The Atlanta Fed with the highly-tracked GDP estimator, slashed its Q1’16 GDP estimate to 0.1%. As a reminder, this number was as high as 2.7% two months ago – ouch!

The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.1 percent as April 8, down from 0.4 percent on April 5. The negative adjustment followed the wholesale trade report from the U.S. Bureau of the Census, the forecast for the contribution of inventory investment to first-quarter real GDP growth fell from –0.4 percentage points to –0.7 percentage points.

The U.S. economy’s on-going struggle to generate consistent and meaningful growth continues to negatively impact U.S. defined benefit plans (DB).  How? Actually the impact is felt in several ways, and it touches both assets and liabilities.  The lack of demand for goods and services is impacting the earnings and profits for corporate America, and it is highly anticipated that S&P 500 earnings will be negative for the third consecutive quarter. As we enter earnings season, it will be quite interesting to see how this unfolds.

Despite the tremendous rebound in equity prices that followed a deep sell-off earlier this year, stock prices do reflect growth in earnings and dividends over time.  A continuing struggle to generate earnings will eventually weigh heavily on stock price performance.

With regard to liabilities, they reflect changes in the interest rate environment, as they are bond-like in nature.  As a reminder, they DON’T grow at the ROA.  As plan sponsors and asset consultants continue to underweight fixed income for fear of rising rates (how long now?), assets and liabilities are heavily mismatched.  With U.S. GDP growth remaining quite low, it is highly likely that the Federal Reserve will work to keep rates low.

Even if we were to see a modest increase in the discount rate at some point this year, it is highly unlikely that longer dated US bonds would see an increase in their yields with the trillions of $s in negative real interest rates trading globally.  U.S. long bonds are quite attractive on a relative basis, and they are likely to generate tremendous interest as Japan and European central banks continue to drive rates lower.

2016 is once again shaping up to be a poor year for DB pension funded ratios and funded status following the difficult 2014 and 2015 years.  Isn’t it time to try something new? Stop focusing on the ROA and all the associated volatility, and begin to de-risk your plan through a strategy that focuses on your plan’s liabilities.  The only thing going up in this environment are contribution costs, and most plan’s can’t afford that reality!

Offering a retirement plan, whether DB or DC, is neither trivial nor inexpensive!  Thank you to the sponsors of these plans who are looking out for their employees (and our society)!  Unfortunately, a wide swath of the US population (mostly those in small companies) don’t have access to a retirement vehicle of any kind.

Since the founding of KCS, I have been an outspoken critic of what is transpiring in the US with regard to the retirement industry.  I much prefer DB plans to DC plans, but as most know, the DB plan is nearly extinct in the private sector, while public and Taft-Hartley plans continue to maintain their offerings, but are struggling in many cases to adequately fund them.

Why do I favor DB relative to DC? First, in many cases the employer is making the contribution or certainly the yeoman’s share of the contribution. Second, these plans are professionally managed.  Since we don’t do a great job of providing our students with adequate financial literacy, why should we expect them to manage these plans effectively? Third, the cost of administering / managing a DB plan is lower than that of a DC plan, although DC costs have come down.  Importantly, DB plans insulate the participant from market shocks that might alter one’s ability to retire with a DC balance and not a monthly check, if that balance has seen significant market losses (2007-2009).

In addition, DC plans have features that just don’t support the average participant.  If DC plans were truly retirement vehicles we wouldn’t allow loan features.  We would eliminate premature withdrawals when employees move from one job to the next.  Finally, we would insist that every 401(k) / 403(b) provide annuity features to minimize the use of lump sum distributions that come with significant management responsibility in retirement.

DC plans were initially used as supplemental savings plans for high income earners, and they are well suited for that use, but they are not retirement plans! I have never been a participant in a DB plan. Boy, do I wish that I had been.  I have only participated in DC plans since the early 1980s. Fortunately, as an investment professional for the last 35 years I have been able to handle this responsibility, but we are asking too much from those that haven’t spent their careers in the investment industry.

I know that many participants like the portability that comes with investing in a DC plan, but regrettably about 50% of the premature withdrawals from DC plans are related to movements among jobs in which the participant fails to rollover their balance.

We can do better as an industry, and we must! We are on the verge of having a significant percentage of our population retire without the means to remain participants in our economy.  The economic and social consequences of this development are potentially quite grave. We must do a better job of preserving DB plans for the masses in both the private and public sector.  This can happen, but they need new thinking with regard to how they are managed. The time has come!!

We are pleased to share with you the latest edition in the KCS Fireside Chat series.  This article titled, “Your ROA Won’t Be Impaired!”, reflects our thoughts on a new game plan for DB plan sponsors.

Click to access KCSFCApr16.pdf

We remain concerned about the long-term viability of traditional defined benefit plans, and feel that it is increasingly necessary for sponsors to adopt a new strategy for managing them before they are permanently impaired. We hope that you find our insights helpful. As usual, please don’t hesitate to call on us if we can be of any assistance to you.

Many corporate DB plan sponsors have have begun to de-risk their plans by adopting some form of a liability driven investing (LDI) approach.  Despite this trend, there remains a significant subset of corporate plans, and most public and Taft-Hartley plans that haven’t begun to de-risk their plans.

According to Prudential the top 100 corporate plans saw their funded status decline by roughly 50% from 1999 to the present (135% funded to 83% today) while at the same time they contributed a collective $600 billion in contributions.  Oh, my!

There has been significant volatility in both funded ratios and contribution costs in the last 15 years, and a lot of it has to do with plans trying to achieve an ROA objective instead of providing the promised benefit at the lowest cost possible.  Traditional approaches to asset allocation inject significant risk into the process.

Adopting a cash flow matching strategy for near-term retired lives does not impair a plan’s ability to improve funding, as the yield on the cash matching portfolio will far exceed the yield on a Barclays Aggregate portfolio.

Don’t continue to live with the excessive volatility of traditional asset allocation approaches, which may compromise the stability of your DB plan, when successful, time-tested approaches exist that will stabilize your funded status on annual contribution costs.

KCS is in the process of searching for Global equity managers for one of our clients. The only requirement is that the fund be offered in either a mutual fund or commingled vehicle. We are not opposed to using smaller shops (small AUMs) with young track records (no minimum requirement). Interested firms should contact Russ Kamp at rkamp@kampconsultingsoultions.com. Thank you, and have a great day.

We are pleased to share the following link, which provides access to a recent interview of Russ Kamp by Asset.TV.

https://www.assettv.com/player/default-player/100435

The interview focuses on the US retirement crisis, and particularly the need to preserve DB plans or re-establish them if they’ve already been terminated.  Why? We are asking too much from our untrained employees.  These individuals aren’t investment professionals and this critical task should be left to those that are.

Ron Ryan, Ryan ALM, and the KCS team would like to encourage plan sponsors and their consultants to re-think the use of traditional fixed income in a defined benefit plan, especially given where rates are after a 3o+ year bull market for bonds.  It is truly unfortunate that most plans have dramatically underweight fixed income during the last 15+ years, and as a result they’ve created a significant asset / liability mismatch, while missing one of the greatest performance periods for U.S. fixed income.

First, we’d like for you to ask yourselves what is the value in having Bonds in your portfolio? As mentioned above, yields are historically low suggesting below average potential returns. Historically, the PIPER study shows that active bond management adds little to no value versus their index benchmark based on the median bond manager versus the Barclay’s Gov/Corp index. But, it gets worse, as this comparison is shown “before fees”.

After fees the median manager would lose consistently to the index benchmark.
So, what is the value in bonds? Answer: Cash Flows. Bonds are the only asset class with a known cash flow. That is why bonds have been used for defeasance, dedication, immunization and de-risking strategies. The most cost effective way to de-risk a pension is “cash flow matching”, as opposed to duration matching liability driven investing. For example, a Liability Beta Portfolio (LBP) model (produced by Ryan ALM) will cash flow match liabilities at a cost savings of 4% on 1-10 year and 10% on 1-30 year liabilities given its yield advantage.  That is tremendous savings on a $200 million portfolio ($8 to $20 million).

Second, pension liabilities are “Interest Rate Sensitive” just like bonds. Since they have on average longer durations than bond indexes they are more interest rate sensitive, and by a factor of 2, maybe 3 times. Since 1982 (the beginning of the great bond bull market) interest rates have been in a secular decline, which has created significant growth in the present value of DB pension liabilities.

When interest rates go up as a trend, the opposite effect will happen. The present value growth of pension liabilities will be very low, and importantly, perhaps even negative. This will provide the best chance for DB Plan Funded Ratios to recover to a fully funded status. Pension assets will need little positive growth to outgrow liabilities and create significant liability Alpha.  As we’ve stated many times, the ROA isn’t the objective for a DB plan, but that plan’s liabilities certainly are!

By converting your current fixed income from a performance oriented portfolio to one that is used to cash flow match, we set the plan on a de-risking path, remove interest rate sensitivity, and begin to stabilize contribution costs. Let us know how we can help you!

We remain concerned about the singular focus by plan sponsors on the return on asset assumption (ROA) to drive asset allocation.  Why? First, the ROA is not reflective of a plan’s liability growth.  Second, trying to create an asset allocation that achieves a 7.5% (average ROA) objective in this market is leading to excessive volatility.

It was once a fairly easy objective when interest rates provided a healthy 5%-6% return.  However, in this low interest rate environment the standard deviation of returns around a 7.5% objective is roughly 17%-18%.

What does that mean for the plan sponsor and their asset consultant? It means that 68% of the time (1 standard deviation), the annual return for a DB plan will be anywhere from 25% to -10% (using 17.5% as the standard deviation).  It also means that 95% of the time (19 out of 20 years) the return to the pension plan could be 42.5% to -27.5%.  WOW!! You can drive multiple trucks through that gap.  Is this range of results comforting to you?  It shouldn’t be!

What is particularly troubling is the fact that there are well funded and less well funded plans using the same 7.5% objective and roughly the same asset allocation.  How does this make sense?  One would think that a plan with a 90% funded ratio would remove a significant portion of the above mentioned volatility from the asset allocation process.  Either one plan’s asset allocation is too conservative or the others is way too aggressive.

We need to protect and preserve DB plans as the primary retirement vehicle.  Injecting too much risk into the asset allocation process is destabilizing these plans.  We need to rethink this approach before it is too late.

We are pleased to provide you with the latest edition of the KCS Fireside Chat series. This article is titled, “DC Plan Participants Speaking Up”, and boy are they! Just when corporate America thought that they were reducing the company’s liability by freezing / terminating the DB plan, plan participants in defined contribution plans are reminding them that there is still significant liability to be had. Don’t be fooled into thinking that these DC lawsuits and DOL audits only occur in large entities. DC audits have been know to be taken on plan’s as small as $1 million in AUM.

Click to access KCSFCMar16.pdf

If you haven’t rebid your platform provider / record keeper within the last 5-7 years, you are a prime candidate for an audit.

We hope that you find the thoughts from Dave Murray, KCS’s DC Practice Leader, useful and compelling. Please don’t hesitate to call on us if we can assist you in making sure that you and your DC plan are prepared for an audit. A little time and money invested today, can save you a lot of both in the near future.

Be well, and thank you for your on-going support.

The true objective for a defined benefit pension plan is to fund the liabilities (benefit payments) at stable and low contribution cost to the plan. Such an objective should be funded at reduced risk through time.  In order to accomplish this objective a plan sponsor and their ASSET consultant need to depart from the roller-coaster ride provided by pursuing the ROA. At KCS (an asset AND liability consultant) we focus first, and foremost, on the plan’s liabilities and funded ratio, which we use to drive the investment structure and asset allocation decisions.

Attached is an overview on the importance of having a custom liability index (CLI) measure your plan’s specific liabilities.  Let us know if we can build one for you.

Click to access KCSPensionAmericaCLI.pdf