Maintain Your Asset / Liability Mismatch At Your Own Peril!!

Recent news from around the world indicates that growth is slowing in nearly every region. Japan and China are pumping liquidity into their systems to encourage more growth. Europe, an unmitigated disaster, will need to continue to provide stimulus, and not austerity, in order to get their citizens working and consuming. The US continues to plod along, but given our trading partners’ struggles, it would be naive of us to think that our ability to export goods won’t be negatively impacted.

With that said, US interest rates remain significantly above those of our partners in Europe and elsewhere, particularly in the 5- and 10-year space. The US rates provide real value relative to these other countries, and so it is likely that the value will be captured as investors seek those higher yields.

In the US pension arena, most plans continue to be dramatically underweight fixed income, as they fear higher rates and yields that are well below the ROA. Stop! The ROA isn’t the objective, and rates aren’t necessarily going higher. The only asset that moves in lock step with a pension plan’s liabilities is fixed income. We have a major funding issue in the US that will be exacerbated should rates continue to fall.

A new direction is needed in the day-to-day management of DB plans. Call us if you want to receive our insights.

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Of Course They Are Going To Pick Above Average Managers!!

I had the pleasure of attending the Opal Conference in Newport, RI the last few days. Opal’s “Public Funds Summit East: Navigating the Future” was well attended by public fund trustees, asset consultants and investment management professionals. I will provide a general overview in a later blog post, but I want to dedicate this text to an issue related to investment management fees.

I was particularly disturbed by a comment by an asset consultant when the issue of performance fees was raised. This consultant was troubled by the notion of paying performance fees to managers of any ilk because managers are chosen by his firm who can and will add value, so why pay more for their services? How naive!

Just prior to this panel’s discussion, we were implored by a plan sponsor to seek economies of scale, while also being cognizant of fees (all fees, and not just investment manager fees), as they can be destructive to a plan’s long-term health. I absolutely agree.

Even if a consultant thought that a manager had the above average ability to provide an excess return on a fairly consistent basis, why would they or their clients be willing to pay a manager their full fee without the promise of delivery? As a reminder, the “average” manager will return the performance of the market minus transaction costs and fees.

It is fairly easy to calibrate the performance fee with the asset-based fee based on the expected excess return objective. If the manager achieves the return target, the fees paid should be roughly equivalent, with perhaps the performance fee relationship paying slightly more as compensation for the manager assuming more risk. However, in no case should the performance fee reward a manager to a much greater extent than the asset based fee would have generated.

If the manager truly has the ability to add consistent value, they should be comfortable assuming a performance fee. Importantly, the plan sponsor shouldn’t fear the injection of more risk into the strategy, as the manager is not likely interested in jeopardizing their reputation for a few more basis points. In addition, there are easy ways to track whether this is happening.

Lastly, paying flat asset-based fees in lieu of creating a more incentive based compensation structure is just wrong. Plans should be happy to pay fees based on value-add, but should be infuriated when forced to pay an asset-based fee for the usual less than index return.

KCS has a white paper on this topic that can be accessed on the KCS website. Don’t hesitate to reach out to us if you’d like to discuss this issue in greater detail. Asset consultants are kidding themselves (and their plan sponsor clients) if they think that they will only pick above average managers!

Seeing “Double DB” in Your Future?

Seeing “Double DB” in Your Future?

The latest KCS Fireside Chat is attached for your review. This edition is the 24th Fireside Chat in our monthly series. This one addresses the development of a new hybrid plan called the Double DB. KCS is pleased to be involved in bringing this new pension plan design to the marketplace. We believe that sharing risk among both the plan sponsor and the participant is the better approach than one entity bearing all the risk. This exciting new pension plan design accomplishes this objective, while also bringing many additional attributes to the marketplace.

Please don’t hesitate to call on us if we can answer any questions that you might have about this exciting development.

Unintended Consequences

Unintended Consequences

Recently I had the opportunity to speak at the Financial Research Associates’ conference in NYC on non-traditional fixed income. I had the pleasure of participating on a panel with an industry icon – Ron Ryan, Ryan ALM  He and I presented on the topic “Taking a Close Look at the Liability Beta Portfolio”.  However, before presenting our views on the proper use of fixed income in a defined benefit plan, especially in a low interest rate environment, Ron and I addressed the unintended consequences from accounting rules, both GASB and FASB, that have lead to an under-reporting of plan liabilities and an overstatement of plans assets.  Given both, it is obvious that funded ratios are overstated, too.

The IASB (International Accounting Standards Board) has moved to a mark to market accounting of both pension liabilities and assets.  It isn’t too far fetched to believe that the US will adopt these same standards in the near future.  Unfortunately, since GASB uses the ROA to value plan liabilities, it becomes clear as to why the pension community continues to focus on the asset side of the equation instead of the liability side, which should be driving asset allocation and investment structure.

Attached for your review is our presentation.  We encourage you to reach out to us if you have any questions or challenges.

 

 

Where are the Economies of Scale?

Since its founding in August 2011, KCS has tried to highlight some of the issues facing the US retirement industry in the hopes that perhaps best practices could be identified and DB plans, as a result, SAVED.  I recently came across the “Status Report on Local Government Pension Plans” for Pennsylvania.  The report was released in December 2012, and it used information through calendar year 2011.

The following paragraph jumped out at me:

“Pennsylvania’s local government pension plans comprise more than 25 percent of the public employee
pension plans in the United States. There are now more than 3,200 local government pension plans in
Pennsylvania, and the number is continuing to grow. Seventy percent of the local government pension plans
are self-insured, defined benefit plans, and 30 percent are money purchase or other type plans. The pension
plans range in size from one to more than 18,000 active members, but more than 98 percent of the pension
plans can be characterized as small (less than 100 members). While 68 percent of the local government
pension plans have ten or fewer members, 32 percent have three or fewer active members.”

I find it hard to believe that anyone thinks that having more than 3,200 local government plans in PA is a good idea, especially when one considers that 98% of the plans have fewer than 100 employees. The local governments and their participants would be much better off pooling their resources into larger, more professionally managed DB plans that afford everyone the benefit or economies of scale. 

I suspect that there exist other states in the Union with a similar governance structure, but if we are to preserve the defined benefit plan as the retirement vehicle of choice, we need to reduce the cost of managing these plans.  Allowing thousands of defined benefit plans with fewer than 100 participants to exist is not sound governance.

“The U.S. Pension Crisis”

Congratulations to Ron Ryan, CEO at Ryan ALM, on the publishing of his book titled, “The U.S. Pension Crisis”.  Ryan’s book articulates what needs to be done NOW to save America’s pensions. 

When testifying before the ERISA Committee in 2003, Ron highlighted the issues related to GASB and FASB accounting rules, and the distortions to contributions, funded ratios, earnings and balance sheets brought about by their failings.  This book is a must read for anyone who truly wants to understand why our defined benefit plans are in such a state right now.