Weakening Jobs Growth To Further Pressure DB Plans

Given the news from this morning regarding US job growth (only 142,000 jobs added and revisions down in the previous two months), it would not surprise us to see US interest rates continue to fall.  If in fact this happens, DB plans’ funded ratios and funded status will continue to weaken. As we’ve reported on numerous occasions, plan liabilities, although discounted at the ROA, do not grow at the same rate as assets.

Liability growth has far outpaced asset growth in the last 15 years, and the asset allocation mismatch that exists between a plan’s assets and liabilities continues to be dramatic.  With most everyone expecting interest rates to rise, fixed income exposures have been reduced and bond durations shortened. A combination that continues to weigh on plan performance.

We continue to believe that weak global growth will keep interest rates low for the foreseeable future, and as such, fixed income exposures should be increased and reconfigured to meet near-term liabilities.  I will be discussing this concept / strategy at the upcoming FPPTA conference on Tuesday in Naples, FL.

Plans continue to focus almost exclusively on their fund’s ROA, but the liability side of the equation needs some attention, too, especially given the prospects for continuing global economic weakness.  In this environment, a plan will not close it’s funding gap through outperformance relative to its ROA.


“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?

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?

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.

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.


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.

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.

NJ’s Singular Focus on the ROA is Misdirected

On Sunday, February 1, 2015, The Record (Northern, NJ daily) reported that NJ’s pension fund beat market expectations in 2014 with a 7.3% return. However, it was also highlighted that the return fell short of the 7.9% return on asset assumption (ROA) that NJ has established as their annual asset objective. Worse, and not mentioned, is the fact that liability growth (estimated at >20%) far outpaced asset growth in 2014, as long-term interest rates continued to plummet. Even if NJ’s pension plan had achieved the desired 7.9% ROA, the plan’s liabilities grew substantially larger, further exacerbating the plan’s underfunding.

It is truly unfortunate that plan sponsors of defined benefit plans continue to focus exclusively on the asset side of the equation, neglecting liabilities, which at the end of the day are the only reason that these plans exist. Understanding a plan’s liabilities will help with asset allocation decisions, and should lead to more stable funded ratios and contribution costs, which is imperative as the annual contributions become a larger percentage of NJ’s budget.

I am not opposed to the state sponsoring a traditional defined benefit plan. On the contrary, DB plans need to remain the backbone of the US retirement industry, as defined contribution plans (401(k)-type) have proven to be inadequate retirement vehicles for most of our private sector employees today. Why? 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. Worse, the median retirement savings for those 55-64 years old is only $14,500. How do we expect that astonishingly low account balance to support anyone’s retirement, especially as we are on average living longer?

Public fund plan sponsors need to take a different approach to managing these plans. It is truly regrettable that the pursuit of the ROA, as if it were the Holy Grail, has lead NJ and other public entities to abandon traditional equity and fixed income investments in lieu of alternative investments, such as hedge funds, that have failed to generate commensurate returns. In fact, a simple (unrealistic) 60% US equity allocation (Russell 3000) / 40% US bond allocation (Barclays Aggregate index) would have produced a 10% return in 2014, far outpacing the 7.3% result highlighted in the article, and at substantially reduced fees.

Lastly, it was stated that NJ’s pension system was underfunded by roughly $37 billion, as of June 30, 2014. However, according to an analysis by Moody’s, New Jersey’s unfunded pension liabilities doubled to an astonishing $83 billion at the end of June. New more realistic accounting guidelines required by the Governmental Accounting Standards Board (GASB) require New Jersey, and other states, to use smaller discount rates (not the ROA) to determine the true liability. The Moody’s report — New Jersey Reports Surge in Unfunded Liabilities Under New Pension Accounting Rule — indicates New Jersey has limited time to fix its poorly funded public pensions.