Happy New Year! May 2016 be filled with great health, much laughter, and prosperity.

We are pleased to share with you the latest edition of the KCS Fireside Chat series, in which we present three of our top blog posts from 2015 based on viewership and comments.

Click to access kcsfcjan16.pdf

As you’ve come to know, we are not shy about suggesting alternative approaches to standard DB pension orthodoxy. We believe that it is imperative that new thinking be given serious consideration based on the current state of Pension America.

Please don’t hesitate to call on us if we can be of any assistance to you.

First, my colleagues at KCS and I would like to wish you and your families a very Happy New Year filled with great health, lots of laughter, and much prosperity!

2015 is over, and as you will soon find out, it was not a good year for DB pension plans.  This marks the second consecutive year in which pension funds have missed their ROA targets.  However, unlike 2014 when plan assets also dramatically underperformed liabilities, 2015 will likely reveal that most total funds were flat to slightly UP versus their liabilities last year.

That said, funded ratios likely fell since liabilities aren’t marked to market while assets are, and funded status likely further deteriorated, which will negatively impact contribution costs.  What, if anything, are you going to do about this?  Unfortunately, this trend has been evident for more than 15 years now, and nothing seems to have been done.

Well, something needs to be done! Striving to achieve the ROA has lead to asset allocation decisions that have greatly increased volatility, but certainly not the probability of success.  Adopting a strategy that pays heed to a plan’s specific liabilities, in addition to the assets, will likely lead to a very different asset allocation, especially within traditional fixed income.

Are you ready to learn more?

Following two straight years of sub par performance for DB pensions versus their ROA target AND Plan Liabilities, 2016 is going to be the year that Pension America embraces derisking as a prudent approach to the day-to-day management of plan assets.

Derisking can be achieved by any DB plan whether that plan is fully funded, well funded or poorly funded.  The idea behind derisking is to achieve a greater knowledge of plan liabilities, then using that insight to develop a sounder approach to asset allocation, investment management structure and cash flow (liquidity) management.

How does one gain greater transparency of plan liabilities? Through the creation of a Custom Liability Index (CLI), which uses the output of the annual actuarial report, but unlike the actuarial output, the CLI’s information is made available monthly or quarterly depending on the frequency that the client desires. With this greater insight comes the ability to adjust the playbook to meet the challenges of the current environment.

With regard to those challenges, 2016 is looking very much like a year in which both equities and bonds will likely produce modest results, at best, making the achievement of the ROA an even more difficult objective.  Furthermore, the volatility associated with traditional asset allocation models can lead to wide fluctuations in the performance of assets versus liabilities putting further pressure on funded ratios and cash flow.

Given that the US Federal Reserve has already moved on interest rates, traditional active fixed income will likely struggle to achieve a return commensurate with portfolio’s yield.  Sponsors should seek an alternative approach that works for the plan and not against it. What might that be? The strategy that we would suggest is Cash Flow matching, which can be done far more inexpensively than traditional fixed income (10 bps versus 25-30 bps). We also believe that the cash flow matching strategy is superior to duration matching, and may result in significant cost reduction. Have we grabbed your attention yet?

Regrettably, traditional ROA-centric approaches have not worked.  It is time to move onto a different course.  One in which a plan sponsor has greater knowledge of their liabilities, and uses that information to dynamically drive a responsive asset allocation and liability matching. Let us help you make 2016 a superior year for your pension plan.

As reported by P&I, defined contribution plans consistently underperform defined benefit plans, most likely due to higher investment fees, said a new research brief issued Tuesday by the Center for Retirement Research at Boston College. The report covered the period 1990-2012.

The BC report cited investment fees, which typically account for 80% to 90% of total expenses, as the most likely reason for DC plans’ underperformance as DC plans invest mainly through more expensive mutual funds and DB plans invest through other vehicles such as separate accounts and / or less expensive commingled trusts.

We would also suggest that a big reason for the underperformance of DC plans relative to DB plans is the reliance on the individual in the DC plan to handle this responsibility relative to professional management of DB plans.

Unfortunately, the report also found that individual retirement accounts (IRAs), which now hold more assets than DB or DC plans, produced even lower returns than DB or DC plans.

The report was based on a review of Investment Company Institute data and Form 5500 filings, which found that IRAs returned an average 2.2% per year between 2000 and 2012 , compared to 3.1% for defined contribution plans and 4.7% for defined benefit plans.

A DC plan account owner would have earned an additional $85,777 (on a beginning balance of $100,000) or 42% more by achieving a 4.7% return versus the 3.1% achieved on the average DC plans during this 23 year time frame.

The research report was written by Alicia Munnell, director of the Center for Retirement Research; Jean-Pierre Aubry, associate director of state and local research at the center; and Caroline Crawford, a research associate at the center.

The full report is available on the center’s website.

MLPs as an investment category have been whacked severely year-to-date according to the Alerian MLP Index, which has fallen 42.9% through December 4th! As a contrarian by nature, I am always looking to get into a potential investments that have gotten beaten up provided that nothing fundamentally has changed to permanently impair the investment category.

I am not close to being an expert in this area. So as I began to get more intrigued with MLPs I reached out to a friend, Jeremy Hill, Old Blackheath Companies, who is and who was kind to share his views.  Here you go:

As for MLPs, I don’t think there is much of a catalyst other than the stabilization of the price of oil. That seems odd because it assumes that pipeline capacity is a function of the price of oil. It is not. It is a function of how much oil is piped. So far, pipelines continue to be busy. Where the pipelines (MLPs) go wrong is that they have frequently become vertically integrated oil and gas companies that call themselves pipelines and they have a lot of debt. The idea that because the price of oil is down, less oil will be sucked out of the ground, therefore less oil pumped and piped and therefore less revenue/profits for the pipelines is intuitive. It is intuitive investing, not math-based investing.

Take a look at Kinder Morgan. Although they are not an MLP, they are lumped in with the MLPs. They cut their dividend severely and the stock is doing nothing but going up. For a pure reversion to the mean type of investment, I think KMI may be interesting at these levels. Their credits may be even more interesting. And, possibly selling puts could be a nice strategy for some of these companies.

The rub, of course, is that so long as investors (largely retail in MLPs) conflate the oil price/MLP equation, these stocks have a lot of embedded gamma risk. The real risk to these stocks is that banks stop financing them. I also think that there are likely to be more dividend cuts. In sum, I wouldn’t step into MLPs any time soon.

Thanks, Jeremy! We will continue to monitor MLPs for possible investment opportunities, but it looks like a 2016 event at this point.

We are happy to report that the Association of Benefit Administrators, Inc. has published an article by KCS in their Fall 2015 Newsletter.  The article, titled “The Truth Will Set You Free”, addresses the need for plan sponsors to focus more attention on DB plan liabilities to drive asset allocation and investment structure decisions.

We would be happy to send you the article upon request.

“You Can’t Manage What You Don’t Monitor”

We hope that you had a wonderful Thanksgiving Holiday, and we wish for you and your family a joyous holiday season. Where has 2015 gone?

We are pleased to share with you the latest edition of the KCS Fireside Chat series. In this article we discuss the importance of managing against a DB plan’s liabilities through the use of a custom Liability Index (CLI). Furthermore, we begin an important discussion on how to use the output from the CLI to drive more informed asset allocation decisions. We hope that you find our thoughts both refreshing and useful.

Click to access KCSFCDec15.pdf

Please don’t hesitate to call on us with any questions that you might have. We always enjoy the give and take that follows our distribution of the FC.

Have a wonderful day, and we look forward to working with you in 2016 and beyond.

Sincerely,

The KCS Team

P&I just posted their performance study by Morningstar. As usual, it shows little or no value in ACTIVE bond management over most time frames. Moreover, given today’s low yields the question is: What is the value in bonds if one is striving to achieve the ROA?

Answer: CASH FLOW
Bonds are the only asset class with a known future cash flow and future value. That is why bonds have been picked as the choice for defeasement, dedication, immunization, and LDI strategies.

Instead of maintaining your current active fixed income program convert it to a Liability Beta Portfolio (LBP).  The LBP model is a cash flow matched model that provides the matching of liabilities at low cost and importantly, low risk. Versus ASC 715 discount rates (AA corporate securities)  funding costs are reduced by 8% to 12%. At a fee of only 10 bps, the LBP would be a proper replacement of active bond management, which has a 25 bps to 30 bps average fee. Given a 20% allocation to bonds, inclusive of contributions, the LBP model could possibly fund the next 7-10 years of liabilities with no change to the plan’s current asset allocation.

The true question is: Why have active bond management when you can de-risk the plan gradually with a LBP model that will reduce the cost of funding liabilities, while also reducing significantly fixed income fees?

Please don’t hesitate to reach out to Ryan ALM and KCS to discuss this concept in more detail.

Our regular readers have likely been wondering where we’ve been this month, as the KCS blog has been quiet.  I can assure you that it wasn’t because we spent the entire month on a beach in Florida.  We were given the opportunity to speak / present at four conferences during the month, including;

1. November 9, Financial Research Associates, Manager Selection, Due Diligence, and Oversight – Princeton Club, NYC – “The Economy: What Impact Is It Having On Your Manager Selection?”
2. November 17, Opal’s Endowment and Foundation Forum, Boston, MA – “A one and five year strategic investment and planning mechanism for small and mid sized foundations”
3. IMI’s 32nd Annual Consultants Congress, Cornell Club, NYC – “Standing Out In A Crowded Marketplace”
4. Association of Business Administrators, NY, NY – “Benefit of Knowing Your Liabilities”

We were honored to be asked to present our views at these important forums, and we would be pleased to speak with you on any of these topics should you have any questions. Presentation material is available for some of these as well.

We are pleased to provide you with the latest edition of the KCS Fireside Chat series.  In this article, Dave Murray, KCS’s DC Practice Leader updates you on some important DC information as you head into 2016.  Hopefully, his insights will help guide you through the balance of this year and into next.

Click to access KCSFCNov15.pdf

As you know, KCS is a big fan of defined benefit plans for a lot of reasons, but primarily because DC plans (401(k), 403(b) and 457s) were not designed as retirement accounts, and because of loan features act like glorified savings plans.  It is good to see that disclosure is being tightened around one’s ability to take hardship loans.  We realize that emergencies present themselves, but borrowing from a DC account should be the absolute last resort.