S&P is out with a recent analysis suggesting that many American cities with weak pension funded status will likely face challenges in meeting both pension obligations and other social safety net funding. According to an article by Cole Lauterbach, Illinois News Network, S&P Global Ratings is predicting that growing public retirement debt will eat up a greater share of the funds available to meet other taxpayer needs.

S&P’s annual report specifically highlights the funding for America’s largest 15 cities and their public debt. It is not surprising that S&P warns that taxes will rise and services will be cut if additional sources of revenue cannot be identified. This problem has been anticipated for a long time. What is disappointing is the fact that S&P does not focus on the management of the pension systems, but only speaks to the growing burden created by these plans. The failure of pension America to secure full-funding in the late 90’s when the war was won is a critical component not often discussed when highlighting the burgeoning deficits.

Furthermore, we are now 9 1/2 years into a historic equity market bull market and yet, funding hasn’t improved for many of these plans. Focusing on the return on asset (ROA) assumption has never been the right strategy, but it is particularly fraught with peril at this time. Pension systems should be managed against their promised benefits, and investment structure and asset allocation determined by the plan’s funded ratio. By adopting more of a liability focus, plans can remove much of the short-term funding volatility, while extending the investing horizon for the balance of the assets in order to capture the liquidity premium of equities, real estate, private equity, etc.

Pension obligation bonds are another means to close some of the funding gaps, but only if the proceeds are used to defease retired lives (and terminated vesteds) and not placed in a traditional asset allocation subject to all of the equity market’s volatility. It is one thing to repay the bond and interest, but an entirely different scenario to have to make up for a 20% decline in the value of the bond proceeds.  Let’s hope that America’s largest cities develop a willingness to try alternative approaches to the management of these critically important pension programs.

A decade after the Great Financial Crisis and we find that nearly 6 in 10 American workers have still not recovered from that horrific financial event. In a survey of workers from the Transamerica Center for Retirement Studies, 56 percent of respondents said they have not fully recovered. 37% of those polled indicated that they had recovered somewhat, 12% said that they had yet to recover, and the remaining 7% felt that they never would recover.

This comes at a time when the country is enjoying a historic equity bull market, unemployment is at decade lows, and median family income has risen for the third consecutive year to >$61,000. What gives? Well, for one, many American workers lost more lucrative jobs during the GFC only to be forced into lower paying occupations just to survive. So, yes, they are employed, but those individuals will never be able to recover when annual incomes have been slashed to the extent that they were.

In addition, many American workers already had their “retirement” plan shifted from a traditional pension, such as a defined benefit fund to a defined contribution offering.  For many workers, the shock of seeing the markets fall by roughly 50% has steered many away from continuing to contribute. As a result, only about 50% of American workers have access to or are funding a retirement benefit. So when we discuss the terrific bull market, we are really addressing the 10% of Americans that own 84% of the outstanding stock.

Yes, median family incomes have begun to rise, but the 1.8% increase from 2016 didn’t keep pace with the growth in the CPI. Furthermore, a significant percentage of Americans are now tasked with funding health care and retirement to a greater extent than those from prior generations. Less traditional worker/employer relationships (on-call employment) means fewer benefits in general.  In addition, housing and education costs are also rising rapidly. Asking workers who have not been trained to fund, manage, and then disburse a retirement benefit is a poor policy decision.

Happy to share the following graphic with you.

As the above chart highlights, the recalculation by the CBO of the costs associated with the Butch Lewis Act makes it a clear-cut choice relative to the propping up of the PBGC. Furthermore, the absence of benefit cuts will reduce the likelihood that many of these retirees would need subsequent assistance through some kind of social safety net.

As we’ve discussed many times before, the benefits that these retirees receive are an engine to economic growth throughout the communities in which they live. Cuts to benefits impact more than just the pensioner.

In yesterday’s KCS Blog post, “No More Excuses”, we touched on the fact that CBO scoring for the Butch Lewis Act legislation showed only a $34 billion price tag down substantially from the original $101 billion calculated last year. Our friends at Cheiron (outstanding actuarial firm) have shared the following with us.

The CBO scoring came in at $34 billion, and reflects the following changes:

1. Eligibility: the pension plan must be in critical and declining (C&D) status as of implementation date, or be critical as of the same date, but have a funded ratio of under 40% and the ratio of actives to in-actives is under 40%.
2. PBGC financial assistance will not kick in until the plan is within 5 years of insolvency. This reduced the scoring significantly.
3. The loan amount will be for Retirees and Term Vesteds (this is new).
4. To incentivize the plans to pay back the loan, they will be offered two loan repayment options at the front end; either accept the 30-year interest with a balloon payment at the end, or 20 years of interest, with the loan then being amortized over the last ten years. Plans choosing the latter payback option will enjoy a 50 bps reduction in the loan repayment interest rate throughout the term of the loan.
5. The maximum interest rate on any loan will be 20 bp above the prevailing 30 year Treasury bond rate.
6. The PBGC will be able to recommend merger that they see fit, plans that do not want to merge will need to show why remaining independent would be in the best interests of plan participants.

The most significant changes, as we see, are the PBGC’s support being withheld until a plan is within 5 years of insolvency, the opportunity to repay the loan earlier and at a reduced interest rate, and the fact that the PBGC could recommend merging two or more plans.

We touched on the repayment options yesterday, but the possibility of receiving a loan with a 50 basis point discount is meaningful. It is too soon to know how many of the critical and declining plans would seek this option, but I would hope that a majority would be in a position to elect the accelerated payment schedule.

Cheiron mentioned that the CBO scoring was impacted significantly by the fact that the PBGC will withhold funds until a plan is within 5 years of insolvency under this new proposal. I have not seen the math behind this aspect of the revised bill to be able to comment on this provision. However, I am concerned that not having the assets in the fund from day one and growing at the projected ROA of 6.5% seems potentially harmful to the ultimate success of the loan program. But, then again, placing the PBGC assets into a traditional asset allocation more than 9 1/2 years into an equity bull market may be worse.  We’ll see if we can get a better handle on this revised language.

Lastly, the PBGC’s ability to recommend merging pension plans together is interesting. We, at KCS, are not sure at this time what the criteria are to make such a suggestion, but once the recommendation is made the onus falls on the plan sponsor to say why it doesn’t make sense for their plan. We often highlight the fact that municipal and state pension systems would benefit from greater economies of scale by combining pension systems.  Is this any different?

The CBO has revised estimates for the costs associated with the loan program under the proposed Butch Lewis Act (BLA) legislation. This revised estimate is well below the CBO’s initial $101 billion projected cost and makes the BLA the most affordable option currently being considered by the Joint Select Committee on Solvency of Multiemployer Pension Plans.  According to Senator Brown’s spokesperson, Jenny Donahue, the difference in the CBO’s calculation is the result of  “smart changes to the legislation that make it a better bill and the cheapest option for taxpayers”. 

Most importantly, it solves the multiemployer pension crisis without benefit cuts to the plan participants, who are facing the prospect of severe cuts to their benefits should Congress fail to act. As we’ve discussed previously, one option being considered is to allow these plans to fail thus placing responsibility for the management of the pension systems on the Pension Benefit Guaranty Corporation (PBGC). The cost of doing “nothing” would be roughly $78 billion according to the PBGC’s Director Thomas Reeder. 

These proposed changes are not radical by any stretch of the imagination. What is being considered at this time is a cap of 0.2% on the interest rate charged to these plans relative to the 30-year U.S. Treasury Bond.  In addition, pension plans can save additional money by beginning to repay the loan in year 20, as opposed to year 30. If a plan chooses to prepay the loan beginning in year 20 a 0.5% lower interest rate will be made available and the pension plan would be required to make 10 annual installment payments until the loan is paid back.  Finally, only the neediest plans are eligible (those categorized as Critical and Declining plans that face insolvency within 15 years) to receive a loan, but I was under the impression that this grouping was the only cohort eligible in the first place.

Given the significant reduction in the CBO’s cost estimate, the potential paying back of the loan beginning 10 years earlier, and the fact that benefits can still be protected without burdening the PBGC, it seems that passing this legislation should be a no-brainer. There really are no more excuses for not passing this critically important legislation.  The financial fate for millions of American retirees is in the hands of the members of the JSC.  It is long past time for positive action.

We recently published a blog post highlighting the fact that U.S. “Growth” stocks have dominated performance relative to “Value” stocks during the last several years. We are concerned about the narrowing of equity market leadership.  Furthermore, we pointed out that style cycles have been a part of the equity markets since their beginning.  The last period of sustained underperformance for value occured during the 1990’s. You may recall that many market experts were predicting a new investing “paradigm” in which value investing was dead. The 2000s soon arrived and the Dotcom bubble came to a screeching halt.

Could we be witnessing another cycle nearing its end? I am always leery when market pundits begin to speak about the demise of this style or that investing insight. Here we go again. The WSJ has published an article today questioning the future of “Value” investing. The use of Price-to-Book as a measure of value is being called into question because of accounting practices related to how intangible assets are treated. There may be some merit in this analysis, but there are many measures of value, such as P/E, Price to Sales, Price to Free Cash Flow, Price to Enterprise Value, etc. that have also failed to positively correlate with market leadership.

“There are important differences between then and now. Today, the economy is booming, inflation is low, regulatory restrictions on business have been eased and money flows into the stock market from a much larger segment of the population.” As you shake your head in agreement, realize that the above quote comes from a WSJ article from January 18, 2000, or less than 2 months before the Dotcom bubble burst! As you may recall, the Nasdaq Composite lost 78% of its value as it fell from 5046.86 to 1114.11.

We certainly aren’t smart enough to know when Growth investing will begin to underperform Value investing as a style or the magnitude of that underperformance, but it will happen. When it does, you are best to be in active equity strategies relative to the passive indexes. If there is one benefit from having been involved in this industry for almost 40 years, it is learning one simple fact that history does repeat itself when it comes to investing.

According to a recent study by the advocacy group New Jersey Policy Perspectives (NJPP), New Jersey’s Millennial (18-39 year-olds) population is not fleeing the state in droves but has maintained the same pace of exodus that has been in place since 2004.  Furthermore, “the rate of millennials leaving New Jersey isn’t any different from the rate of that same group leaving ““comparable”” states.” Oh, that’s comforting!

In this case, the comparable states include other “Blue” states, such as New York, Pennsylvania, Connecticut, and Massachusetts. Since KCS’s founding (8/11), we have been concerned with the impact of underfunded state pension systems on the ability of those states to meet the expanding cost of providing the required social safety net.  The issues related to New Jersey’s pension underfunding are well known, and they are and will continue to influence migration to and from our state.

Millennials are hounded by poor job prospects, the lack of wage growth, rising taxes, expensive housing, and growing student loan debt. These inputs are certainly not the formula for a robust economy. Did you know that more NJ Millennials live with their parents or a relative than Millenials in any other state? Not surprising then that Millennial outmigration hasn’t expanded, yet. However, Mom and Dad or Uncle and Aunt so and so are not the long-term answer.

New Jersey’s recently completed budget process once again involved a series of tax increases on business and individuals (supposedly millionaires). With property tax bills among the highest in the country, there remains little appetite or room for further tax increases. We believe that DB plans need to be maintained, but a new course in managing them must be undertaken sooner rather than later.

There is a narrowing of market leadership within global equity markets, and it clearly begins and ends with the U.S. in general and more specifically with growth-oriented stocks/indexes. U.S markets continued the steady climb higher (R3000 +3.5%), while many overseas markets, both developed (EAFE -1.9%) and emerging (EM -2.7%), declined during the last month. However, as mentioned above, market leadership is much narrower than the U.S. versus everyone else.

Equity markets are being led by companies exhibiting growth and not value characteristics, continuing a trend that has been in place for several years now.  Is this trend sustainable and what are the implications for active managers versus passive benchmarks? In August, the Russell 3000 Growth Index produced a 5.5% return and it is now up 16.6% year-to-date. While growth was producing a robust return, the R3000 Value Index was up only 1.6% for the month and it has produced a much more modest 4.2% YTD return in 2018.

Historically, the small value index (R2000 Value) has bested large growth (R200) by 3.1% per annum for the last 20 years through August 2018.  However, given the meaningful outperformance of both large-cap and growth during the last 5 years, this relationship has been flipped completely with large-growth outperforming small-value by 7% per annum during this time frame. A 3-year comparison also favors large growth by 5.1% per annum.

This concentrated outperformance by large growth has impacted active managers in the U.S. many of which have inherent biases to both smaller capitalization companies (build equal-weighted portfolios) and value (screen for price to something, such as book value, earnings, sales, enterprise value, free cash flow, etc.). We don’t believe that this concentration is good for the markets or it’s participants longer term and we believe it is time to consider rebalancing from large growth to small value and from passive to active at this time.

Ron Ryan (Ryan ALM) and KCS have been crisscrossing the country for the last 6-7 years trying to encourage plans sponsors (and in some cases their asset consultants) to embrace the use of their plan’s liabilities to drive investment structure and asset allocation decisions. We are now 9 1/2 years into a historic U.S. equity bull market and funded-ratios haven’t improved a whole bunch and contribution expense continues to escalate.  Do sponsors truly believe that their plans will earn their way to better funding in the next several years? Unfortunately, corrections occur and we are likely to see one in the not too distant future.

Here are our thoughts on the return on asset assumption (ROA) and why we believe that having a cost objective is superior to one focused on return.

1. The true objective of a pension is to fully fund (secure) benefits in a cost-efficient manner with prudent risk. It is NOT a return objective.
2. Projected benefit payments are future value (FV) dollars while the ROA is in present value (PV) dollars.
3. The ROA is a forecast (and not a particularly good one). Actual annual asset returns (and liability growth rates) deviate greatly from the ROA. This deviation is called actuarial gains and losses and could be significant each year and for multiple years.
4. The ROA is NOT a calculated number! It ignores the funded status. As a result, pension systems with 60% and 90% funded ratios could have the same ROA and the same asset allocation. The Ryan ALM and KCS teams can calculate the true ROA needed to fully fund the plan (with future contributions factored in). We recently completed a project for a client who had a 7.75% ROA. When we ran the Asset Exhaustion Test it was obvious that even at 6.00% ROA, the assets were not exhausted suggesting that 6.00% would be a better fit as the target hurdle rate for asset allocation. Why run at a more aggressive rate than is necessary?
5. The Funded Ratio is in PV dollars. Would a pension plan have the same funded status with an asset allocation of $100 million PV of:
6. 1. 100% Treasury portfolio with a YTM of 3.00%
   2. 100% A corporate bonds with a yield of 4.00%

Answer: The same Funded Ratio in PV, but certainly better funded in FV dollars when using the corporate bond portfolio.

1. If you focus on returns then it should be asset growth vs. liability growth in market value dollars, not actuarial valuations (AV). This is where the creation of the Custom Liability Index (CLI) can play a role.
2. If you focus on market values and if interest rates go up by 60 basis points per year on average over the next 5 years, liability growth (based on a 30-year Treasury as the proxy discount rate) would have a -2.56% per year average growth. As a result, low asset growth of just 5% would create liability Alpha of 7.56% per year and enhance a 60% funded ratio to 87.8% in just 5 years.

If one were only focused on asset growth and a plan generated that 5% annual return there would be the feeling that the yearly return was inadequate. However, when comparing assets versus liabilities that 5% looks almost heroic versus a negative liability growth rate.

The U.S. Federal Reserve is certainly on a path to raise U.S. interest rates. In this environment, liability growth will likely be negative. We could see funded ratios improve rather dramatically in an environment such as this, but who would know if a sponsor and their consultant are only focused on the ROA as an asset objective and liability discount rate? It really is a poor practice.

President Trump will sign an executive order today directing the Treasury Department to review rules requiring minimum distributions from defined contribution plans beginning at age 70 1/2.  In addition, the executive order will direct the government to look into making it easier and more cost-effective for small businesses to offer 401(k)-type plans. Both initiatives may take as much as 180 days to a year to review and approve, but it is a start.

Allowing defined contribution participants to spread their retirement savings over a longer period should protect those with longer life spans from running out of savings prematurely. Since a review is to be taken details on just how the additional time will work are not forthcoming.

With regard to the commingling of small business 401(k)s, multiemployer plans have existed for years among businesses with similar trades, but this effort being considered would permit small business of any kind to join together to find economies of scale in offering these retirement benefits. The hope is that by commingling these plans they will become less costly and burdensome to administer. However, Small Business Majority founder and CEO John Arensmeyer. “Secure Choice” retirement-savings programs “add no cost or fiduciary responsibility to an employer, and are public-private partnerships that allow private-sector employees to contribute to an individual retirement savings account through modest payroll deductions.” (WSJ)

The move away from traditional defined benefit plans has been done primarily because of the expense and liability carried by management. If in fact the commingling of these plans somehow increases the liability of small businesses they are less likely to use them.

Both of these proposals are part of a broader piece of legislation known as the Retirement Enhancement and Savings Act (RESA), which has bi-partisan support, but regrettably, it hasn’t advanced this year. A majority of our future and present retirees are in desperate need of help in building an appropriate retirement nest egg. This legislation and others, including the Butch Lewis Act, need to be supported now.