Housing Rental Expense killing DC contributions?

Despite the fact that inflation, as measured by the CPI, seems to be contained, rental expense for housing has jumped significantly in the US during the last decade.  As a country we are moving away from being a home ownership society to one that rents housing, as home ownership is now at its lowest since 1967! Furthermore, the only reason the home ownership rate is as “high” as it is, is due to homeowners in the 65 and over age group. For everyone else, home ownership rates are now the lowest recorded.

Compounding this problem is the fact that US household incomes are 7.2% less than they were in 1999. The lower incomes are being crushed by rising housing costs, medical expenses / insurance and education. Is it no wonder that folks don’t have any additional resources to fund their DC plans? What percentage of the US population really has discretionary income at this time?

According to the “State of the Nation’s Housing” report released by the Center for Housing Studies at Harvard, which showed that while inflation among most products and services may indeed be roughly as the Fed and BLS represent it, when it comes to rent things have never been worse.

According to the report, 2013 marked another year with a record-high number of cost burdened households – those paying more than 30 percent of income for housing. In the United States, 20.7 million renter households (49.0 percent) were cost burdened in 2013.  Alarmingly, 11.2 million (25%) all renter households, had “severe cost burdens, paying more than half of income for housing.” The median US renter household earned $32,700 in 2013 and spent $900 per month on housing costs.

So, do you still believe that the failure to fund defined contribution plans is because we have a population hellbent on consumption? The demise of the DB plan means that a significant percentage of our population will never be able to make adequate contributions (if any) into their retirement plan. The social and economic consequences for our country will be grave.

Future Contributions Into A DB Plan Should Be Considered An Asset Of The Fund

Recently, Mary Williams Walsh, NY Times, penned an article titled,

“Standards Board Struggles With Pension Quagmire”.

The gist of the article had to do with what role did the actuaries and actuarial accounting play in the current state of public pension funding. Many of the actuaries felt that they were pressed by politicians into reverse-engineering their calculations to achieve a predetermined result (contribution cost). “That can’t be good public policy,” said Bradley D. Belt, a former pension regulator, who is now the vice chairman of Orchard Global Capital Group.

According to Ms. Walsh, “he called for additional disclosures by states and cities, including the current value of all pensions promised, calculated with a so-called risk-free discount rate, which means translating the future benefits into today’s dollars with the rate paid on very safe investments, like Treasury bonds.”

Actuaries currently use higher discount rates, which complies with their professional standards but flies in the face of modern asset-pricing theory. Changing their practice to resolve this is one of the most hotly contested proposals in the world of public finance, because it would show the current market value of public pensions and probably make it clear that some places have promised more than they can deliver.

But, if we are going to require DB plans to mark-to-market their fund’s liabilities, inflating future promised benefits, we should also include future contributions as an asset of the plan. Since many, if not most plans, have a legal obligation to fund the plan at an actuarial determined level or through negotiations, these contributions are likely to be made (NJ is one of the exceptions).

When valuing liabilities at “market” without taking into consideration future contributions, plans are artificially lowering their funded ratio, while negatively exacerbating their funded status. Most individuals (tax payers) would not understand the “accounting”, but they would certainly comprehend the negative publicity of a < 50% funded plan.

Most public pension plans derive a healthy percent of their assets through contributions.  Not reflecting these future assets in the funded ratio creates the impression that these funds are not sustainable, which for most public plans is not close to reality.

We need DB plans to be the backbone of the US retirement industry. Only marking to market liabilities without giving a nod to future contributions doesn’t fairly depict the whole story. We can do better.

Rethink the Use of Fixed Income in a Defined Benefit Plan

With the closure of the first quarter, we’d like to remind you of a blog post that we first published in early January.  Our thoughts are still relevant, especially given the market action within fixed income during the quarter and what is transpiring in US fixed income today.  The 10-year Treasury has rallied 2% today, and we think that it may continue to move lower.  The following paragraphs are what we originally posted.

What I’d like to highlight today is a new use for a plan’s current fixed income exposure. In day two of the conference, I attended a panel discussion titled, “Opportunities in Fixed Income and Credit Markets”.  The panel was occupied by 4 senior investment pros (plan sponsor, consultant, and investment managers).  They generally discussed the likelihood that interest rates were going to rise (I’m beginning to wonder if there is anyone out their who doesn’t think that rates will rise), and the implications of that movement on traditional fixed income portfolios.  Most of the panelists talked about various sub-sectors (mortgages, asset backs, bank loans, etc) and which ones might hold up better. There was discussion about shortening duration, etc. They also talked about fixed income’s traditional role as an anchor to windward, a risk reducer, and a provider of liquidity.

However, only one individual mentioned taking a step back to truly contemplate the “role” of fixed income.  He didn’t provide any further perspective, which is why I’m addressing the issue here and today.  I believe (as do my partners at KCS) that a plan’s liabilities should be the focal point of any pension discussion.  As such, they need to be the primary objective for the plan, the driver of asset allocation decisions and investment / portfolio structure.  The asset class most similar in characteristic to liabilities is fixed income.  As such, fixed income needs to play a prominent role in a defined benefit plan.

Instead of worrying about the implications from a rising interest rate environment on an LDI strategy that currently consists of long duration corporates, change the emphasis to matching near-term liabilities, by converting your current fixed income portfolio into a Treasury STRIP portfolio that matches cash flows with projected benefits (Beta portfolio).  First, you are improving liquidity.  Second, duration is shortened in an environment that may not be conducive to long bonds.  Third, you are lengthening the investing time horizon for the balance of the corpus, which will allow asset classes / products with a liquidity premium a chance to capture that performance increment (Alpha portfolio). Finally, the funded status and contribution costs should begin to stabilize.  As the Alpha portfolio outperforms liability growth (hopefully), siphon excess profits and extend the beta portfolio.

This is a proactive move to restructure the fixed income portfolio in an environment of uncertainty.

Lastly, I am not of the general school of thought that interest rates are definitely going to rise, and soon.  I believe that we still have slack demand in our economy, brought on by underemployment, which will keep inflation in check and provide room for stable to slightly lower rates.