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!

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.