Ryan ALM is out with their second quarter pension scorecard, and things aren’t that bad so far in 2018 despite lackluster asset class returns. Ryan ALMs asset mix produced only a 1.09% return for the six months, which would look quite weak if we were just focused on the return on asset assumption.  However, when viewing asset returns relative to a plan’s liabilities, the correct objective, asset performance looks pretty attractive.  How’s that?

Liability growth has been negative for the first six months when looking at more appropriate valuation criteria.  In fact, under FAS 158 (ASC 715) liabilities are down -6.63% through June 30th. On a mark-to-market basis using Treasury STRIPS, liabilities have generated a -2.89% return. It is only using the GASB methodology that allows for the use of the ROA as a liability discount rate do we get a positive number for the first half at 3.75%.

Public pension plan executives and their boards must be wringing their hands quite a bit thinking that funded ratios are falling when in fact the first half of 2018 is not that bad when using a mark-to-market accounting. According to Ryan ALM, plan assets have exceeded liabilities using Treasury STRIPS by 4.0% during this period.

How about requesting (requiring) public pension systems to use multiple discount rates to measure liabilities so that the sponsor and their board have a full picture of how plan assets are doing versus the promise that has been made.  Inappropriate decisions may just be taken without a true understanding of how things are stacking up.

Anyone who has ever read one of the KCS blog posts knows that we are big fans of defined benefit plans for the masses, both private and public employees. We fear the negative implications of our failure to preserve and protect these valuable benefits given that the alternative is to have untrained individuals become portfolio managers responsible for their retirement. Nuts!

However, a recent excellent report by Jonathan Trichter, a candidate for NY State Comptroller, suggests that new employees in defined benefit plans are getting short-changed relative to those employees who have greater tenure because of the tiering of benefits that have occurred. We agree. In fact, the NY State Employees Retirement System (ERS) currently has 6 different tiers and one’s benefits are determined by the start date.

We believe that employees doing the same job should receive the same benefits, and it shouldn’t matter how long they have been in that position. According to Trichter, longer-tenured State and local workers in NYSLRS will have about 60%-100% of their benefit financed through employer contributions. For younger employees that percentage falls to about 20%.

It gets worse, as roughly 70% of newer employees will never receive one dollar in employer-financed benefits. Furthermore, about 2/3rds of workers hired at 25-years-old would be better off cashing out their contributions than receiving a pension at a later date.

Trichter’s report proposes several solutions. As we stated above, we aren’t huge fans of DC alternatives but given the math above, it doesn’t make sense for younger employees in multi-tiered pension systems to fund someone else’s pension without the benefit of one for themselves. We think that Jonathan Trichter’s report/analysis is worth your investment of time.

Just read a thoughtful piece by Jennifer Mueller, titled “How the Janus Ruling Might Doom Public Pension Next”. Of course, the Janus, in this case, is the (Mark) Janus versus AFSCME lawsuit, which saw the Supreme Court overturn 40 years of “settled law” dealing a blow to organized labor’s fundraising activities. Mueller believe’s that this legislative decision could create a similar outcome for public pension systems that mandate employee contributions to help fund future benefits.

Let’s assume that a public union worker that opposes many of the union’s positions refuses to allow a deduction for “dues”.  Would they also feel the same way if they knew that their employee contributions to the pension fund were being used to impact proxy voting decisions for many of the same issues that the union employee was opposed to when they withheld their dues? As Mueller points out when DB pension systems were first launched the plan’s investments consisted mostly of bonds and cash.  However, today those plans have roughly 50% of their assets in equity-related securities, which allow for a voice through the proxy process.

Public DB pension systems are already facing funding challenges, let’s hope that an employee of a public union and a participant in the retirement system can appreciate the benefit that is being provided later in life. A benefit that most of us in the private sector would love to have available.  It would be tragic if Janus versus AFSCME began to be applied to pension contributions, but if it were, defined contribution systems, in which the individual controls the investment decisions, would likely become the retirement system of choice. Oh, no!

The last one and one-half days at the Opal Public Funds Summit East conference has been filled with outstanding panel discussions on a variety of asset classes and investing strategies.  Each discussion geared toward the plan sponsor’s dilemma of achieving the return on asset assumption (ROA). For most public plans the ROA objective falls between 7% and 8%.

In this environment, the likelihood of meeting the ROA has been diminished, as the bull market for public equities and bonds extends.  The hand-wringing has been quite noticeable. Why? Because most plan sponsors have been told that achieving the ROA is the only way to pension “success”, meaning that a plan has accumulated the assets necessary to meet the plan’s promise to their participants (liability).  They are mistaken.

Trying to shoot for a combination of assets at this time that will achieve the Holy Grail ROA will likely mean that the plan has had to inject more risk (investment and liquidity) into the process. However, there is another path, but one that is seldom discussed among public fund trustees because their asset consultants and actuaries believe that plan assets and liabilities grow at the same discount rate, which couldn’t be further from the truth.

The possibility that a plan might generate a return well below the ROA can create anxiety for the sponsor, but their minds could be put at ease if they understood that liability growth can be negative.  How? Pension liabilities are highly interest rate sensitive similar to bonds. In a rising interest rate environment, both liabilities and bonds will fall in value. Pension liabilities also have a fairly long duration so “losses” can be significant, and funded ratios can improve quickly. More “money” isn’t the only formula for improving pension funding in an environment of rising rates.

Unfortunately, most sponsors don’t get a mark-to-market view on their plan’s liabilities as their actuary is likely presenting a once per year view under GASB preferring to discount liabilities at the ROA discount rate. By creating a set of economic books (preferred by the Society of Actuaries) a plan trustee can quickly see how interest rate sensitivity impacts liability growth. As the liabilities fall in value in a rising rate environment, the funded status can improve.  Plan sponsors should take risk off the table by cash flow matching as many of the plan’s retired lives as possible. The remainder of the assets now has an extended investment horizon that will prove useful in trying to capture the liquidity premium.

We’d love the opportunity to speak with you about our approach. Don’t fret about the possibility of missing the ROA objective, and certainly don’t stretch for return in this environment, as greater volatility will be realized but the hoped-for return might not.

I had the opportunity during the weekend to read the Comprehensive Annual Financial Report (CAFR) for a municipality, which will remain unnamed. These reports provide a lot of really good information.  I always find the Retirement Systems and Deferred  Income Plans section to be particularly interesting, and this report didn’t disappoint.

I was heartened to see that this municipality was participating in a state-sponsored defined benefit system that was actually using a discount rate of their liabilities (5%) that wasn’t equal to the state’s return on asset assumption (7%), and was truly more representative of a legitimate discount rate in today’s interest rate environment.

Where I take umbrage with this analysis is in the long-term “forecast” of asset class returns by either the asset consultant or actuary or both.  I had to laugh when reviewing the data because this (or these) entity (entities) had used 10.63% to represent the expected return for “debt-related private equity”. Buyouts/venture capital had a forecasted long-term estimate of 13.08%. In fact, 13 of the 15 asset class return forecasts were to the second decimal. Are you serious?

It is highly unlikely that these forecasters will get the first number to the left of the decimal place correct let alone get their prediction anywhere close to two decimal places to the right! Was the use of two decimal places supposed to make this a more legitimate exercise to prove that they had some mystical power to forecast what others couldn’t?

Again, managing a pension plan shouldn’t be about creating a return that exceeds some return on asset assumption (ROA), and in this case 7%. Managing a DB plan should be about exceeding liability growth, as that is the only reason why a plan exists in the first place. But, the industry spends nearly all of its time trying to build a better mousetrap when allocating assets and creating an investment structure. Everyone would be much better off in the long run, and there would be far less guesswork if the plan’s primary objective was the plan’s specific liabilities.

Furthermore, the return forecasting exercise, which was for the periods ending both June 30, 2017, and June 30, 2016, had the consultant/actuary use Global Debt ex U.S. as one of the asset class categories that had a 5% target allocation. The long-term forecasted return was -2.5%. Why then would you have this “asset” in your fund?

Finally, can we please stop making this process much harder than it needs to be? Can we stop playing games with long-term forecasted returns to two decimal places as if we have real knowledge of how markets will perform during the next 10-, 20-, or 30-year period? Can we finally agree that the only reason a pension plan exists is to fund a promise that was made to that entities employees? If we can agree to that, can we agree then that the true objective shouldn’t be a made up ROA, but that plan’s specific liabilities?

We have occasionally highlighted the insights of real estate expert Keith Jurow, who provides a unique perspective on many aspects of the general real estate environment, but mortgages in particular.  He has recently produced an outstanding analysis/article on the current environment of mortgage REDEFAULTS. The media and other real estate analysts would have you believe that the worst is far behind us and that our real estate markets have recovered following the Great Financial Crisis (GFC).  According to Keith, they haven’t and things may actually be deteriorating further!

Fannie Mae and Freddie Mac have saved 4.1 million homeowners from default, including another 68,000 in Q1’18, since the GFC. But, according to Jurow, this effort has been a massive failure, as homeowners across the country are redefaulting again once, twice, and in some cases, three times. According to Jurow’s analysis, 37% of homeowners who had received a loan modification from Fannie Mae had redefaulted by Q4’17. Incredibly, 30% of homeowners who received a loan modification in 2017 had redefaulted in three months!

“Even mortgage pros don’t really know that there is a problem. How could they? The re-default numbers … have been buried where few people can find them, said Jurow. At Bank of America, the redefault rate on “troubled debt restructurings” is 45%. At PNC, it’s 57%. At Wells Fargo, it’s 35%. These and other lenders, loan servicers, and Fannie and Freddie “have been able to pull off this charade because hardly anyone knows how bad the re-default situation really is,” Jurow said.

I highly recommend that you take the time to read his article. Furthermore, Keith’s work is worthy of a visit to his website, which can be found at http://www.keithjurow.com. You will not be wasting your time!

According to P&I, Avery Dennison Corp will terminate its defined benefit plan. In addition, they will make a $200 million contribution prior to August 15th in order to claim a tax deduction on their 2017 taxes.

The U.S. DB plan has a funded ratio below 70%. The company is looking to settle its liability, estimated to be $950 million, through a combination of lump-sum distributions and an annuity contract (which is not inexpensive). There is no mention on the path going forward for Avery Dennison employees.

I suspect that Avery Dennison shareholders have benefited from recent federal tax law changes. I guess it is too much to ask that their employees also receive some of that largesse.

According to a recent study by Irish Life, one of the largest participants in the Irish retirement industry, 90% of Irish workers are not on track with their retirement savings. Boy, if that doesn’t sound familiar.  Here’s the scary part – Irish Life is advising clients that they need to have saved enough to replace annually one-third of their salary, which doesn’t seem nearly enough for the average worker, as the “rule of thumb” in the U.S. is to replace at least 50% of one’s final salary.

The fact that 90% of Irish workers can’t replace even 30% of their compensation should truly concern the powers that be in Ireland, as the lack of financial wherewithal will negatively impact Ireland’s economy going forward. One of the key findings by Irish Life was the fact that the average worker only begins saving for retirement at age 37, and this delay is significantly reducing the potential accumulated wealth.

Auto-enroll and auto-escalate features would certainly help the average worker but in many cases, it is the lack of wage growth that is restraining employees from participating to the extent that they should. We are certainly seeing that in the U.S.

The Active versus Passive debate rages on, but the results would suggest that large capitalization active managers are about to lose on a 10-count! According to a SPIVA study of large-cap managers versus the S&P 500 through December 31, 2017, 89.5% of managers failed to beat the index for the 10-year period.  Results are slightly better for the 3- and 5-year periods at 80.6% and 84.2%, respectively, but the slight improvement shouldn’t give anyone too much confidence that the tide is about to change.

However, I believe that the percentage of large-cap U.S. equity managers will begin to outperform.  Why? At KCS, we think that there are three environments that favor active managers versus the S&P 500, including markets that favor value, smaller capitalization stocks, and bear market environments. The last 10 years have been dominated by large-capitalization growth stocks, as the Russell Top 200 Growth Index has bested the Russell Mid Cap Value index by 2.3% per annum.  The margin of outperformance has continued to grow substantially in recent periods, peaking (?) at 18.6% in 2017 (31.9% versus 13.3%).

So, what gives us reason to believe that value-oriented, smaller capitalization securities will once again have their day in the sun? History! History has a way of repeating itself, and so do market cycles. Mid-cap value ate large growth’s lunch for the 20 years ending 12/31/17 (9.5% versus 6.6%) despite the significant underperformance during the last 10+ years.  Also, valuations and fundamentals ultimately matter, and there is little justification for the valuations currently attributed to the top 200 growth stocks.

We believe that there is a role for both active and passive management in a well-diversified equity portfolio, but the large growth versus mid value cycle should be used to “tilt” one’s portfolio within appropriate asset allocation bands. If you aren’t prepared to bet that large growth will continue to significantly outperform mid value then you should act sooner rather than later before the next cycle is well underway.