS.   As you’ve heard us mention on numerous occasions, liabilities and assets don’t have the same growth rate, so it makes no sense to discount liabilities at the ROA.  Why does this matter? It matters a heck of a lot, and it is leading to inappropriate asset allocation decisions that are being exacerbated in this market environment.

I attended the Tri-State Institutional Investor Forum today at the Harvard Club.  It was a well-attended conference, with very good presenters, but as usual, the singular focus was on the asset side of the DB equation.  In attendance were several representatives from a very large public pension plan from a state near and dear to my heart. Each of this state’s representatives mentioned that their fund had a 7.9% ROA. They also mentioned that they weren’t particularly focused on the liabilities given GASB’s ridiculous accounting methodology, and as a result they didn’t have much exposure to traditional fixed income, as the low yield environment would be a “drag” on performance, as if the only thing that mattered was the yield?

However, what they did do was to “equitize” their fixed income exposure by allocating to high yield, emerging market debt, preferred securities, and other more exotic alternative sources of fixed income exposure, betting that these securities would presumably benefit from rising equity markets.  Unfortunately, our equity markets are not cooperating, and instead of holding higher quality, more liquid fixed income (Treasuries) that have rallied significantly (the yield on the US 10-year has fallen by more than 50 bps so far in 2016), these equity alternatives are under significant pressure. UGH!

So, again, I ask, “just because GASB permits liabilities to be discounted at the ROA, should plan sponsors do this?  NO! Asset allocation decisions undertaken in an attempt to achieve a 7.9% ROA are accomplishing little in terms of generating return, but are certainly a breeding ground for volatility and uncertainty. Public pension plans should pay some heed to their liabilities.  They should use the current funded status to drive asset allocation decisions and not some generic ROA objective that has nothing to do with how liabilities actually perform. As a plan gets closer to full funding, the plan should de-risk, and not subject the entire corpus to unnecessary risk-taking.

Just like me when I was a kid, these plans need to pause before they continue to gorge unnecessarily! In the case of these DB plans they are choking on the risk associated with an asset allocation policy designed to achieve the ROA, with little likelihood of getting the benefit that they desire.

Managing a pension plan is difficult!  Unfortunately, the task has been made more difficult by not having a complete picture of the plan’s true objective. What do I mean?

Well, as everyone knows, the big game is on Sunday, and much of the country will be glued to their seats watching Carolina and Denver play.  Just think what a different experience it would be if there was no scoreboard, and you didn’t know who was winning or losing. Can you imagine a team trying to run an offense without the knowledge as to whether they should become more aggressive (more passing) or conservative (3 yards and a cloud of dust)? How about a defense not knowing whether to blitz on every play or use 5-6 defensive backs to stop the big play?

Well, unfortunately for most of our plan sponsors this is what they experience all the time – at least 364 of 365 days (non leap years).  How is that possible? The most important piece of information that a plan sponsor can have is absent, missing, no where to be found! Plans only exist to meet a promise that has been made, yet that liability is only calculated once per year and usually received about 4 to 6 months in arrears.

Plans blindly manage asset allocation decisions versus a generic return on asset assumption (ROA), and I say generic because every liability stream is different, yet roughly 50% of public pensions use 7.5% as their objective.  How can that be?  Also, they assume that liabilities grow at the same rate as assets, but of course that isn’t correct. As we’ve seen during the last 15-16 years, liabilities have grown at nearly three times the rate as plan assets.  Wonder why we have a funding crisis?

By not knowing what the plan’s liabilities are it is impossible to adjust a plan’s asset allocation to reflect either improvement or deterioration in the funded ratio.  Plans experiencing improved funding should de-risk the portfolio (adopt that no hail Mary strategy), while plans struggling to improve funding might just need to get more aggressive.  Clearly, a one-size-fits-all ROA objective of 7.5% can’t be right.

The standard deviation associated with a combination of assets that might get you 7.5% in this environment is roughly 17.5%.  Are you comfortable living in an environment in which 68% of your annual observations ( 1 standard deviation) could have your plan up or down anywhere from 25% to – 10%? I don’t think so!  Yet that is exactly what is happening.

I encourage you to get greater clarity on your liabilities so that asset allocation and management structure decisions are based on fact and not some generic ROA that doesn’t have anything to do with liabilities. With greater clarity comes a more likely victory! Get a Custom Liability Index (CLI) so that you have a monthly view on your promised benefits.

We are pleased to share with you the latest article in the KCS Fireside Chat series. This article is titled “Greasing The Market Slide”.  We discuss what is currently happening within the Oil sector and what you should do as a DB plan sponsor and / or a DC participant.

Click to access KCSFCFeb16.pdf

As always, we hope that you find our insights helpful, and please don’t hesitate to reach out to us if we can be of any assistance to you.

Today was the day that I was supposed to be at FRA’s “Made In America” conference in Las Vegas.  Ironically, the title of our panel discussion is “Digging Out Of Your Underfunded Status”. There certainly is a lot of digging our going on in the Northeast, but regrettably it has little to do with funded ratios or funded status for Pension America.

The basis of my presentation today was to focus on the need to first stabilize the plan through some fairly simple steps, but one’s that throw common pension orthodoxy out the window. So in that regard, not simple at all, as we are finding that there is great reluctance (inertia) to change one’s approach.

At KCS, we are espousing a three step approach to setting DB pension plans on the right course to improved funding.  The process begins with a thorough analysis of the plan’s liabilities through the creation of a Custom Liability Index (CLI). This index utilizes readily available data from a plan’s actuary, but instead of getting an annual look at your liabilities through the actuarial report, a plan sponsor can get a monthly view through the CLI.  The CLI will showcase the growth rate, interest rate sensitivity, and the term-structure of the plan’s liabilities.

With this output, we can determine how much alpha is needed relative to the liabilities, not the plan’s stated return on asset objective (ROA), in order to close the funding gap over the modified duration of the plan’s liabilities. Furthermore, we can determine how much of the plan’s assets can be placed in the beta portfolio (a cash matched or duration matched strategy) to begin to immunize near-term liabilities.  The balance of the assets will be in the “alpha” portfolio with the goal, as stated before, of exceeding liability growth.

The final step in our process is to begin to implement our beta / alpha approach by converting the current fixed income portfolio, with all its credit and interest rate risk, into a more effective beta portfolio. With these three steps, the DB plan’s funded ratio will be stabilized, and the plan will now be on a glide path toward full funding, and contribution volatility will be lessened.

Unfortunately, current pension thinking would have one ratcheting up the ROA, jumping into new products / asset classes, trimming benefits, extending retirement age, lowering costs, etc., all in an attempt to stabilize the plan. Well, striving for the ROA has only lead to greater funding volatility, and given how the global markets have behaved so far in 2016, more volatility is not the medicine that we should be ingesting.

Click to access KCS4Q15.pdf

It seems almost silly that we are presenting you with a Fourth Quarter review for 2015 given what has transpired in the markets through the first 19 days of 2016.  However, we think that it is important that one understand that 2015 wasn’t as bad for pensions and Pension America as most people believe, and certainly not nearly as bad as 2014.

Why? Well, despite the significant underperformance of plan assets relative to DB plan ROA’s, assets actually modestly outperformed liability growth last year.  Thanks to Ron Ryan and his firm (Ryan ALM), we have a great understanding of what is happening to pension liabilities on a monthly basis, and you should, too. Unfortunately, most DB plans only get a yearly view on their liabilities, and then only valued at the ROA as the discount rate.

We hope that you continue to find our thinking on pension related issues useful.  As always, please don’t hesitate to call on us if we can be of any assistance.  You can also glean our insights from the KCS website, blog and social media accounts that are highlighted in the attached review.

May 2016 be a year filled with great health, much laughter, many friends, and peace!

Click to access KCS4Q15.pdf

The Kamp Family hopes that 2016 is a wonderful year for you, your family and friends.  May it be filled with much laughter, great health, calmer markets, and peace. 

Certainly global stock markets have gotten off to an ugly start in 2016.  Don’t panic! Maintain your long-term asset allocation policy, and since most equity-oriented assets have seen significant pullback, this means re-balancing back to policy normal levels. Why? There are significant regression to the mean tendencies in our markets, and as a reminder, it is much better to buy low and sell high.

This is not to say that our markets are stable, that equity markets can’t fall further from these levels, but we would caution you on selling into this weakness only to lock in losses that are only on paper at this time.  Furthermore, although the US economy appears to be slowing (Atlanta Fed is forecasting a 0.8% Q4’15 GDP growth rate), we do not see a recession in the foreseeable future, and significant market corrections are usually driven by recessionary environments.

Unfortunately, most of us have become traders instead of investors, and that goes for holders of mutual funds and ETFs and not just individual stock pickers.  Given the significant pullback in stocks associated with energy (-21% to as much as -47%, depending on the market capitalization index) and commodities ( -32.9% in 2015), and those impacted by the hit to energy and commodities, including emerging markets (-14.6% in 2015), miners, transportation companies, and MLPs (-32.6% in 2015), there are some significant dislocations that might just provide very attractive long-term opportunities.

If you already have a policy allocation to some of the above mentioned instruments / exposures, re-balance back to policy.  If you don’t currently have exposure to these potential investments now is a great time to begin educating yourself on the products available to you.  Don’t worry, they’ve been beaten down so badly that you won’t miss the opportunity, if you don’t get into them today.  Happy hunting!