We recently published a blog post highlighting the fact that U.S. “Growth” stocks have dominated performance relative to “Value” stocks during the last several years. We are concerned about the narrowing of equity market leadership. Furthermore, we pointed out that style cycles have been a part of the equity markets since their beginning. The last period of sustained underperformance for value occured during the 1990’s. You may recall that many market experts were predicting a new investing “paradigm” in which value investing was dead. The 2000s soon arrived and the Dotcom bubble came to a screeching halt.
Could we be witnessing another cycle nearing its end? I am always leery when market pundits begin to speak about the demise of this style or that investing insight. Here we go again. The WSJ has published an article today questioning the future of “Value” investing. The use of Price-to-Book as a measure of value is being called into question because of accounting practices related to how intangible assets are treated. There may be some merit in this analysis, but there are many measures of value, such as P/E, Price to Sales, Price to Free Cash Flow, Price to Enterprise Value, etc. that have also failed to positively correlate with market leadership.
“There are important differences between then and now. Today, the economy is booming, inflation is low, regulatory restrictions on business have been eased and money flows into the stock market from a much larger segment of the population.” As you shake your head in agreement, realize that the above quote comes from a WSJ article from January 18, 2000, or less than 2 months before the Dotcom bubble burst! As you may recall, the Nasdaq Composite lost 78% of its value as it fell from 5046.86 to 1114.11.
We certainly aren’t smart enough to know when Growth investing will begin to underperform Value investing as a style or the magnitude of that underperformance, but it will happen. When it does, you are best to be in active equity strategies relative to the passive indexes. If there is one benefit from having been involved in this industry for almost 40 years, it is learning one simple fact that history does repeat itself when it comes to investing.
According to a recent study by the advocacy group New Jersey Policy Perspectives (NJPP), New Jersey’s Millennial (18-39 year-olds) population is not fleeing the state in droves but has maintained the same pace of exodus that has been in place since 2004. Furthermore, “the rate of millennials leaving New Jersey isn’t any different from the rate of that same group leaving ““comparable”” states.” Oh, that’s comforting!
In this case, the comparable states include other “Blue” states, such as New York, Pennsylvania, Connecticut, and Massachusetts. Since KCS’s founding (8/11), we have been concerned with the impact of underfunded state pension systems on the ability of those states to meet the expanding cost of providing the required social safety net. The issues related to New Jersey’s pension underfunding are well known, and they are and will continue to influence migration to and from our state.
Millennials are hounded by poor job prospects, the lack of wage growth, rising taxes, expensive housing, and growing student loan debt. These inputs are certainly not the formula for a robust economy. Did you know that more NJ Millennials live with their parents or a relative than Millenials in any other state? Not surprising then that Millennial outmigration hasn’t expanded, yet. However, Mom and Dad or Uncle and Aunt so and so are not the long-term answer.
New Jersey’s recently completed budget process once again involved a series of tax increases on business and individuals (supposedly millionaires). With property tax bills among the highest in the country, there remains little appetite or room for further tax increases. We believe that DB plans need to be maintained, but a new course in managing them must be undertaken sooner rather than later.
There is a narrowing of market leadership within global equity markets, and it clearly begins and ends with the U.S. in general and more specifically with growth-oriented stocks/indexes. U.S markets continued the steady climb higher (R3000 +3.5%), while many overseas markets, both developed (EAFE -1.9%) and emerging (EM -2.7%), declined during the last month. However, as mentioned above, market leadership is much narrower than the U.S. versus everyone else.
Equity markets are being led by companies exhibiting growth and not value characteristics, continuing a trend that has been in place for several years now. Is this trend sustainable and what are the implications for active managers versus passive benchmarks? In August, the Russell 3000 Growth Index produced a 5.5% return and it is now up 16.6% year-to-date. While growth was producing a robust return, the R3000 Value Index was up only 1.6% for the month and it has produced a much more modest 4.2% YTD return in 2018.
Historically, the small value index (R2000 Value) has bested large growth (R200) by 3.1% per annum for the last 20 years through August 2018. However, given the meaningful outperformance of both large-cap and growth during the last 5 years, this relationship has been flipped completely with large-growth outperforming small-value by 7% per annum during this time frame. A 3-year comparison also favors large growth by 5.1% per annum.
This concentrated outperformance by large growth has impacted active managers in the U.S. many of which have inherent biases to both smaller capitalization companies (build equal-weighted portfolios) and value (screen for price to something, such as book value, earnings, sales, enterprise value, free cash flow, etc.). We don’t believe that this concentration is good for the markets or it’s participants longer term and we believe it is time to consider rebalancing from large growth to small value and from passive to active at this time.
Ron Ryan (Ryan ALM) and KCS have been crisscrossing the country for the last 6-7 years trying to encourage plans sponsors (and in some cases their asset consultants) to embrace the use of their plan’s liabilities to drive investment structure and asset allocation decisions. We are now 9 1/2 years into a historic U.S. equity bull market and funded-ratios haven’t improved a whole bunch and contribution expense continues to escalate. Do sponsors truly believe that their plans will earn their way to better funding in the next several years? Unfortunately, corrections occur and we are likely to see one in the not too distant future.
Here are our thoughts on the return on asset assumption (ROA) and why we believe that having a cost objective is superior to one focused on return.
- The true objective of a pension is to fully fund (secure) benefits in a cost-efficient manner with prudent risk. It is NOT a return objective.
- Projected benefit payments are future value (FV) dollars while the ROA is in present value (PV) dollars.
- The ROA is a forecast (and not a particularly good one). Actual annual asset returns (and liability growth rates) deviate greatly from the ROA. This deviation is called actuarial gains and losses and could be significant each year and for multiple years.
- The ROA is NOT a calculated number! It ignores the funded status. As a result, pension systems with 60% and 90% funded ratios could have the same ROA and the same asset allocation. The Ryan ALM and KCS teams can calculate the true ROA needed to fully fund the plan (with future contributions factored in). We recently completed a project for a client who had a 7.75% ROA. When we ran the Asset Exhaustion Test it was obvious that even at 6.00% ROA, the assets were not exhausted suggesting that 6.00% would be a better fit as the target hurdle rate for asset allocation. Why run at a more aggressive rate than is necessary?
- The Funded Ratio is in PV dollars. Would a pension plan have the same funded status with an asset allocation of $100 million PV of:
- 100% Treasury portfolio with a YTM of 3.00%
- 100% A corporate bonds with a yield of 4.00%
Answer: The same Funded Ratio in PV, but certainly better funded in FV dollars when using the corporate bond portfolio.
- If you focus on returns then it should be asset growth vs. liability growth in market value dollars, not actuarial valuations (AV). This is where the creation of the Custom Liability Index (CLI) can play a role.
- If you focus on market values and if interest rates go up by 60 basis points per year on average over the next 5 years, liability growth (based on a 30-year Treasury as the proxy discount rate) would have a -2.56% per year average growth. As a result, low asset growth of just 5% would create liability Alpha of 7.56% per year and enhance a 60% funded ratio to 87.8% in just 5 years.
If one were only focused on asset growth and a plan generated that 5% annual return there would be the feeling that the yearly return was inadequate. However, when comparing assets versus liabilities that 5% looks almost heroic versus a negative liability growth rate.
The U.S. Federal Reserve is certainly on a path to raise U.S. interest rates. In this environment, liability growth will likely be negative. We could see funded ratios improve rather dramatically in an environment such as this, but who would know if a sponsor and their consultant are only focused on the ROA as an asset objective and liability discount rate? It really is a poor practice.
President Trump will sign an executive order today directing the Treasury Department to review rules requiring minimum distributions from defined contribution plans beginning at age 70 1/2. In addition, the executive order will direct the government to look into making it easier and more cost-effective for small businesses to offer 401(k)-type plans. Both initiatives may take as much as 180 days to a year to review and approve, but it is a start.
Allowing defined contribution participants to spread their retirement savings over a longer period should protect those with longer life spans from running out of savings prematurely. Since a review is to be taken details on just how the additional time will work are not forthcoming.
With regard to the commingling of small business 401(k)s, multiemployer plans have existed for years among businesses with similar trades, but this effort being considered would permit small business of any kind to join together to find economies of scale in offering these retirement benefits. The hope is that by commingling these plans they will become less costly and burdensome to administer. However, Small Business Majority founder and CEO John Arensmeyer. “Secure Choice” retirement-savings programs “add no cost or fiduciary responsibility to an employer, and are public-private partnerships that allow private-sector employees to contribute to an individual retirement savings account through modest payroll deductions.” (WSJ)
The move away from traditional defined benefit plans has been done primarily because of the expense and liability carried by management. If in fact the commingling of these plans somehow increases the liability of small businesses they are less likely to use them.
Both of these proposals are part of a broader piece of legislation known as the Retirement Enhancement and Savings Act (RESA), which has bi-partisan support, but regrettably, it hasn’t advanced this year. A majority of our future and present retirees are in desperate need of help in building an appropriate retirement nest egg. This legislation and others, including the Butch Lewis Act, need to be supported now.
As the chart above highlights, savings among American households is not great, especially for those lower wage Americans who we highlighted yesterday in our post regarding 50% of Americans not being able to meet basic needs. We speculated that if food and housing are a stretch for them then you can basically forget about seeing them save for retirement. Well, this picture certainly highlights their plight.
Modest wage growth, rising costs for housing, education, medical, insurance, and food, and loss of a traditional DB plan (for most of the private sector) and you have a formula for failure. We often talk about the social and economic implications of our failure to provide a decent retirement plan. How is the bottom 50% ever going to transition from the workforce with dignity?
P&I is reporting on information recently released by Moody’s regarding the funded status for the 50 U.S. states as of fiscal year 2017. According to Moody’s analysis, the adjusted net pension liabilities grew substantially from 2016 and now stands at $1.6 trillion up from $1.3 trillion in 2016. This analysis was done following a difficult performance year in 2016 in which the state plans produced an average 0.54% return.
The analysis is clearly dated, and the net pension liability will have likely decreased if performance is the only factor influencing this calculation, as fiscal years 2017 (12.4%) and 2018 (8.2%) have been much better for these public plans.
However, the article doesn’t mention what discount rate is used to determine the liability. I suspect that each plan’s return on asset assumption (ROA) is being used, which masks the true value of the liability. Furthermore, as long interest rates have been rising, the actual improvement in the net pension liability may be greater than what is presently being forecast.
Clearly, state plans such as Illinois, New Jersey, Kentucky, Connecticut, and others have funding issues, but if a true mark-to-market analysis were done on the state plans we might finally begin to understand the true cost. Furthermore, with the use of an appropriate discount rate, changes in interest rates would be captured in the calculation for total liabilities. In a rising interest rate environment, liability growth will likely be negative. It doesn’t take an outsized return in such an environment to meaningfully improve plan funding.
The lack of true transparency regarding plan liabilities is impacting critical decisions regarding investment structure, asset allocation, contribution rates, and benefit conversations.