The comeback of Pension Obligation Bonds (POB) shouldn’t surprise anyone. State and local governments are desperate for ways to address projected public pension deficits of >$4 trillion when liabilities are marked to market.

In one of the more recent examples, trustees of the Kentucky Teachers Retirement System, a DB pension plan funded at barely 50%, and with nearly $14 billion in unfunded liabilities, moved forward with a proposal to issue a $3.3 billion POB, passing the bill to the state Senate, where it is expected to be reviewed next week. With passage of the legislation, the $3.3 billion infusion into the plan would immediately bump the teachers’ funding level to 63 percent, according to KTRS trustees.

In Kansas, meanwhile, Gov. Sam Brownback is proposing Kansas sell $1.5 billion in POBs to help close the Kansas Public Employees Retirement System’s $9 billion funding gap.  We understand how tempting it is to issue bonds at these low interest rates to close huge funding gaps in these public pension plans, but does it make sense in this environment, especially after six years of an equity bull market?

In July, 2013 the KCS team published a Fireside Chat on the subject of POBs.  Here is a link to the original article http://www.kampconsultingsolutions.com/images/kcsjul13fc.pdf

We weren’t thrilled with the idea of POBs at that time, and given how markets have continued to rally, we are less supportive at this time.  Please don’t hesitate to reach out to us with any thoughts related to this subject.

Oxymoron – “A rhetorical figure in which incongruous or contradictory terms are combined, as in a deafening silence and a mournful optimist.” (Yahoo dictionary search)

Well, we need go no further than most public DB plan’s actuarial reports to find a “perfect” example of an oxymoron – the “Schedule of Funding PROGRESS”! This schedule is truly a treasure chest of information, but to describe what has transpired in nearly all public plans during the last 10-15 years as “progress” would be an outrageous exaggeration.  Let’s take a look at the following information that I was able to grab from the web on a public pension plan, whose identity will remain anonymous.

As of year-end 1999, this plan had an actuarial value of assets in excess of $450 million and an actuarial accrued liability of $611 million, giving the plan an unfunded actuarial accrued liability (UAAL) of $161 million and a funded ratio of 73.7%.  The payroll supporting this plan was $178 million, so that the UAAL was 90.4% of payroll.  Let’s fast forward 13 years from 1999’s conclusion to December 31, 2012.  Unfortunately, the data that I am about to share with you doesn’t paint a happy picture.  The actuarial value of assets has grown nicely, net of contributions / benefit payments, and now stand at $667 million, but the actuarial accrued liability has jumped to $1.3 billion, for a UAAL of $653 million, representing an increase in excess of 400%!  Furthermore, the funded ratio has plummeted from 73.7% to 50.5%, and that isn’t on a mark to market basis. Lastly, the UAAL now represents more than 270% of payroll.

How did this happen?  The common practice in public DB plans is to focus on the return on asset assumption (ROA), as the plan’s primary objective, and not the plan’s specific liabilities. When attributing blame for the poor funding of public DB plans, most sponsors and their consultants regularly mention as the culprit the bear markets of 2001-2003 and 2007 – 2009.  In reality, it has been the massive decline in US interest rates that have exacerbated Pension America’s funding woes.

As the data above highlights, DB plans on average were much better funded in the late ’90s, with many plans being significantly over-funded. Had they adopted their plan’s liabilities as the primary objective and not the ROA, it is safe to say that these plan’s would not have significantly reduced their exposure to traditional fixed income, which only served to exaggerate the asset / liability mismatch, and lead them to seek more risky assets, including alternatives.

As 2014 will further highlight, liability growth continued to far outpace asset growth deepening DB Plan funding issues.  The benefits received from traditional retirement programs are too valuable to lose.  The communities in which these beneficiaries live derive great economic stimulus from the monthly annuity that is received.  We need, and can, do a better job.

For one thing, plan sponsors need to get a better handle on their plan’s liabilities.  Receiving an actuarial report every one to two years, delayed six months will not accomplish that objective.  Plan sponsors need to drive asset allocation decisions based on the plan’s liabilities and expected contributions, and not on some ROA, that is more of a Goldilocks number (it just “feels” right) than fact.  We believe that every plan should have a custom liability index (CLI) created using their specific liabilities.  It is only with a CLI that asset allocation can be responsive to changes in the plan’s funded ratio.  Let’s talk before contribution costs get so out of control that your DB plan becomes the next victim of the rush to DC alternatives.

Since the launch of KCS in August 2011, we have had as our mission the preservation of defined benefit (DB) plans as the primary retirement vehicle.  Unfortunately, the use of DB plans continues to wane, and today there are fewer than 24,000 DB plans in the US.  The private sector has been hit particularly hard with only 10% of companies using DB plans covering only 18% of the workforce.

We continue to believe in our mission, as we forecast that there will be economic consequences and perhaps social ones, too.  In a recent study by the Center for American Progress, titled “The Reality of the Retirement Crisis”, by Keith Miller, David Madland, and Christian E. Weller (January 26, 2015) the magnitude of the problem is brought front and center.  I would encourage each of you to read the report because if nothing else, it will hopefully get you more focused on the importance of funding your retirement, as early as possible.

Highlights (perhaps lowlights):

• Millions of Americans will likely have to reduce their annual consumption by a significant margin in retirement
• It is estimated that nearly 50% of US households are in danger of having insufficient assets to meet retirement needs
• According to a recently released household survey conducted by the Board of Governors of the Federal Reserve System, as of 2013, approximately 31 percent of Americans reported having zero retirement savings
• As of 2013, the median retirement account balance among all households ages 55 to 64 was only $14,500, and these are near-retirement households.
• The NIRS suggests that more than 2/3rds of 55-64 year olds will fall short in retirement
• Importantly, a couple in retirement should expect to spend more than $220,000 on healthcare expenditures alone
• Given the weak savings rates, where are those assets to come from?

As you can see, KCS personnel may have sounded a bit like “Chicken Little”, but our concerns haven’t been unfounded. Regrettably, there isn’t much that can be done at this time to protect the 55-64 cohort, but there are game plans that can be instituted to help those that follow.  However, time is of the essence! The failure to help our workforce retire with dignity is unacceptable and the ramifications profound.

We are pleased to share with you the KCS Fourth Quarter update.  As you will note, 2014 was a poor year for Pension America, and specifically, funded status, as liability growth far outpaced asset growth. Here is the link to the KCS quarterly:

Click to access kcsfcjan15.pdf

Please don’t hesitate to reach out to us if we can be of any assistance to you.

Clearly the global equity markets have been inspired by the announcement from Europe that the ECB will engage in a “QE” program designed to stimulate economic activity in the Eurozone through the purchase of Euro $1.1 trillion in sovereign debt.  Given the positive market reaction how might this bond buying program negatively impact US DB plans?

Unfortunately, most consultants and plan sponsors remain fixated on the asset side of the pension equation (ROA as Holy Grail), and given that focus they will be heartened by this news.  Well, given the robust rally in the bonds of the Euro participants, in which yields on government debt continue to fall (precipitously) it is highly unlikely that the US Federal Reserve will have much impact on US interest rates in the foreseeable future.

Currently, the US 10-year Treasury is trading at a yield of 1.83%, while the equivalent German and Japan 10-year yield 0.33% and 0.24% (1/23 @ 11:40am).  Given the announced purchase of European sovereign debt, those yields are likely to fall further (at least in Germany’s case).  As such, the much greater yielding US debt will likely become attractive to foreign investors, further driving down the yields on our government debt.

The present value of US pension plan liabilities will likely continue to grow at a faster pace than the assets given the continuing fall in rates.  Since most US DB plans are underweight US fixed Income (at least long duration / high quality bonds), the asset / liability mismatch will continue to create funding problems for pension America.  DB plans need to mitigate this risk by focusing more attention on their plan’s liabilities.  Just because interest rates appear low based on recent history, there is no guarantee that rates will rise anytime soon. Most DB plans, but especially cities and states, cannot afford the contribution volatility that arises from a plummeting funded status.

In the January 2015 edition of the KCS Fireside Chat, we share with you part two of our emerging manager article.  We hope that you enjoy, and as usual, please don’t hesitate to reach out to us. Here is the link: http://www.kampconsultingsolutions.com/images/kcsfcjan15.pdf