Today, the Illinois Supreme Court struck down pension reform law as unconstitutional.  The December 2013 law was designed to lift retirement age, cap pensionable salaries, and reduce cost-of-living increases.  On the surface this will be viewed as a victory for the DB participants, but is it truly?  The law’s intent was to help municipalities manage more appropriately contributions into the system.  Through this appeal process “victory”, I fear that Illinois public systems will come under greater scrutiny, likely leading to more pressure to freeze or terminate DB plans for both existing and future employees.  Instead of helping to secure a longer life for DB plans, which we feel is an absolute necessity, this court action may be the death knell.

Any movement to reduce participation in DB plans, while forcing future employees into DC-like programs, will further exacerbate a retirement crisis that is quickly unfolding in the US. We’ve discussed at great length the pitfalls of an employee-lead retirement program, so we won’t cover that here, but would encourage you to go to the KCS website at http://www.kampconsultingsolutions.com to view the many articles in our Fireside Chat series.

Lastly, if a DB system is not likely to be sustained, we would encourage both plan sponsors and board trustees to explore the benefits of alternative DB-like structures (hybrids), including Double DB, a fixed-cost retirement plan design, before migrating your employees to a DC plan.  Asking an untrained employee to manage a very difficult assignment is just not fair, and the financial outcome will likely fall far short from what the participant would have experienced if they’d remained in a DB plan with a monthly annuity feature.

We are pleased to provide you with the KCS First Quarter  2015 Update.

Click to access KCS1Q15.pdf

We live in very interesting times for the global markets, as witnessed during the first quarter’s action. The fall in global interest rates continues to challenge most market observers’ expectations, especially with regard to US rates. The growth in pension liabilities continues to outpace asset growth, putting additional pressure on the funded status of most DB plans.  Just meeting the ROA expectation isn’t enough these days if your plan is in an underfunded state.  Asset growth needs to be focused on eclipsing liability growth by a healthy margin. If not, don’t be surprised to see the plan’s UAAL growing substantially.

But, the decline in long-term interest rates isn’t solely a pension issue, as low rates continue to make it very challenging for retirees to create a monthly income stream without eating into their balances or forcing individuals to assume much more risk.

We are prepared to help you with both your assets and liabilities.

Thank you for your continuing support of KCS.

Sincerely,

Dave, Ivory, Jock, Larry, Lillian, Penn and Russ

We are pleased to provide you with the latest edition of the KCS Fireside Chat series.

Click to access KCSFCApr15.pdf

In this article we touch on a couple of recent experiences / conversations that we’ve had.  As always, we hope that the sharing our our views / insights lead you to think about issues in a different light.  Enjoy, and happy holidays.

I had the opportunity this past Monday to attend the Opal Financial Group’s “Investment Consultants Forum”.  There were many interesting topics covered during the day, including my session on “Asset Allocation Strategies in a Volatile Market”. However, there seemed to be outsized interest in the active versus passive discussion, especially as it related to U. S. equities.

I listened intently to the discussion, as I’ve been a student of the markets, products, cycles, etc, for much of my 33 years in the business.  I was disappointed by the responses that I heard, especially from one consultant who “favored” active because their firm can pick superior “alpha generating” managers on a consistent basis.

I did not hear one consultant address the real issues related to why active and passive approaches both make sense depending on the environment, and how active managers are influenced by their own portfolio construction biases.

Most active managers (there are always exceptions) have a value tilt to their stock selection criteria / factors, tend to build equal weighted portfolios, which creates a small cap bias vis a vis the large cap indices, and they maintain some residual cash, even if they aren’t making an asset allocation call.  Given these portfolio construction biases, it is fairly easy to understand that active managers aren’t going to perform well in strong up markets, favoring mega cap firms, which is where we’ve been!  The passive index benefits from being fully invested, and the large cap bias (market weighting) is further fueled by the momentum (non-value indicators) driving the these large cap stocks and the markets.

As you can imagine, these trends are further exacerbated by strong positive cash flows into the recently better performing segments of the market, whether that be retail or institutional money, as neither group exhibits an ability to be a Contrarian.

Given the portfolio construction biases that exist, what is likely to happen in the passive / active relationship in the next 1-2 years? We believe that it is time to reduce one’s exposure to passive strategies (not eliminate), as we see small and mid cap stocks leading the US markets in the near-term.  Why? First, the strengthening US $ will negatively impact the earnings and profits of US mega cap companies that derive a meaningful percentage of their revenue from overseas activity.  Second, large cap stocks (S&P 500 as proxy), fueled in part by the aggressive move into passive approaches, have beaten small cap stocks (R2000 as proxy) by 9+% in the last 12 months, and have performed in line for the last 10 years, despite small cap stocks supposedly being more risky and less liquid (where’s the compensation?).

We would suggest that you move your large cap allocation to the bottom of your target range, while increasing small to mid cap to an overweight exposure.  Furthermore, if you have a target allocation for both active and passive exposures that you shift more assets into active US equity approaches at this time.  After 6 years of US equity strength, large cap dominance, a strengthening $, and a slight style outperformance by growth versus value, we think that the time is right for active managers to begin to add value, while benefiting from the biases that they create in their portfolios.

KCS was recently invited to participate in a finals presentation for a small public defined benefit plan.  We were one of six consulting firms to present that evening, and fortunately, the last firm to present on what turned out to be a very late evening.

As I predicted, each of the firms that preceded us talked about how they would go about achieving the prospect’s 7.5% return on asset assumption (ROA) through “superior” asset allocation strategies and manager selection.  I attempted to throw cold water on their claims by stating that hitting the ROA was basically irrelevant, especially given the poor funding status of this plan, and that the only true benchmark / objective for a plan sponsor’s DB plan should be their plan’s liabilities.

According to Trust Universe Comparison Service (TUCS), the average public pension had a 6.8% return in 2014.  This result fell slightly below most public pension return objective, but it wasn’t devastating on the surface, especially if one only focused on the asset side of the pension ledger.  However, and in fact, 2014 was a bad year for Pension America, as a further decline in US interest rates exacerbated liability growth by more than twice asset growth.

In attempting to differentiate ourselves from the competition we stressed the need for plan sponsors to get an update on their liabilities more often that once every year or two, delayed 6 months, until they received their actuarial reports.  It is our claim that asset allocation should be driven by the plan’s liabilities, funded ratio and contribution policies, and not the assets.

As one would expect, our claims were met with skepticism, since each of the firms that went before only spoke about assets and the ROA. We were told that asset consultants focus on the asset side because they are “tangible” and liabilities are not.  REALLY? What is more tangible than a promise that has been made to a plan participant? Like assets, liabilities can be priced daily. They are bond-like in nature and are impacted by changes in the interest rate environment and benefit formula adjustments. The present value of future DB plan liabilities have grown substantially during the last 15 years, as US interest rates have plummeted.

What did plan sponsors do? They exacerbated the situation by creating a huge mismatch between their plan’s assets and liabilities by reducing exposure to traditional US fixed income. Why? The yield on US bonds declined to less than the ROA, and  they argued (as did their consultants) that fixed income would become a drag on the portfolio’s return.  Focusing on assets, and not liabilities, has had a devastating impact on the funded status of America’s DB plans (particularly multi-employer and public pensions).

As if that wasn’t enough, yesterday I spoke at the Opal Financial Groups “Investment Consultants Forum”.  Notice that it wasn’t titled the “Investment and Liability Consultant Forum”. I spoke on asset allocation strategies with two others. Neither of my fellow panelists spoke about needing to understand the objective, and they certainly didn’t address a plan’s liabilities.  In fact, one gentleman from a leading asset consulting firm talked about his firm using a model portfolio. Given that every client’s liabilities are different, how can there be such a thing as a model portfolio for a DB plan?  This business never ceases to amaze me!

Pension America is in crisis due to the demise in the use DB plans.  It will only get worse if we continue to support the notion that only the asset side of the pension equation is relevant.  We better embrace a new approach before it is too late, as the same old, same old isn’t working and it won’t start now.  There is nothing more tangible than a promise made. Not having the financial resources to meet that promise would be devastating for the participant.

We are pleased to share with you the latest edition of the KCS Fireside Chat series.  The March 2015 article focuses attention on the need for plan sponsors of qualified retirement plans to restate or rewrite their plan to conform to current law.  The IRS is responsible for overseeing this process.  We hope that you find our partner, Dave Murray’s insights helpful.  The link follows:

Click to access KCSFCMar15.pdf

We’ve often spoken about the fallacy of the return on asset assumption (ROA), as not being the appropriate objective for a pension plan, but we’ve never introduced the idea that the funded ratio is not a good indicator of a plan’s financial health until today.  We think that a plan can hide behind the funded ratio, which can mask the true economics of that plan. How is that possible? Let us given you an example. But, first some facts.

• During the last 5 years (ending 12/31/14) the average public pension plan (TUCS universe) has generated a 9.95% annualized return, which would be considered very good relative to most plan’s stated ROA (8%).
• Also, during the last 5 years, liabilities (according to Ryan ALM) have grown by 10.14% annualized.
• Given the fact that asset growth easily eclipsed the ROA, and kept pace with liabilities, one would think that the funded ratio would remain fairly stable, and you’d be right.  So what is the issue?

Let’s look at pension math. Let’s assume that your plan has $375 million in assets as of December 31, 2009, and a funded ratio of 75% (S&P stated that the average plan was 72% funded at that time). That would suggest that your liabilities amounted to $500 million.  If you grow assets by the 9.95% and liabilities by the 10.14%, your funded ratio only falls from 75% to 74.4%.

On the surface, everything seems to be stable, if not improving.  However, the funding gap in terms of the plan’s unfunded actuarial accrued liability (UAAL) has ballooned. In our example, assets grew to $602.6 million, while liabilities increased to $810.4 million. The UAAL went from $125 million, as of 2009, to $207.8 million in just five years, increasing by a whopping 65.8%.

So, do you still think that the ROA, which was easily eclipsed, and the funded ratio, relatively stable at roughly 74 -75%, are the key pension metrics? Managing a pension plan shouldn’t be about return, but about providing a stated benefit at the lowest cost possible. How many budgets can afford the volatility witnessed in our example? We suspect that few can! This is why a plan’s liabilities need to be at the forefront of asset allocation and manager structure decisions, and not a bit player, as they are today.