Today’s employment news should send shivers through the DB pension community! Expectations (hope?) of an interest rate rise in June / July have been thwarted, as the U.S. economy added only 38,000 jobs in May.  UGH! Worse, the Labor Participation Rate fell 0.2% to 62.6% matching December 2015.  In addition, March and April employment gains were revised down by 59,000.  We haven’t seen a jobs report this weak since September 2010.

Fed Chairwoman Janet Yellen said a week ago that an increase in short-term interest rates would be appropriate “probably in the coming months” if the economy continues its upward trajectory. The strength of the labor market plays an important role in the Fed’s decision to adjust interest rates, alongside inflation and economic growth, which remain muted.

Well, it is highly unlikely that we will see a rate rise in June or July given this jobs report.  For plan sponsors that were hoping to see a rate rise, which would reduce the present value of their plan’s liabilities (corporate plans under FASB), they will have to continue to live with very low rates.  The U.S 10-year Treasury Bond has rallied 28/32nds on this news and the yield is at 1.705%.

For our retail clients, the low interest rate environment continues to constrain their returns from a moderate to conservative asset allocation profile, forcing many to eat prematurely into their principal or causing them to seek more aggressive (risky) investments to create some additional yield (HY, bank loans, etc.).

We have some ideas on how to navigate your portfolio in this environment.  Don’t hesitate to reach out to us if you think that we can help you.

We hope that you had a wonderful Memorial Day weekend with family and friends, while remembering all those that gave the ultimate sacrifice to preserve and protect our freedoms.

It was during this past weekend that a couple of industry colleagues passed along a very interesting article written by John Hussman, who is one of the best financial analysts in the nation. Here is a link to his latest piece on the looming disaster of pension funds and what caused it:

http://www.advisorperspectives.com/commentaries/20160523-hussman-funds-the-coming-fed-induced-pension-bust?channel=Retirement


John has a very interesting take on the ZIRP enacted by the U.S. Federal Reserve, and its potential impact on defined benefit pension plans.  John posits that equity and bond returns have been dramatically altered and accelerated due to near zero interest rates. As a result, we are paying much more now for the higher valuations that have occurred, which will lead to much lower returns during the next 10-12 years.

Furthermore, the “artificially” higher equity and bond returns in the most recent past (last 7 years) have kept pension contributions lower than they should have been under more normal returns.  As a result, pension plans (particularly public and Taft-Hartley plans) will incur greater funding risk in the coming decade when returns are low and the contribution expense escalates.

We can see John’s point, especially if we can’t get GASB moving closer to FASB  / IASB in marking-to-market pension liabilities.

In a WSJ article today “Pension Funds Pile on Risk Just to Get a Reasonable Return”, Christopher Ailman, CIO, California State Teachers Retirement System, laments the difficulty of building an asset allocation framework in this environment that will generate a return close to the funds 7.5% ROA.  Well, if we can’t get the return in this environment, just imagine how difficult it will be if John Hussman is proven correct!

I received in my email inbox the following update yesterday.

(Zerohedge) When Goldman warned on Friday that a “big drop” in the market is possible before the S&P hits the firm’s year end price target of 2,100, one of the bearish reasons brought up by the firm’s chief strategist David Kostin is that stocks are now massively overvalued. In fact, according to Goldman , while the aggregate market is more overvalued than 86% of all recorded instances, the median stock has never been more overvalued, i.e., it is in the 100% valuation percentile, according to some key metrics such as Price-to-Earnings growth and EV/sales.

This is what Goldman said:

Valuation is a necessary starting point of any drawdown risk analysis. At 16.7x the forward P/E multiple of the S&P 500 index ranks in the 86th percentile relative to the last 40 years. Most other metrics paint a similar picture of extended valuation. The median stock in the index trades at the 99th percentile of historical valuation on most metrics (see Exhibit 3).
http://www.zerohedge.com/news/2016-05-15/goldman-median-stock-has-never-been-more-overvalued

Why is this important? Given that most public retirement systems and Taft-Hartley DB plans have dramatically reduced fixed income exposure during the last 15 years, while increasing equity and alternative exposure, an overvalued market such as the one described above could potentially set up these plans for dramatic underperformance relative to both the plan’s liabilities and the stated ROA.

With Funded Ratios low and falling, and the plan’s poor Funded Status large and growing, DB plans cannot afford (nor can the entities that fund them) to suffer out-sized losses. We believe that plans should undertake to transition a percentage of their portfolio to meet near-term benefit payments, which will improve liquidity, transform interest rate sensitive fixed income portfolios to more of a risk reducing tool, and importantly, extend the investing horizon for the riskier assets in the portfolio to weather stormy markets. Now is the time to begin to act and not after the red ink from the equity market losses has dried.

I happened across a P&I survey in a Tweet today. The survey was focused on state pension plan’s and future costs.  Here is the question and the potential answers:

What is the best change states have made to reduce future pension costs?

• Raising age and tenure requirements
• Change to a DC plan
• Shrinking or stopping cost-of-living increases
• Increasing employee contributions
• Trimming salary calculation formulas

Most, if not all, state plans have enacted several changes during the last 6-7 years to try to reduce their plan’s liability, and many of those changes are part of the suggested answers above.  However, we continue to believe that the best approach to improving funding (reducing costs) is to manage the plans with a focus on that fund’s liability and not the return on assets assumption (ROA), which has been the singular focus for decades.

Regrettably, the potential responses cited above are all directed at the beneficiary (plan participant). Is that fair?  Remember, the benefits paid on a monthly basis provide excellent economic stimulus to the local economy.  With the demise in the use of DB plans in the private sector and the transferring of the pension liability from the sponsor to the individuals (DC plans), we are jeopardizing future economic activity.  Our economy is already struggling with <2.5% annual GDP growth. Any further reduction in the demand for goods and services could be severely damaging.

I think that P&I does a wonderful job of elevating and reporting on the critical issues for our industry.  In fact, I just spent 90 minutes at their office early this week discussing many of the issues plaguing our retirement system.  They get it! However, I think that the survey posted above should have included at least one item that focused on re-thinking the day-to-day management of DB plans, and not just the whittling of benefits or the escalation of employee contribution costs.

If you asked me how I would vote above, I would say definitely don’t move employees into a DC plan, as they were never intended to be anyone’s primary retirement vehicle, and they’ve proven to be ineffective as such. Many employees are already paying a significant chunk into the system, so that wouldn’t be my choice either, unless there exists a plan that doesn’t receive any contribution on the part of the employee.  Raising age and tenure may be doable for some employees, but there are a number of occupations where one is just not physically able to perform the task well into their 60s.

I would support the shrinking of cost of living adjustments if the plan is below a certain funded ratio / status – perhaps 80% funded.  Also, DB plans were once considered part of the overall retirement plan (along with personal savings, social security, home equity, etc.), and as such they were meant to replace a certain % of the employee’s compensation – not all of it!  We should get back to basing the benefit on an employee’s salary or lifetime average earnings, and not include elements such as vacation and sick pay, and over-time, when that liability hasn’t been known and couldn’t have been managed by the fund’s actuary.

Lastly, and before doing any of those possible strategies above, I would try to get plans to gain greater knowledge of the liabilities, build an asset allocation and investment structure that reflects those liabilities, and make sure that my asset allocation decisions are dynamic and responsive to changes in the funded ratio. This approach sets the plan on a derisking path that should stabilize contribution costs and begin to move the plan toward, and then beyond, full funding.

We are pleased to share with you the latest article in the KCS Fireside Chat series.  This article is our 46th in the series, and it deals with one of the most pressing subjects for DB pension plans.  As you will read, DB plans continue to singularly focus on the ROA as their fund’s primary objective.  Unfortunately, and despite meaningful outperformance, beating the ROA does not insure a well-funded plan. Just look at the 104 Massachusetts public funds.

Click to access KCSFCMay16.pdf

In this article we discuss the need for sponsors and their consultants to focus more on a plan’s specific liabilities to drive investment structure and asset allocation decisions.  Are you ready to explore a different path to success?  Call on us to help you find your way.

We, at KCS, will likely be doing a search in the next three months for a bank loan manager, and possibly more than one.  If you would like for your firm to be considered for this assignment, please send us an overview of your capability to handle a bank loan mandate of size (mandate likely >$50 million).  We would appreciate brevity as this is the first step in putting together a working universe.  Please provide information on the team, philosophy, process, performance and fees, but most import, please share with us how you are different from your competitors. Thank you!

Many DB plans are sitting with a fairly modest exposure to fixed income, as sponsors and consultants anticipate higher interest rates.  Unfortunately, the current economic environment isn’t cooperating with that thought process and asset allocation decision. Despite the Fed’s action in December to raise the discount rate by 25 bps, it doesn’t appear that there will be any follow through in the coming months.

Unfortunately, S&P 500 earnings are the weakest they have been since the great financial crisis, marking three consecutive quarters of negative earnings.  Couple this news with the fact that consumer sentiment has fallen and that home ownership is at a 48 year low, where is the catalyst for economic expansion and inflation, which would provide the thrust necessary to see rates lift off?

Furthermore, a significant percentage of global bonds are currently trading with negative real yields, making the US rate environment very attractive on a relative basis.  As such, both the fundamental and technical factors support rates remaining at or below these levels.  Neither scenario is good for pension liabilities, which change in value based on current interest rates (no they don’t grow at the ROA!).

DB plans should initiate a de-risking approach where current fixed income exposure is used to meet near-term retired lives, thus mitigating interest rate sensitivity, while enhancing liquidity and extending the investing horizon for the balance of the fund’s assets. Managing a DB plan is about providing the promised benefit at the lowest cost. Continuing to use the ROA as the primary objective injects too much risk / volatility into the asset allocation process.

We are pleased to share with you the KCS quarterly for Q1’16.  As you will read, DB pension liabilities continue to outperform assets, exacerbating a trend that has lasted for more than 15 years. As a result, funded ratios continue to deteriorate. Also, learn what is new at KCS and read what our senior team has been doing during the quarter.

Click to access KCS1Q16.pdf

We hope that you find our insights helpful.  Please don’t hesitate to call on us if we can be of any assistance to you.

Several large public pension funds have recently implemented a plan to or are in the process of reducing / eliminating their exposure to hedge funds.  Numerous reasons have been cited for this action, including size of the plan’s allocation, complexity, lack of internal resources, but given the less than stellar results achieved from within the hedge fund space, I can’t say that we are shocked by this action despite a good bit of challenge from many within the retirement industry.

As for the performance, for the 10 years ending March 31, 2016 the HFRI Composite Index has a +3.4% annualized return, while the S&P 500 (+7.0%) and the Barclays Aggregate Index (+4.9%) have beaten it handily.  The fact that the 10-year period encompasses all of the Great Financial Crisis (GFC) when hedge funds should have provided significant down-side protection speaks to the failure of many hedge funds to do what was expected of them. Fees of 2% and 20% or more is a hefty price to pay for perceived risk reduction because you are clearly not getting benefit from exposure to HFs on the return side of the equation.

For the record, we at KCS have been discussing for some time now the misalignment of plan assets and plan liabilities within DB funds.  Anyone who knows us has heard us speak about the importance of making sure that the correct bogey (plan liabilities and not the ROA) is being used.  DB plans have a relative objective, and not an absolute one.  Endowments and Foundations, as well as HNW individuals, have an absolute objective (positive spending policy), and the use of hedge funds in this space is perfectly reasonable, if you can select those that provide appropriate risk / return characteristics after fees.

Of course there are excellent hedge funds just as there are terrific managers of long-only equities, fixed income, real estate, etc. Unfortunately, our industry has a tendency to overwhelm the better investment firms / products with positive asset flows until the ability to add value has been arbitraged away.

DB plans don’t need expensive hedge funds in order to close their funding gaps.  They need to only outperform liability growth in order to accomplish that objective, and cheap beta strategies are more than capable of providing that excess return.  If we finally begin to see positive economic growth, here and abroad, a bit of inflation, and gradually rising interest rates, we could see asset growth easily exceed liability growth, which might actually be negative in that environment.

The last 15+ years have not been kind to plan sponsors and their DB plans. A return to the basics is what is needed at this time. We need to get refocused before it is too late.  Too many employees, both private and public, are losing the opportunity to participate in a traditional DB plan. The alternatives are just not cutting it, and the social and economic consequences may be grave!

Asset consultants and plan sponsors of DB pension plans continue to pursue the return on asset assumption (ROA) as if it were the Holy Grail!  Believe me, it is not! In fact, if one ever believed that achieving the ROA automatically brings funding success, the following statistics will debunk that thought, and quickly!

The following information is from the Public Employee Retirement Administration Commission (PERAC) website. PERAC was created for and is dedicated to the oversight, guidance, monitoring, and regulation of the Massachusetts Public Pension Systems. The professional, prudent, and efficient administration of these systems is the public trust of PERAC and each of the 104 public pension systems for the mutual benefit of the public employees, public employers, and citizens of Massachusetts.  A very admirable objective!

To PERAC’s credit, they annually publish a summary of performance results and the Funded Ratio for each of the 104 plans for which they have oversight.  As we’ve highlighted before, the “average” ROA objective for public funds nationally is about 7.5%.  According to the most recent performance report from PERAC covering periods through June 30, 2014 all 104 public entities achieved a 30-year return that exceeded the 7.5% average objective. Amazingly, only 6.7% of the funds failed to achieve a >8% return for 30 years! In fact, 45% of the plans generated a return for 30 years that eclipsed 9% – truly outstanding.

Since the ROA is the objective for most sponsors and consultants, and given the fact that most MA public plans have far exceeded that objective, it must be safe to assume that these plans are currently fully funded. WRONG! Despite the fact that 100% of the plans have exceeded the average ROA not one plan (0%) have a Funded Ratio above 100%.  How can that be?  In fact, only one plan had a Funded Ratio that exceeded 90%. It gets worse, as 81 of 104 plans have Funded Ratios that fall below 70%, with Springfield achieving a woeful 27% Funded Ratio despite generating a 30 year return of 8.53%!

Well, if beating your return objective doesn’t assure funding success, what does? DB plans will achieve success only when they outperform their liabilities. As a reminder, the plans only exist to fund a promise that has been made.  It doesn’t matter how well the assets perform as long as they exceed liability growth. Given the numbers cited above, clearly plan LIABILITIES do not grow at the ROA, and they have had a growth rate that has far exceeded the growth in assets.

Unfortunately, results for most of these plans in 2015 and 2016 will reveal underperformance to both the ROA objective and liability growth, as asset performance has been modest at best, while declining interest rates continue to inflate liabilities. If PERAC was created for and is dedicated to the oversight, guidance, monitoring, and regulation of the Massachusetts Public Pension Systems, then I would suggest that PERAC insist that a new approach be taken by the sponsors of these plans because what is being done currently is not working.

We need to preserve DB plans, but we are afraid that they will continue to come under greater public scrutiny as contribution costs escalate, while Funded Ratios plummet. That isn’t a formula for long-term success.  Liabilities need to be monitored more frequently, and the output from that exercise (review) should be used to drive the plan’s investment structure and asset allocation decisions. I would definitely describe myself as being stubborn, but even I would seek an alternate approach if what I’d been doing for 30 years failed to achieve my ultimate objective – full funding!