05.20.15
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Double DB® – Answers To Your Questions

Earlier this week we shared with you the virtues of Double DB® and encouraged you to reach out with any questions.  I am very pleased with the response that we’ve gotten.

As a reminder, a group of us have confronted two important pension issues: pension cost volatility and resultant perilous pension indebtedness due to prior underfunding (see Illinois, NJ, and a host of other plans).

We have developed an over-arching, patent pending answer to all of it – Double DB®, which;
(1) Provides pensions, not “employee accessible” cash.
(2) Is “percentage of payroll” financed.
(3) Easily “manages” debt from past underfunding.

Here are some of your questions.

Q: How do you manage debt from past underfunding of a traditional DB plan?

Have the plan actuary determine the percentage of payroll expected to finance the plan debt in 30 years based on the actuary’s estimate of the rate of growth in the underlying payroll and the estimate of the rate of growth of the debt. Plan to allocate this percentage of payroll to debt financing every year. If it turns out that more or less than 30 years is required, simply accept the longer or shorter term or adjust the allocated percentage of payroll along the way.

Q: How do you fund and manage Double DB®?

Have the actuary determine the percentage of payroll needed to finance future service benefits of the plan. Plan to pay this percentage of payroll in every future year. In the first year, plan to place one half into a trust fund identified as DB1 and the other half into a trust fund identified as DB2. In the second and each future year, place the then actuarial cost of half of the future service benefit cost into DB1 and the remainder into DB2. Accordingly, one half of the future costs of the plan will always be financed on an actuarially sound basis within DB1, while DB2 will have assets reflecting the extent that experience is more favorable or less favorable than expected at the outset.

Q: What benefit can the employee expect to receive?

In each year of retirement a pensioner will receive one half the scheduled plan benefit from DB1 and an experience modified variation of the scheduled plan benefit from DB2. If an entering plan participant would prefer to have a level benefit rather than the two-part benefit as described, he/she may elect an option to receive, say, 90% of DB1 benefits from DB2 and thereby receiving 95% of the benefit value to which he/she is entitled in retirement. Accordingly, the DB2 component of the plan will be provided a 10% “fee” for taking the risk of paying a larger benefit than the benefit to which the pensioner was entitled over the years of retirement. The 90% component can be more than 90% if the actuary for the plan is satisfied that a higher percentage is justified based on his/her appraisal of the risk.

We thank you for your continued interest.  Please don’t hesitate to bring additional questions to our attention.

05.18.15
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Double DB® – The Answer to a DB Plan’s Funding Volatility and More

Level cost, as a percentage of payroll, is the preferred basis for financing any retirement plan obligation, which is why 401(k) type defined contribution systems have become the nation’s most prevalent retirement vehicle.

Aware of this development and concerned about pre-retirement spending of accumulating funds by participating employees (loans, premature withdrawals), a group of us have confronted the culprit issues: pension cost volatility and resultant perilous pension indebtedness due to prior underfunding (see Illinois, NJ, and a host of other plans).

We have developed an over-arching, patent pending answer to all of it – Double DB®, which;
(1) Provides pensions, not “employee accessible” cash.
(2) Is “percentage of payroll” financed.
(3) Easily “manages” debt from past underfunding.

While accomplishing the above tasks, Double DB also removes the individual from having to manage these retirement assets.

If you would like to have a conversation about how a conversion of a current defined benefit plan to a Double DB® plan might work, please ask and we can send illustrative language or provide contact with our attorney / actuary.

Finally, It may be of interest to note that Chief Counsel’s Office of IRS regards the Double DB® concept favorably.

05.08.15
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Another Unintended Consequence?

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.

05.01.15
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KCS May 2015 Fireside Chat – Do You Know The Answer?

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

Click to access KCSFCMay2015.pdf

This article is the 34th in our series.  In this piece we explore whether or not the US Federal Reserve is likely to raise interest rates in the near-term – the $64,000 question.

The uncertainty surrounding this action continues to challenge DB plan asset allocation decisions.  Level to falling US rates will continue to harm DB plan funded ratios.

We hope that you find our insights thought provoking.  Please don’t hesitate to reach out to us with any comments and / or questions, or if we can be of any assistance to you.

04.22.15
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What is Consulting PLUS?

During the last decade or so, the rage within fixed income investing has been for plan sponsors to seek or investment managers to offer Core Plus fixed income capability. The investment thesis put forward is that a fixed income manager with multiple capabilities can enhance the risk / reward behavior of a single core capability.  The enhancements may be in the form of exposure to such instruments as high yield, international / emerging debt, bank loans, secured debt, etc.  One of the thoughts supporting this concept is that managers should be able to do a better job, on average, than committees in timing exposures and implementing asset shifts.  We agree that by providing a manager with greater investment freedom and breadth the investment process should see an improvement in its risk / return characteristics.

Given the troubles that continue to plague traditional defined benefit plans, especially as it relates to funding them, we, at KCS, feel that this idea should be expanded to other aspects of pension management, including asset consulting.  It seems to us that the asset consulting industry needs to rethink its approach from one focused exclusively on the asset side of the equation to one that rightly focuses on the plan’s liabilities, too.

We’ve written numerous times on the benefits of measuring a plan’s liabilities through the creation of a custom liability index.  Importantly, the output from this exercise helps one better understand their plan’s liability growth rate, term structure and interest rate sensitivity.  Without this insight, how does one allocate assets?  Since every plan’s liabilities are unique, it doesn’t make sense that a generic 8% return (ROA) target could adequately and effectively guide one’s asset allocation.

The seven senior members of KCS’s team have well over 200 years of combined, relevant investment experience. In addition, our senior talent have worked with and consulted to many of our industry’s largest plan sponsors. We understand the asset side of the equation as well as any other firm, while also understanding its limitations, especially in the short-term. Importantly, with KCS you get the PLUS. We are unique in our ability to measure and monitor liabilities, and to use the output to drive asset allocation and our risk-reducing glide path toward full funding.

Why settle for just asset consulting when you can have Consulting PLUS through a firm that knows both ASSETS and LIABILITIES!  If providing greater breadth in fixed income enhances the risk / reward characteristics just wait until you see how adding liability insights enhances your traditional consulting relationship.

04.22.15
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KCS’s First Quarter 2015 Update

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

04.01.15
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KCS Fireside Chat, April 2015 – Pension Plan Liabilities – See Me, Feel Me, Touch Me

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.

03.19.15
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My plan was up 10% in 2014 – Was that Good?

We frequently receive updates in our email in-boxes about various pension funds and their returns in 2014, and not surprisingly the numbers vary quite a bit.  According to Wilshire’s TUCS comparisons, the average public pension plan was up 6.76% in 2014. However, we’ve seen some funds reporting returns closer to 10%.  It seems to us that a plan did better the more traditional the plan’s asset allocation, meaning more equities and fixed income, and less in alternatives, particularly hedge funds.

In most cases the announcement of a total return was hailed as good or bad depending on how it did relative to the plan’s return on asset assumption (ROA).  However, is that really the true objective? If a plan generated a 10% return and its ROA was 8% (49% of public plans have 8% as their ROA) it was reported as a great year.  However, what did the plan’s liabilities do in 2014? Since most sponsors and consultants assume that liabilities grow at the ROA, they would likely assess that 2014 was good on both the return and liability front.  Unfortunately, they would be wrong.

With the precipitous decline in US interest rates continuing through much of 2014, the average defined benefit plan had its liabilities grow more than 15% in 2014.  Given this fact, I’d say that any return that didn’t exceed liability growth was a poor year, with the average public pension (6.8%) doing quite poorly versus liability growth.

Can you imagine if you were playing a football game without a scoreboard? Let’s assume you are in the fourth quarter and you’ve scored 27 points.  How do you play your offense or defense? Do you get more conservative or aggressive? You don’t know, do you? Exactly! Well, this is how Pension America is playing the game.

A significant majority of DB plans only get a look at their liabilities every 1-2 years, and the results are usually presented with a 3-6 month lag.  It is quite difficult to have a responsive asset allocation when you don’t know whether or not you are winning the pension game versus your liabilities, just as it is impossible to play football if you don’t know how your opponent is performing.

At KCS we place liabilities and the management of plan assets versus those liabilities at the forefront of our approach to managing DB plans. Pension America has seen a significant demise in the use of DB plans, and we would suggest it has to do with how they’ve been managed. Focusing exclusively on the asset side of the equation with little or no regard to the plan’s  liabilities has created an asset allocation that is completely mismatched versus liabilities.  It is time to adopt a new approach before the remaining 23,000+ DB plans are all gone!

03.13.15
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Is Now the Time to Move to Active From Passive in U. S. Equities?

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.

03.11.15
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Are Liabilities Tangible? See Me, Feel Me, Touch Me!

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.