As Promised, we will be posting answers to the questions that we posed in our most recent Fireside Chat, “Your Liability-Aware Cheat Sheet” during the next couple of weeks. Let’s begin:

• Is the primary pension objective an absolute return (ROA) or a relative return (liability growth) goal?
• Furthermore, is the ROA a calculated number?

The objective of a pension plan is not to generate the highest return, but to secure the promised pension benefit payments in a cost-efficient and prudent risk manner. When defined benefit plans first started, the current assets plus contributions were used to cash-flow match the plan’s benefit payments (i.e. liabilities).  It wasn’t until the development of the asset consulting industry in the late 1960s and early 1970s did pension plans migrate to a return orientation from one focused on funding cost.  Striving for a greater annual return ensures greater volatility of returns, but doesn’t ensure funding success, especially in an environment of stretched valuations for both equities and bonds.

What may come as a surprise to many in our industry is the fact that the return on asset assumption (ROA) is not a calculated number. The ROA is a discount rate for the plan’s liabilities and it determines the level of annual contributions that are required. Hitting the ROA objective does not guarantee funding success. A simple example proves the point. If you had assets of $60 and liabilities of $100 with an ROA of 7.50%, then don’t the assets need an ROA of 12.5% to earn $7.50, not the actuarial ROA of 7.50%! Performing an Asset Exhaustion test (an analysis of a plan’s solvency under GASB 67/68) will calculate the actual return needed to be generated by the fund that ensures that the fund’s assets will never be exhausted based on the contributions being forecast and will fully fund the benefits promised until the last participant has passed away.

We are pleased to share with you the latest edition of the KCS Fireside Chat series. This article, titled, “Your Liability-Aware Cheat Sheet”, encourages plan sponsors/trustees to have more on-going conversations regarding their plans specific liabilities.  We share with our readership some questions that we think will help start the conversation.

For the last 6+ years, we’ve discussed the importance of becoming more liability-aware, believing that with this greater awareness, plan sponsors can engage in a more dynamic and responsive asset allocation that responds to changes in the plan’s funded status.

During the next couple of weeks, we will be providing answers to the questions that we’ve proposed, so please check back to the blog.

The WSJ published an article on Sunday that questions return assumptions by America’s pension plan sponsors and their consultants. The author, Jason Zweig, is particularly concerned given that U.S. stocks are currently at all-time highs.

Zweig references a study by professors Aleksandar Andonov of Erasmus University Rotterdam and Joshua Rauh of Stanford University who looked at expected returns among more than 230 public pension plans with more than $2.8 trillion in combined assets. The professors estimate that the average return on asset assumption (ROA) for these plans is 7.6%, which is roughly 4.8% above an inflation assumption. Almost 25% of these large plans still expect to generate a return in excess of 8%.

The study looks at the average pension plan’s investment profile by asset class.  The average plan has exposure to cash, bonds, both U.S. and international, U.S. and international stocks, real estate, hedge funds, private equity, and real assets (commodities). In order to achieve the 4.8% real return, plan sponsors were asked to forecast the returns that they would get over the long-term (10-30 years). The study reveals that plan sponsors expect to achieve a 3.2% return from cash, 4.9% from bonds, 8.7% from stocks, 6.9% from hedge funds, 7.7% from real assets, including real estate, and 10.3% from private equity.

Given that interest rates are substantially below the cash and bond expectations for future returns, a plan would have to make a dramatic switch into lower quality instruments in order to come close to those return targets.  Furthermore, corporate America has produced a roughly 6.3% annual growth in dividends and earnings for about the last 100 years, while the stock market has generated a 6.5% real return. How likely is it that stocks will achieve the forecasted 8.7% with valuations at these levels? Not likely.

As we’ve discussed in previous blogs, the U.S. pension game has morphed into a return seeking endeavor as opposed to the original mandate, which was one predicated on providing the promised benefits at the lowest cost. Pension plans can protect their funded status in this environment by adopting a bifurcated approach to asset allocation. By adopting this approach the pensino plan can reduce cost and volatility by cash flow matching near-term retired lives, while extending the investing horizon for the balance of the corpus, that now benefits from more time to capture the liquidity premium that exists in equities, real assets, private equity, etc.

Most U.S. defined benefit plans will not survive another major market crash.  The plans may be perpetual on paper, but that doesn’t mean that they are sustainable. Regrettably, we’ve already seen a move to alternative retirement structures among public pension sponsors, and that movement will only accelerate as contribution costs become a bigger share of a state’s or municipality’s annual budget.

DB plans need to be protected, but doing the same thing that has been done for the last 50 years is not the approach needed in this environment. Take the path less traveled, as you are less likely to get trampled when the rest of the plan sponsor community heads for the exits.

Yesterday the WSJ published an article highlighting the fact that several (they estimated roughly 12) corporations have announced plans to increase company matches into their 401(k) as a result of the benefits from the recent corporate tax changes. We are thrilled to read that this is occurring.

For many plan participants, the contributions into their 401(k)s from both themselves and their employer, are woefully inadequate.  We were surprised to see that many of the increases were going from 50% of the first 2-3% to perhaps 50% of the first 4%. This movement, although positive, is not earth-shattering. In order to ensure an adequately funded retirement program, the annual contributions should be in the 15% range. However, there are some companies, such as Visa, that do a great job with their benefits as they have announced that they will begin matching 200% of the first 5% that an employee contributes up from their current 200% on the first 3%. Now, that is significant!

We would prefer to read that these increases are permanent, but for many of the companies, it appears that this enhancement is a “bonus” payment for this year. On the other hand, we much prefer to see any additional employee compensation go into their retirement accounts instead of enhancing current take-home pay. It is ruly unfortunate that a majority of Americans are not prepared to fund a retirement, let alone a lengthy one.

One additional comment, we love the idea that SunTrust Banks is going to open accounts for the 8% of their workforce that has opted out of the company 401(k) with the aim to deposit the 1% bonus payment that they are planning to make for the 92% of their 24,000 employees who have opened 401(k) accounts at this time. Hopefully, this action will encourage that 8% to begin funding those accounts, even if it is just 1% of pay.

Roughly 12 companies is a start, but Corporate America is gaining a heck of a lot more from the tax law changes.  Let’s hope that their newfound windfall spurs on many other entities to engage in this positive corporate behavior.

As if this winter’s weather hasn’t been cold enough, the freeze announced by the corporate giant, Alcoa Inc., Pittsburgh, will surely chill its employees to the bone! Continuing a trend which began decades ago within the private sector, Alcoa announced Wednesday it will freeze its defined benefit plans for its U.S. and Canadian salaried employees, effective Jan. 1, 2021.

All salaried employees in the U.S. and Canada will cease accruing retirement benefits for future service under the current DB plans. It was announced that the roughly 800 affected employees will be moved to country-specific defined contribution plans.

In order to lessen the impact, Alcoa will contribute 3% of the affected participants’ eligible earnings to their DC plans in addition to its existing employer savings match.

Seniors seem to be getting whacked from all angles these days.  First, it was the reality for most that they would be retiring on Social Security alone, and now they are finding out that the long-term care insurance that they secured years ago may not be as secure as they thought, at least at the rate they thought that they were getting it. The WSJ published an article today regarding the state of the insurance market for long-term care in the U.S.

It appears that the industry is in deep trouble caused by financial turmoil that is causing angst among the roughly 7.3 million long-term policy owners.  According to the Journal, this cohort is equal to about 20% of the senior population (those over 65 years-old). Steep policy rate increases are forcing many to either pay up or pull out of the program.

At one time, there were about 100 firms selling long-term care policies.  Today that group numbers roughly 12, and many of them are not on steady footing.  In fact, GE has announced that it is taking a $9.6 billion charge that is mostly attributable to their long-term care business.  In addition, more than $10 billion in additional charges have been taken by insurance companies in this space since 2007.

Long-term care often costs more than $100,000 / year for an individual and it is estimated that long-term care was over $200 billion last year. Most individuals don’t have the resources to meet this expenditure, especially given the lack of a DB pension, anemic DC balances, and weak personal savings rates. A collapsing long-term care industry is just another sad event for many of our senior citizens.

This scenario just further solidifies for me the likelihood that we will have multiple generations living under the same roof sooner than later.

For a while now, we’ve speculated that the demise of traditional DB plans and the significant increase in student loan debt ($1.5T) would combine to adversely impact housing markets, as Seniors would not be able to remain in their homes, while those 18-30 would defer family unit creation and the purchase of their first homes. We believed that we could once again have a society with 3-4 generations living under one roof reminiscent of the late 1800s to early 1900s. The economic impact of that development could be startlingly negative.

Well, we just might be seeing this development materialize, and faster than we would have imagined. In an article published in Newsday, it was reported that Long Island’s housing costs are so high that four in 10 young adults live with relatives, and incredibly, seven in 10 say they’re likely to move to a less-expensive region within five years, a new survey shows.

Specifically, of Long Islanders 18 to 34 years old, 41 percent live with parents or other relatives, according to the survey to be released Wednesday by the Long Island Index, a project of the Rauch Foundation. These young adults are finding it difficult to find affordable housing and quality jobs that will permit them to stay in the region, and this is happening before the tax law changes take effect that will likely negatively impact long island’s real estate market.

Actually, River City is probably fine right now, but there may, in fact, be some trouble brewing in New York City’s real estate market.  Why you ask? Well, it seems that nearly 1.1 million owner-occupants in NYC and Long Island have received a pre-foreclosure notice from their mortgage servicer.  Yes, that’s right, 1.1 million owner-occupants.

But, we all know that foreclosures and auctions are down, how could this be? You would be correct if you focused exclusively on foreclosed or auctioned properties, but for some strange reason, mortgage servicers are reluctant to foreclose. According to PropertyShark, only 2,000 properties within NYC have actually been foreclosed and auctioned in 2017, and only 731 are currently scheduled as we begin this year.

The real issue here just may be the impact on the local economy. Clearly, most of these 1.1 million delinquent owners are struggling with their monthly payments. That doesn’t bode well for the local economy that depends on the consumer to demand goods and services.

Amazingly, this issue is occurring even before the impact of tax policy changes that will significantly reduce one’s ability in places like NYC to deduct property taxes.  We can only imagine how many more will join this growing list of pre-foreclosure notice owner-occupants.

The U.S. retirement industry is fast becoming a one-trick pony, as defined benefit plans (DB) quickly disappear in favor of defined contribution plans.  We, at KCS, have stated for a long time that asking untrained employees to fund, manage, and disperse a defined contribution retirement program is an incredibly difficult task that will likely lead to a social and economic disaster.  Well, here is further proof that asking individuals to do this in today’s economic environment is increasingly challenging.

Despite “record low” unemployment (we seem to forget about the LPR at 62.7% and 95 million age-eligible workers on the sidelines), wage growth remains muted, and has recently fallen.

Furthermore, there is a certain level of income that is needed just to survive these days, and given the decades of modest real wage growth, we have a significant percentage of our citizens who just don’t have the disposable income needed to meet basic living expenses.

Furthermore, the following chart reflects some rethinking on the part of economists with regard to the actual level of disposable income in the U.S. and the effect of healthcare costs on this measure. Historically, healthcare costs have been considered discretionary, but in reality they are not. If one adjusts disposable income to reflect this observation, the percentage of debt to disposable income ratchets up significantly (see the chart below).

With wage growth lower and housing and healthcare costs rising, do most of our citizens really have the financial wherewithall to fund a retirement program?

Randy Diamond, CIO Magazine, is reporting that the California Appeals Court has ruled that the use of unused vacation days to enhance retirement benefits is not a “right”, but it would not be “equitable” to take it away. The decision has likely paved the way to a review by the California Supreme Court.

The mission at KCS is to preserve and protect defined benefit plans. However, we are not supportive of provisions, such as the use of unused vacation days, to “spike” benefits that have not been actuarially funded. These practices are destabilizing, and subject the entire plan and all of the plan’s participants to greater risk.

We seek to keep DB plans as the core of one’s retirement portfolio, but not at any cost.  We need to fund these critically important benefits based on one’s salary, and we prefer that it be based on the last 3-5 years, at a minimum.  DB plans function best when benefits are actuarially funded based on anticipated growth in an individuals lifetime earnings, a formula, which cannot possibly factor in the spiking of these benefits through the inclusion of overtime, sick pay, vacation time, and hazard duty pay earned in one’s final year of employment.