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.

As the chart above highlights, savings among American households is not great, especially for those lower wage Americans who we highlighted yesterday in our post regarding 50% of Americans not being able to meet basic needs. We speculated that if food and housing are a stretch for them then you can basically forget about seeing them save for retirement. Well, this picture certainly highlights their plight.

Modest wage growth, rising costs for housing, education, medical, insurance, and food, and loss of a traditional DB plan (for most of the private sector) and you have a formula for failure. We often talk about the social and economic implications of our failure to provide a decent retirement plan. How is the bottom 50% ever going to transition from the workforce with dignity?

P&I is reporting on information recently released by Moody’s regarding the funded status for the 50 U.S. states as of fiscal year 2017.  According to Moody’s analysis, the adjusted net pension liabilities grew substantially from 2016 and now stands at $1.6 trillion up from $1.3 trillion in 2016. This analysis was done following a difficult performance year in 2016 in which the state plans produced an average 0.54% return.

The analysis is clearly dated, and the net pension liability will have likely decreased if performance is the only factor influencing this calculation, as fiscal years 2017 (12.4%) and 2018 (8.2%) have been much better for these public plans.

However, the article doesn’t mention what discount rate is used to determine the liability. I suspect that each plan’s return on asset assumption (ROA) is being used, which masks the true value of the liability. Furthermore, as long interest rates have been rising, the actual improvement in the net pension liability may be greater than what is presently being forecast.

Clearly, state plans such as Illinois, New Jersey, Kentucky, Connecticut, and others have funding issues, but if a true mark-to-market analysis were done on the state plans we might finally begin to understand the true cost. Furthermore, with the use of an appropriate discount rate, changes in interest rates would be captured in the calculation for total liabilities. In a rising interest rate environment, liability growth will likely be negative. It doesn’t take an outsized return in such an environment to meaningfully improve plan funding.

The lack of true transparency regarding plan liabilities is impacting critical decisions regarding investment structure, asset allocation, contribution rates, and benefit conversations.

The Urban Institute is reporting the results of their latest survey that highlights the fact that a significant percentage of American households can’t afford their basic needs – food and housing. This information is released at the same time that US stock owners are celebrating the longest “bull market” in history. How is this possible? First, eighty-four percent of U.S. stock is owned by just 10% of the American population. Second, Corporate America has propped up their stock prices through share buybacks and growing dividends, while investing far less in plant, equipment, inventory, jobs, and wages.

Furthermore, real wage growth has been muted for decades, while the return on capital has grown substantially rewarding those that own the companies but shortchanging the American worker, who is now struggling to meet their basic needs. This is clearly an unsustainable development.

In a recent blog post, we highlighted the fact that buying one’s starter home is becoming much more difficult, as the percentage of one’s income needed to fund a house purchase continues to escalate, and in some markets to outrageous levels (see NYC and San Francisco). Given the lack of disposable income for many Americans, is it truly realistic to have them fund and manage a self-directed retirement program?

Bloomberg is quoting the National Association of Realtors in declaring that starter-home affordability is declining, as the share of one’s income to purchase a first home has climbed to more than 23% (from about 14% in 2012). Housing prices are outpacing wage growth at this time. The increase in mortgage rates earlier this year has not helped either.

This issue is particularly acute in “hot” markets, such as New York and San Francisco, where it takes nearly 65% of one’s income to afford a house. Bubble anyone? It wasn’t much better in either Los Angeles (59%) or Miami (55%).

Couple the rising housing costs with the growing burden of student loan debt, and one can quickly see why funding for self-directed retirement accounts remains sketchy, at best. We have seen participation rates grow, but the average contribution remains well below levels needed to adequately fund one’s retirement.

Seven years ago I set up KCS with the mission to preserve and protect defined benefit plans, despite the rapid unwinding of their use in the private sector. During most of the last 7 years, I have struggled to attract opportunities that would provide KCS and my team members the opportunity to pursue this mission. We knew that there were going to be profoundly negative social and economic implications from our failure to preserve these critically important benefits (promises). But, I don’t think that we truly understood the magnitude. That is until we had the opportunity to assist the team responsible for crafting the Butch Lewis Act legislation. It has been incredibly eye-opening!

Once we got involved in that effort, it became crystal clear why we undertook this task. We tried to educate as many people as we could on the benefits of the Butch Lewis Act and the use of cash flow matching strategies to extend the life of these critically important plans that are on life support (114 plans designated as “critical and declining”).  Our effort to provide our insights has lead to us speaking with and exchanging ideas with many wonderful folks around the country. Many of whom will be negatively impacted by our government’s failure to tackle this pension crisis now! One such story that was shared with us concerns Carol. The following words are Carol’s and the depth of her despair should awaken everyone out of their lethargy regarding this issue.

“CAROL PODESTA SMALLEN’s STORY”…

“I was offered an early retirement in 2001 from Teamsters local 805 while working for Panasonic. The offer was “25 and out”, I had 26 years in so my papers state that I will collect $2,600.00 a month “for life”.

I received a letter from the Teamsters in March stating their intention to cut my pension from $2,600.00 a month to $1,022.00 a month….that’s 61%. It is supposed to happen in January 2019. If they get away with this, I will lose my house. I am a 64-year old widow who can hardly afford to pay my mortgage without the cut. In fact, my pension had everything to do with my decision to buy…it pays my mortgage which is $2,300.00 a month. Anyone between 70 and 79 will have minor cuts, they are not touching anyone 80 yrs old and up, nor are they touching anyone on disability or their beneficiaries.

* I feel paralyzed. I don’t know what is going to happen to me. I have nowhere to go.

In 2015 when I had to leave my job as a para for children with autism, I didn’t worry, because I had my wonderful pension. to see me through.

*I have been under doctor’s care for the past 18 years for depression and anxiety, and I was doing fine until 2 years ago. I was forced to give up my prescription plan because I could no longer afford it, so I weaned myself off. I have since had my prescription plan renewed. I pay $1,400.00 a month for medical and $2,300.00 for the mortgage, not including any other house bills. I take in $2,600.00 Teamster’s pension, $387.00 from a small school pension and $1,600.00 death benefit/husband’s SS.

*After paying just those 2 essential bills, I’m left with $887.00 a month to pay PSE&G, Cable, car payment, car insurance, sewer, water, food, medical copay’s, etc. This is all before they decided to strip me of my “for life” pension.

* Whenever I think of it I feel like I can’t breathe.

I wrote a letter to the secretary of the treasury because the teamster’s letter states their application for the cuts is in the Treasurer’s office. But I never mailed it, because of fear that he would ignore it. I was totally alone in this until one night out of desperation, I just googled ‘HELP…the teamsters are cutting my pension and as a result, I will lose my home!’ and hit enter. A website popped up which gave me the opportunity to tell my story. I did, and the next day I was contacted by the Pension Rights Center.

*Bottom line, I am being forced to get out of my house, only I don’t have anywhere to go.

*I have no immediate family and the only savings I have is my small retirement (401 k) I earned while working at Panasonic…

*It isn’t enough to live on by itself, but I knew I would always have my pension to help me stay above water.

*I am so scared of ending up in a shelter. I am not good at legal issues.

*Every time I think of it, I shudder inside…I don’t know what to do.

On advice from Karen Ferguson of the Pension Rights Center, I watched the hearing this morning. It gave me a shadow of hope that I may not be living out on the streets and for that I am grateful.

*Since I got that letter from Local 805 back in March, my health is slipping away.

*I don’t really care about much…I have put on 11 pounds from stress eating, and my doctor put me on Lexapro for depression and anxiety.

*I have become a shell of a person who lives in fear, not knowing if I will have a bed to sleep in after January.

Thank you for giving me the opportunity to tell you my story. Sincerely, Carol Podesta-Smallen
________________________

As a follow-up to our blog post from August 15th, titled, “But, Is It Good For The Plan Sponsor?”, we went back to do a little research on just how much consolidation there has been among consulting firms since 2006. P&I ranked the top 20 Asset Consultants by world-wide Institutional, tax-exempt assets under advisement as of June 30, 2006.  From that list, we identified nine firms that have been acquired or seen ownership change. These include Russell and Watson Wyatt, which were #1 and #2 in P&I’s ranking at that time. That is incredible change. If you extend the analysis to the top 25 consultants ranked by AUA, you have two more that were impacted.

Leading consulting firms impacted by this consolidation trend included firms such as Ennis Knupp and Associates, Hewitt, Rogers Casey, EAI (my former firm), SIS, Richards & Tierney, and the recently announced Summit Strategies, in addition to Russell and Watson Wyatt. These leading consulting firms had their own cultures and unique insights. Many of them had strong research capability. The fact that these firms have been combined with others truly shrinks the independent thinking that we need in our retirement industry.

Seeking to find economies of scale or capturing liquidity to reward one’s lifetime of work may be good for the consulting firms, but is it truly good for their clients and our industry? Who will be next? Will the movement away from defined benefit plans and the move to OCIO models force additional consolidation? We suspect that it is highly likely.

There are few barriers to entry in the consulting business, which is positive, but most plan sponsors are limiting their selection of an asset consultant to the biggest firms, and not those with the best ideas, which we’ve seen played out among traditional investment managers and hedge funds, with mixed success.

It is being reported (PlanSponsor.com) that plan administrator, Retirement Services, miscalculated benefit payments for members of IFPTE Local 21, from the Bay Area of California, that may total $1.5 million. The miscalculation was discovered – get this – in 2011, but according to the article beneficiaries continued to receive the over-payments and they were not informed that their benefit may be overstated until April 2018!

Now, the San Jose Retirement Board is considering their options, including the possibility that retired employees and/or their surviving beneficiary will have to repay the excess benefits plus annual interest.  Are they kidding? Who was asleep at the switch for the last 7 years?

Not surprisingly, IFPTE Local 21 is not happy about the prospect of having to repay this excees benefits and as a result, they have joined forces with AFSCME Local 101 to protest this possibility. Let’s hope that they are successful.