Resource Center

Quarterly Commentary - July 2017

Equity returns were positive around the globe in the second quarter with international developed and emerging markets stocks faring better than those in the U.S. Rising expectations for an acceleration in overseas economic growth and lower relative valuations to their U.S. counterparts are causing international equities to continue to gain ground on U.S. equities after their recent period of relative under performance.

For the quarter, U.S. large company stocks, as measured by the S&P 500, gained 3.09%. U.S. small company stocks trailed slightly with the Russell 2000 gaining 2.46%, while international stocks, as measured by the MSCI EAFE index, rose 6.12%.  Bonds posted modest gains with the Barclays U.S. Aggregate Bond Index rising 1.45%.

As widely foreshadowed, the Federal Reserve boosted rates at the June meeting to a target range of 1.00-1.25% in an effort to return to a more normal monetary policy.  In addition to adjusting rates, the Fed indicated that it would begin reducing its inflated balance sheet later this year.  The Fed has increased its balance sheet by purchasing trillions of dollars of bonds on the open market as part of its quantitative easing programs.  This process will take years to unwind as the Fed attempts to avoid disrupting the stock and bond markets.

The yield on the 10-year U.S. Treasury finished the quarter at 2.29% after touching 2.12% in June, the lowest Elephant Ball US Flagyield for the year.  This recent fall in 10-year rates runs contrary to the Fed’s goal of incrementally higher rates and is primarily the result of stubbornly low inflation.  The Fed has been anticipating that wage inflation would put pressure on prices, but despite record low unemployment of 4.3%, wage pressures have yet to emerge.  In its March meeting minutes, the Fed said transitory pressures were holding down wages. In their June comments, they changed transitory to persistent pressures, raising doubts about rising inflation and the timing of future rate increases.

With interest rates remaining historically low and U.S. equity prices at recent highs, the direction of equity prices going forward will largely be determined by emerging economic data and the next round of earnings releases with continued influence by Fed actions or lack thereof.

ThPension Egg Cracked on Moneye Problem with Pensions

We are all distracted by daily headlines from the ongoing effort in Congress to repeal and replace Obamacare, the circus surrounding the Russian influence on our presidential election, and the growing threats of North Korea’s development of nuclear arms with the capability to reach the U.S. Behind all of these headlines, there are other issues brewing that will surely affect our financial future.  We would like to focus your attention on one such issue, the systemic under funding of pension plans.

For most of us, 401(k) plans have been the vehicle we use to save for retirement. These are known as defined contribution plans.  There was a time when most workers did not have to manage these kinds of “self-serve” plans.  Instead, employers would provide a pension plan, known as a defined benefit plan, where employers would accrue a benefit for employees while working, and when they retired, they received their gold watch and monthly pension checks for as long as they lived.

Over time, many corporations discovered the burden to maintain a viable pension plan for a growing population of retired employees over their collective lifetimes was insurmountable, as this burden fell directly on the sponsor of the plan.   By contrast, with today’s defined contribution plans, most of the heavy lifting falls on the employee with limited obligation from employers.  While working and in retirement, it is the employee’s responsibility to save enough, realize sufficient returns on investments and choose a reasonable distribution rate over their lifetimes.  Even then, there is no guarantee the money will last.  With defined benefit pension plans, all of this responsibility falls on the plan sponsors, and as a result, very few companies still offer them. However, this is not the case with state, and local governments where these plans remain the norm.

Defined benefit plans are sophisticated vehicles with many moving parts, but a plan’s long-term health is quite simply a function of whether the plan trustees accurately estimate future liabilities based on life expectancies, using and achieving reasonable investment return assumptions, meeting the timeline for funding (amortization), and whether sufficient contributions are made to the plan.  It is in one or more of these areas where both corporations and state and local governments have gotten into trouble.   For purposes of this discussion, we are going to focus on public plans.

As it stands today, there is overwhelming evidence that we are in the midst of a growing public pension crisis in this country.  If this issue is not addressed, it will have ramifications, not only for pension recipients, but for taxpayers who will most likely end up paying for bailouts when these plans fail.  Much like our federal debt and deficit, publicly elected officials have been the stewards of their respective pension plans and many have allowed their plans to become grossly underfunded by over-promising benefits and failing to maintain proper controls on these plans. And with each election, they simply transfer this mess to the next official who finds new ways to postpone the inevitable rather than making the painful changes necessary to stop the spiral.

What’s Going Wrong?

Life Expectancy Calculations

This table illustrates the effective tax subsidy for employer-sponsored health insurance.  In this example, Person A does not have employer provided health insurance and is required to purchase insurance through private coverage.  Person A must pay taxes on all compensation as taxable earnings and his employer must pay FICA (social security and Medicare tax) on all of their compensation.  Person B has employer provided health insurance as portion of total compensation and contributes a portion of wages toward the premium.   The employer paid premium plus the employee premium contribution are excluded from Person B’s taxable income, thereby providing a subsidy by lowering the overall taxes by $6,639.

Return Assumptions

90s BoomboxOverly aggressive return assumptions are another critical factor in why plans have become underfunded. Since plans have a long-term horizon, they count on the compounding of contributions at a projected rate of return (the discount rate) to determine their current and future funding requirements. During the “roaring 90’s”, outsized returns created a tremendous tailwind for pension plans. Not only did the stock market produce almost double its long term historical returns, but long term interest rates were close to 9%. This gave many plan stewards a false sense of security about required contribution levels and the plan’s long-term health. It was a politician’s dream to have an opportunity to enrich current workers by increasing benefits to gain political favor with seemingly little negative consequences. This market mirage disappeared in the 2000’s with average market returns falling from twice to half historical averages and long-term interest rates moving down from 9% to below 3%. The following graph demonstrates the impact of the dramaTracking State Pension Graphtic reversal
of fortune.

The average public plan currently uses a target investment return of approximately 7.5%, while overall rates of return in most plans have failed to meet these assumptions. This issue is the single most sensitive one for state and local governments because, no matter how unrealistic their projections, they are reluctant to reduce them because even small reductions can have a dramatic impact on funding requirements and budgets.

Length of Amortization

The amortization period is the time over which the pension liability is assumed to be funded. A simple example of an amortization decision is a home mortgage, where a homeowner decides whether they want to pay their bank mortgage over 15 or 30 years. The shorter the period of amortization, the larger the payments required. With pensions, most plans are required to amortize liabilities over no more than 30 years. However, in a ploy to limit required contributions, many pension boards vote to re-amortize each year to a new 30-year period. To use the mortgage analogy, this would be the equivalent of refinancing into a new 30-year mortgage each year, so that instead of paying down your mortgage, you spread your remaining 29 years over a new 30-year period, thus reducing your mortgage payment. The problem with this ploy is that you essentially never pay off your home. It gets worse. To continue the analogy, every year you have new participants in the plan requiring additional funding, which would be equivalent to a homeowner borrowing more on their mortgage each year in addition to the perpetual amortization!

Funding Factors

The factors above constitute the primary assumptions used to determine the amount to be contributed to a pension plan each year. Based on these factors, actuaries calculate the appropriate funding amount. However, they do not set the assumptions, these are set by a governing board that is a combination of elected and appointed members. Unfortunately, in many cases, these governing boards have failed to maintain realistic assumptions and appropriate oversight. When faced with shortfalls, they are often reluctant or unable to take the necessary steps to address them.

Cartoon Walking on Edge of CliffTo illustrate this point, the governing board of the country’s largest public pension plan, CalPERS, recently voted to reduce their return assumption from 7.5% to 7.0% by 2020. This was in spite of the fact that their investment consultants projected that a maximum return of 6.21% could be expected over the next 10 years. The board’s decision to go with a less aggressive approach rather than an immediate move closer to the 6.21% reflects the challenge that pension plans face: trying to balance funding expectations with the impact of higher annual pension contributions on state and local government budgets. A lower assumed rate of return for the plan’s assets sets off a domino effect, which causes the unfunded liabilities to grow and translates into higher future annual contribution needs. The budgetary pain caused by these increased expenditures brings additional pressure to already stressed budgets.

This is a true dilemma and is already the subject of numerous court battles. State and local governments, faced with mounting pension liabilities, have to choose between cutting pension benefits, making steep cuts in public services such as police, fire and emergency services, raising taxes, or some combination thereof. The courts have generally ruled that guaranteed pension benefits cannot be reduced, but that issue is still being argued and there may come a time where there is no choice. What many pensioners do not realize is many of their benefits are not actually guaranteed.

Closer to home, members of the Ohio State Teacher’s Retirement System (STRS) have recently learned that their annual cost of living increases have been indefinitely suspended on top of major benefit restructuring twice in the last 10 years. The primary reasons cited were recommendations by plan consultants that plan return assumptions were overly optimistic and that life expectancy and payroll growth assumptions were out of whack. In addition, the STRS members’ retiree health fund was affected with the 1% employer contribution to the health fund being diverted to fund the pension shortfall.

How Widespread is the Problem?

US Map MoneyThere is ongoing debate about what constitutes a relatively healthy pension plan. When a pension has an unfunded liability, one measure of health is its funding ratio. A ratio of 100% means the plan has sufficient assets to pay all of the accrued benefits owed. Some argue that a funding ratio of 80% or more is adequate, but the American Academy of Actuaries strongly disagrees. They suggest that pension plans have a strategy in place to attain or maintain a funding ratio of 100%. Sadly, only two of the fifty states have a score of 100% or higher and only seventeen have a score of 80% or higher. Currently, Ohio plans are at 76%. Most local plans fare significantly worse.

Conclusion

Uncle Sam Back WavingJust like our challenges with debt and deficits at the federal level, this public pension problem is not going away. There is plenty we can do as a nation to improve these circumstances, but unfortunately, the political will to make the difficult decisions on these matters remains absent. The longer we wait to address our pension crisis, the fewer choices we will have and the more painful those choices will be. The national media recently ridiculed Governor Chris Christie for using a New Jersey beach that he had closed to the public as a cost-cutting measure due to their anemic budgetary circumstances. It may not be so amusing to the media in the future when pensions or more critical public services become the sacrificial lamb when local and state governments are left with no other choices and their postponement tactics no longer work.

Whether you are a pensioner or not, as taxpayers, we need to be mindful of the possibility that the burden of this situation may ultimately fall on us in some fashion. As your advisors, we cannot stress enough that it is critical to continue to live under your means, prepare for the future through saving and investing, and continually review your plan. In doing so, you will have a full understanding of your financial circumstances giving you the time and flexibility to manage challenges as they may arise, thus assuring you can live the life you deserve.

 


Our Team Continues to Grow

Dan VogelpohlWe are excited to announce that Dan Vogelpohl has joined Wealth Dimensions Group as a Principal and member of our management team. In this role, Dan will focus on building client relationships within the Greater Cincinnati community to bring the firm’s expertise to an expanded market.

Dan brings a wealth of experience and industry knowledge to this role, making him a key addition to the Wealth Dimensions team. Wealth Dimensions is committed to serving a variety of clients, including business owners, executives, dentists and physicians, and Dan will play a key role in helping us continue to bring financial guidance and clarity to those within our growing community.

Dan holds an MBA from Xavier University. And as a former Senior Vice President and Director of the Private Bank at Fifth-Third, he has more than 25 years of experience within the financial industry, serving clients and helping them achieve their goals.

“I am excited to join the leadership team at Wealth Dimensions and work closely with them on strategic growth”, said Dan, Principal at Wealth Dimensions Group. “I share Wealth Dimensions’ dedication to helping clients achieve financial clarity and making a true difference in their lives.”

 


Investment indices are provided by Standard and Poors, Russell Investments, Dow Jones US Select REIT Index and MSCI. Performance of these indices is not indicative of any particular investment. The indices are unmanaged and individuals cannot invest directly in any index. The Barclays U.S. Aggregate Bond Index is comprised of a variety of taxable bonds, and is used as a measure, or benchmark, of the US bond market. No strategy including diversification can guarantee a profit in a down market. Past performance does not guarantee future results.

 Information provided has been prepared from sources and data we believe to be accurate, but we make no representation as to its accuracy or completeness. Data and information is general in nature and not meant as specific to any particular situation. As such, you should not act on this information and should seek advice based on your particular circumstances. Wealth Dimensions Group, Ltd, shall not be liable for any errors or delays in the content or for the actions taken in reliance therein.

 Please be advised that this material is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.