We are pleased to share with you the KCS Second Quarter Update. As we previously reported through this blog, 2015 has been a better year for pension funding than 2014 was despite the lower market returns, as interest rates have backed up creating a negative growth rate for plan liabilities. We hope that you find our update insightful. Have a wonderful day.
XYZ’s AUM Up 4%, Add $5 billion – So What!
We are at that point in the quarterly cycle were the largest asset managers, and our industry watchdogs, are once again reporting AUM changes for the previous quarter and last 12 months. So what! The question that we should be asking and that which should be reported is: “How does this growth or decline in AUM impact the strategy(ies) being managed by the aforementioned firms?”
In my humble opinion, assets are being concentrated among too few firms, and as a result of this asset growth, the products managed by these firms are far exceeding the natural capacity of these strategies. Subsequently, clients end up paying active fees for, at best, index-like performance. If that is going to be the result, buy cheap and not expensive beta – index!
Initially, significant asset growth has the potential of driving performance forward, as managers have to buy the same stocks that are in their portfolios. However, watch out when asset growth levels off or worse, begins to decline, and managers are forced to sell a percentage of their holdings in stocks that remain in their portfolio(s).
Hiring an active manager is never easy, especially given the plethora of options. However, just evaluating a firm based on its performance, people, philosophy and process is not enough. One needs to understand how the additional assets being received will impact that managers ability to maneuver / trade, especially if that manager is in a less liquid area of the capital markets, such as small cap value. Every product has a natural capacity, and investment managers should manage to these levels and be transparent with their clients, especially as they near their target AUM.
As markets grow, so does the natural capacity. But managing through capacity places the client’s interests behind those of the manager, and sets the managers business up for future failure when it becomes nothing more than another underperforming shop.
Relax Plan Sponsors – 2015 is Much Better than 2014!
Many plan sponsors were under the impression that 2014 was a very good year for DB pension funding because the asset growth either met or exceed their plan’s return on asset assumption (ROA). We refuted those claims in blog posts in both March and May highlighting the fact that liability growth should be the primary plan objective, and not the ROA, and that liability growth far exceeded asset growth in 2014.
Well, we still believe that, and we are today sharing with you that the first six months of 2015 have been quite good for DB pensions. Why? According to our strategic partner, Ron Ryan from Ryan ALM, liability growth has been negative in the US in 2015, as US interest rates have trended upward. In fact, using Treasury STRIPS as a proxy for the risk-free rate, liabilities have fallen by nearly 3.7% through June 30th. If one uses AA Corporates as the discount rate, liability growth has fallen by 1.6%.
On the other hand, a 60% / 40% asset mix of the Russell 3000 Index (1.94%) and Barclays Aggregate Index (-0.10%) has returned 1.12% through the first six months. This result certainly appears anemic relative to the average public fund ROA of roughly 7.5%, but it is outpacing liability growth by as much as 4.8%. Funded ratios should be improving as a result of liability growth being exceeded.
Again, managing a pension plan is an incredibly challenging endeavor, made especially difficult when focusing on the wrong objective. Asset allocation decisions made solely on the basis of performance versus the ROA can lead a plan down the wrong path. 2014 was a poor year, yet perceived to be quite good, while 2015 has been a hand-wringing year for many sponsors despite good outperformance for assets versus liabilities.
DB plan sponsors should be focused on their plan’s liabilities as the primary objective and not the ROA. Allow KCS and Ryan ALM to create a custom liability index for your plan. It will provide you with a much greater understanding of how the liabilities are reacting to changes in the interest rate environment. It will also help you realize that 2015 is looking a lot better than your 2014 relative results!
KCS Fireside Chat July 2015 – We’re Your Advocate
Happy Fourth of July! May you have a safe and enjoyable holiday.
We are pleased to share with you the latest edition of the KCS Fireside Chat series. In this article we highlight, once again, the importance of the defined benefit plan as the primary retirement vehicle for our workers.
In recent weeks there have been several studies released / updated that highlight the sorry state of the US retirement industry. Shockingly, 92% of working households for 25 to 64 year olds (according to the NIRS) are not on pace to save enough for retirement. The number is only slightly less scary (65%) when net worth is considered. Yet, DB plans continue to be targets for termination. We can and must do better as an industry. Let us help you.
Click to access KCSFCJUL15.pdf
Market Volatility Giving You The Woollies?
I’ve witnessed many market declines during my more than 33 years in the investment industry, and I would be lying if I told you that I called the beginning, end, and ultimate magnitude of any of the sell-offs. Market declines are part of the investing game. But just knowing that isn’t enough, as unfortunately, they can have a profound impact on retirement plans and retirement planning, both institutional and individual, as they impact the psyche of the investors.
It is well documented how individuals tend to buy high and sell low. The market crash of 2007 – 2009 drove many individuals out of equities at or near the bottom, and many of those “investors” have kept their allocations to equities below 2007 levels. It hasn’t been that much better for the average institutional investor either. We are aware of a number of situations (NJ for one) that plowed into expensive, absolute-return product at the bottom of the equity market only to see that portfolio dramatically underperform very inexpensive beta, as the equity markets have rallied since March 2009.
In some cases, the selling “pressure” was the result of liquidity needs, which lead to the tremendous explosion in the secondary markets for private equity, real estate, etc. in 2009. The E&F asset allocation model, made so famous by Yale, was the undoing for many retirement plans, as the failure to secure adequate liquidity exacerbated market losses. Who knows whether the turmoil in Greece will lead to their exit (expulsion) from the Euro, but there is certainly heightened fear and volatility in the global markets? Are you currently prepared to meet your liquidity needs?
As we’ve discussed within both the Fireside Chats and on the KCS blog, the development of a hybrid asset allocation model geared specifically to your plan’s liabilities, can begin to de-risk your plan, while dramatically improving liquidity. The introduction of the beta / alpha concept will provide plan sponsors with an inexpensive cash matching strategy that meets near-term benefit needs, while extending the investing horizon for the less liquid investments in your portfolio. By not being forced to sell into the market correction, your investments have a greater chance of rebounding when the market settles.
Traditional asset allocation models subject the entire portfolio to market movements, while the beta / alpha approach only subjects the alpha assets to volatility. But, since one doesn’t have to sell alpha assets to meet liquidity needs given that the beta portfolio is used for that purpose, the volatility doesn’t matter. Don’t fret about Greece and its potential implications for the global markets and your plan. Let us help you design an asset allocation that improves liquidity, extends the investment horizon for your alpha assets, and begins to de-risk your plan, as the funded ratio and status improve.
“The Truth Will Set You Free”
I continue to be perplexed, befuddled, mystified, and perhaps stumped by the reticence shown by plan sponsors and their consultants in wanting to know the value of the liabilities in their defined benefit plan on an on-going basis!
As a reminder, the defined benefit plan solely exists to provide a predefined benefit to past, present and future employees of the system in a cost effective manner such that contribution costs remain low and stable. Again, the plan exists to meet a liability. It doesn’t exist to meet a return on asset assumption. Yet, plan sponsors spend 95% of their time worried about the assets in their plan and very little time on how liabilities are being impacted by market forces.
If two pension plans have widely differing fund ratios, say 100% and 60%, should they have the same asset allocation? No, they shouldn’t. They certainly shouldn’t have the same ROA objectives. Why would a plan sponsor of a well funded plan want to live with the volatility associated with an asset allocation designed to support a 60% funded plan? Plan sponsors should adjust their asset allocation based on the plan’s funded ratio.
A more fully funded plan should have a much more conservative asset allocation than a poorly funded program. However, in order to know what the funded ratio is, one needs a more accurate and current understanding of the value of the plan’s liabilities. Currently, the only visibility on a plan’s liabilities is through the annual actuarial report, which tends to be provided 4-6 months delinquent. For many plans, they may still only have a view on year-end 2013 liabilities. We can assure you that liability growth has swung wildly in the last 17-18 months, as interest rates fell significantly in 2014, before backing up so far this year.
In a previous blog posting we discussed 2014’s performance for the average pension plan. We highlighted the fact that the average plan slightly underperformed the average ROA, and that based on that performance most sponsors likely felt that it was an okay year. Unfortunately, that perception would be incorrect as liability growth easily outpaced asset growth in 2014.
In addition, had sponsors taken risk off the table in 1999 when most DB plans were over-funded, they would have adjusted their asset allocations toward fixed income and away from equities. Regrettably, more risk was put into the plans when fixed income allocations were dramatically reduced for fear that the lower yielding environment would reduce a plan’s ability to meet the ROA objective. As you know, DB plans have missed the last 15 years of a bond bull market, while subjecting those plans to greater equity risk and two major market declines.
Clearly, liabilities and assets have different growth rates. Yet, the industry continues to believe that by achieving the Holy Grail ROA annually that everything will be fine. Unfortunately, that perception is false.
Would you be comfortable playing a football game in which you only knew your score (assets), but had no clue as to what your opponent was doing (liabilities)? How would you adjust your play calling or defense? I suspect that you wouldn’t play any game in which this scenario existed. Then why as an industry are we playing the pension game by only focusing on the assets with no understanding as to how your liabilities are doing?
We can win the pension game, WE NEED TO WIN THE PENSION GAME, but in order to do so we must utilize tools that provide us with all the information that we need to manage these plans more effectively. Having greater clarity on the liabilities doesn’t have to be a bad thing! What are you afraid of?
Pension America – Taking Control Of One’s Destiny
For pension plan participants defined benefit plans (DB) must remain the backbone of the US Retirement Industry
The true objective of a pension plan is to fund liabilities (monthly benefits) in a cost effective manner with reduced risk over time. Unfortunately, it has been nearly impossible to get a true understanding of a plan’s liabilities outside of the actuary’s report, which is received by sponsors and trustees only on an annual basis, at best, and usually many months delinquent.
Fortunately, a plan’s liabilities can now be monitored and reviewed on a monthly basis through a groundbreaking index developed by Ron Ryan and his firm, Ryan ALM – The Custom Liability Index (CLI). The CLI is similar to any index serving the asset side of the equation (S&P 500, Russell 1000, Barclays U.S. Aggregate, etc.), except that the CLI measures your plan’s specific liabilities and not some generic liability stream. This critically important tool calculates the present value, growth rate, term-structure, interest rate sensitivity of your plan’s liabilities, and other important statistics such as, average yield, duration, etc. With a more transparent view of liabilities, a plan can get a truer understanding of the funded ratio / funded status.
The use of the CLI enables plan sponsors, trustees, finance officials, and asset consultants to do a more effective job allocating assets and determining funding requirements (contributions). The return on asset assumption (ROA), which has been the primary objective for most DB plans, should become secondary to a plan’s specific liabilities. Importantly, as the plan’s funded status changes, the plan’s asset allocation should respond accordingly.
Importantly, the CLI is created using readily available information from the plan’s actuary (projected annual benefits and contributions), and it is updated as necessary to reflect plan design changes, COLAs, work force and salary changes, longevity forecasts, etc. In addition, the CLI is an incredibly flexible tool in which multiple views, based on various discount rates, can be created. These views may include the ROA, ASC 715, PPA, GASB 67/68, and market-based rates (risk-free), with and without the impact of contributions.
Why should a DB plan adopt the CLI? As mentioned above, DB plans only exist to fund a benefit that has been promised in the future. As a plan’s financial health changes the asset allocation should be adjusted accordingly (dynamic). Without having the greater transparency provided by the CLI, it is impossible to know when to begin de-risking the plan. You’ve witnessed through the last 15 years the onerous impact of market volatility on the funded status of DB plans and contribution costs. Ryan ALM and KCS can help you reduce the likelihood of a repeat, and very painful, performance.
NJ’s Pension Battle – We Are All Losers
Last week the state Supreme Court of NJ ruled that the Christie administration had the right to reduce / eliminate the annual required contribution (ARC) for the public pension system, based on a constitutionally established practice that the responsibility to allocate public funds is embedded in the budget process. What appears to be a victory for Christie and NJ tax payers couldn’t be further from the truth!
In a pattern that has been repeated for nearly 20 years, one NJ “leader” after another has failed to make the necessary payments to adequately fund public pensions. By not making the full contribution again this year, we are once again kicking the proverbial can down the road.
Remember folks, the benefit that has been promised to our public fund employees is a LIABILITY that must be met. Not funding that liability only makes it more challenging for the pension plan in the long-term, as the plan loses the benefit of compounding returns / interest on each contribution. Just think about the economic impact of not funding the $3.1 billion in 2015, especially if the plan would have earned the state’s presumed return on assets over the next 10-20 years. By deferring that payment, we create a pay as you go system that is much more costly for everyone.
Furthermore, NJ’s pension issue isn’t just a matter of not making the annual required contribution. Why on earth would NJ’s pension officers decide to invest heavily in hedge funds / alternatives at the bottom of the market in 2009? This decision has increased management costs, while returns on the funds have substantially underperformed cheap equity beta. DB plans have a relative objective (liabilities) and not an absolute objective (ROA). Using absolute product in a relative return environment makes little sense.
Our elected officials are kidding themselves If they think that the pension liability is somehow going away. By not appropriately funding the liability now, they are only making it more difficult for the state the future. Think that pensions are taking a big slug of NJ’s budget now, just wait for another 15-20 years.
The latest Iteration of the “High School Dance”
It has been a very long time since I was in high school, and as a result, things may be different today. But, what I remember about my high school days and the dances at Palisades Park, NJ, were that the boys stood on one side of the gym and the girls stood on the other. Occasionally a couple of girls would dance, but there was little fraternizing among the boys and girls.
Well, I get the same sense about the management of DB pension plans today, as I did at those dances a very long time ago. It seems to me that we have on one side of the “gym” assets and on the other side is liabilities, and never the twain shall meet. As a result, DB plans haven’t found their rhythm and there is no dancing!
We get periodic updates from a number of industry sources highlighting how the funded status is improving or deteriorating. But we don’t seem to get a lot of direction on how we should mitigate the volatility in the funding of these extremely important retirement vehicles. I can say with certainty that it isn’t striving to achieve the ROA. That’s been tried, and DB plans continue to see deterioration in their funded ratios.
For too long, the asset side of the pension equation has dominated everyone’s focus, and as a result, a plan’s specific liabilities are usually only discussed when the latest actuarial report is presented, which is on a one or two year cycle. This isn’t nearly often enough. We suggest that the primary objective for the assets should be the plan’s liabilities, and that every performance review start off with this comparison. However, in order to get an accurate accounting of the liabilities one needs a custom liability index (CLI).
In order to preserve DB plans we need assets and liabilities dancing as one. Without this, DB plans face a very uncertain future. Are you ready to bring both parties to the dance floor?
Next 10 years Could Really Challenge Your ROA Assumption – Are You Ready?
According to Standard & Poor’s Institutional Market Services, which polled 679 defined benefit plan sponsors, the median return on asset (ROA) assumption is 7.56%, down slightly from 2013. How realistic is this objective? According to Rob Arnott, sponsors will have a very difficult time in the near future meeting this objective. Arnott gave investors a gloomy forecast for medium-term returns at the Inside ETFs Europe conference recently, and urged the audience to think of a new way to attack the ROA challenge.
According to Arnott, “10-year forward-looking expected returns are unanimously low.” He is predicting that Core fixed-income stands at 0.5 percent real returns as well as long-dated inflation linked bonds. Long Treasuries will go barely above zero. U.S. equities are 1 percent above inflation, and small-caps also give 1 percent, despite their yield of 1.8 percent.
Furthermore, the “Growth of earnings and dividends over and above inflation is 1.3 percent, not the 5 percent or more that Wall Street wants us to believe,” said Arnott.
Importantly, these real return expectations are before fees, which for many active strategies would “eat” most of the potential gain. Arnott’s research found that the U.S. top-quartile active manager pockets 0.9371% of the “alpha” and only passes on 0.0629% on to the client.
The plan sponsor quest to meet the ROA challenge has also produced exceptional volatility. In the next 10 years, volatility is likely to remain at these levels or increase, but it seems that the return won’t be there to compensate for that extra volatility. Importantly, we believe that liability growth is likely to be flat to negative during the next 10 years as interest rates rise, so a more conservative asset allocation may accomplish a sponsor’s funding goal.
We would suggest that a plan sponsor focus more attention on the plan’s liabilities to drive asset allocation decisions. However, in order to accomplish this objective, the plan needs to have greater transparency on their liabilities. Receiving an actuarial report every one or two years will not suffice. In order to gain greater clarity, we would suggest that plans have a custom liability index (CLI) produced. The CLI will use various discount rates, and will provide a view with and without contributions factored in. The CLI is provided on a monthly basis.
As a reminder, the only reason that a DB plan exists is to fund a benefit that has been promised in the future. Knowing how that benefit is changing on a regular basis should be a goal of every plan. We stand ready to provide you with the tools necessary to gain greater transparency on your plan’s liabilities, since it doesn’t seem that plan’s will win the funding game by generating outsized returns in the next decade.
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