NEW YORK - Cynthia Steer's arrival Jan. 23 as vice president-benefit investments at Philip Morris Cos. Inc. heralds an era of change for the $6 billion defined benefit plan - particularly in its international and alternative investments portfolio.
In her four years as director of pension investments for Hartford, Conn.-based United Technologies Corp.'s $10.5 billion in U.S. pension assets, Ms. Steer overhauled the fund's real estate investments, reorganized its private investments, and created what is the only in-house currency trading desk for a U.S. pension fund.
Now she is taking on an even broader mandate at Philip Morris, where she will report directly to Chief Financial Officer Hans Storr and will deal with a board-level pension committee chaired by New York Stock Exchange Chairman William Donaldson.
On the surface, both the Philip Morris plan and the $6.5 billion UTC defined benefit plan are structured similarly. Both use index core portfolios and satellite managers, although UTC relies more heavily on passive strategies.
But changes are likely to be forthcoming at Philip Morris, probably more within asset classes than an overhaul of the entire fund. Among the key issues on the agenda this year:
A top-to-bottom review of the pension fund's asset allocation, manager mix and long-term performance are planned. Ms. Steer also intends to take a hard look at the fund's overall benchmarks and individual performance targets for its managers.
An expansion of the fund's alternative investments portfolio is in the cards. Ms. Steer will inherit a staff of five professionals, but has the authority to hire two more to handle alternative investments, such as real estate and private investments.
Real estate will extend to non-U.S. developed and emerging markets; the UTC fund recently invested $1.5 million in a Shanghai office building.
A new currency management policy might be devised. Philip Morris probably will consider creating its own foreign exchange trading desk.
Funding for overseas retirement obligations will be reviewed, particularly in countries such as Germany where a book-reserve system is the norm. Philip Morris also has major operations in the United Kingdom, the Netherlands, France, Switzerland and Canada. Philip Morris has non-U.S. pension assets totaling $1.4 billion, while its projected benefit obligation is $2 billion, including $600 million for Germany alone.
While Ms. Steer also will oversee investments of Philip Morris' $4 billion 401(k) plan, she will have much less to do there. Philip Morris officials already are in the process of expanding investment options for the plan, which is 35% invested in company stock.
Taking a view
Ms. Steer said she learned an important lesson teaching disadvantaged children in New York's lower East Side in the mid-'70s: "There are 200 ways to approach a problem, none of which is the absolute right way. But you do have to take a position. You have to take a view, and alter your view based on experience."
Ms. Steer's views on global capital markets may lead to greater flexibility at the Philip Morris fund. She has challenged pension industry executives to re-examine their assumptions.
"The global economies are changing so radically one cannot make the same assumptions as to the historical economic interrelationships (between countries) as one did five years ago," Ms. Steer said.
Her key assertions include:
Capital costs will soar for U.S. companies - perhaps by 300 to 400 basis points over time, as U.S. spending continues to outstrip savings, imports exceed exports, and growth rates stay low. Meanwhile, demand for capital elsewhere will soar and capital costs will shrink around the world.
That change, she says, "has dramatic implications for asset allocation" ones that won't be addressed by looking to historic rates of return.
The easy double-digit returns of the 1980s are gone. "In the '80s, you could have invested in almost anything - train cars in Ghana -and made money. Now, if you make a mistake within an individual investment, you cannot expect the other asset classes to pick up the slack."
Traditional money managers are not seeing the deal flow to the same extent as in the past. "The challenge of the '90s is that the deal flow is being diverted from the traditional sources. It is not coming through the money manager community as much."
As a result, Ms. Steer had started directing potential deal-makers to the UTC fund's outside money managers - a process she will continue at Philip Morris.
"Outside the U.S., the argument is increasingly being made and won that correlations between countries are going down. Therefore, you need local contacts. This linkage is why I would see a merchant bank from Brazil while I would not let them have an appointment 18 months ago."
Pension executives cannot drive their funds into the future using a rear-view mirror and must actively look to new sources for added value, she said.
Ms. Steer's willingness to adapt to change is most visible in UTC's alternative investments program.
In real estate, the fund took a painful 40% writedown on its assets in 1992, while shifting to a cash-on-cash appraisal from one based on capitalization rates. Making that switch enabled Ms. Steer and her staff to restructure every lease, while the investment committee decided which properties to hold and which to sell.
That effort has paid off: Every property but one now is enjoying close to double-digit returns.
UTC's pension committee also agreed to partially rebuild the fund's real estate allocation, raising another two percentage points from the current level of 3% - although still below the 1991 level of 8%.
But efforts to find suitable properties in the United States have been frustrating, leading UTC officials to look abroad "where we think economic trends and prices are more attractive," Ms. Steer said.
Consequently, the UTC fund recently invested $1.5 million into a 1.1 million-square-foot office project in Shanghai. No other pension funds have invested in the $250 million project, named 46F.
Ms. Steer expects a big payoff from this and other real estate in emerging markets; she anticipates annual returns well over 40%, excluding currency effects and net of depreciation.
"What you have going for you in some of these markets are clear economic trends and insatiable demand," she said.
But added risks comes with high returns. Questions of title risk, lack of comparable data and development risk arise, she said.
Ms. Steer also has overhauled UTC's portfolio of more than 60 limited partnerships handling private investments, which include venture capital and leveraged buy-out funds.
She placed the management of about half of those programs in the hands of an outside firm, Haberkorn, Mawrie & Mahoney, a Boston based-venture capital firm. That way, she was able to delegate part of the management responsibility and pare fees by about one-third.
Ms. Steer also will guide the Philip Morris plan's international stock and bond investments, which comprise 22% of plan assets.
Ms. Steer's experience at UTC might provide some guide for her future actions at Philip Morris. UTC has a target of 20% to 25% in international assets, with half of international equities passively invested.
Before she left UTC, fund officials were considering whether to alter the composition of their foreign holdings, without increasing the total allocation. In particular, they were exploring whether to expand their allocation to emerging markets equities, now around 10% of the international stock allocation. They also were considering whether to venture into emerging markets debt.
But currency exposure is where Ms. Steer - a former foreign-exchange trader with American Express Corp. and the Bank of Montreal - might have an even greater impact.
When she joined UTC in 1991, the fund was 70% hedged on its currency exposure, as the conventional wisdom of the time dictated. A paper published last year by Harvard University academic Ken Froot convinced Ms. Steer the hedging ratio should be much lower.
That paper says hedging is less important for longer-term positions. While short-term hedges reduce risk substantially, over the long haul hedging often creates greater volatility because inflation shocks and real interest-rate surprises become more important.
Another problem with many of the earlier papers is they assumed transaction costs of 50 basis points, but failed to include costs of taking forward positions. By the late '80s, costs of taking forward positions had soared to 400 to 800 basis points, Ms. Steer said.
On that basis, a 20% to 30% hedge is appropriate - not stratospheric hedging levels of 70%. "That intellectual foolishness cost plan sponsors like myself millions and millions of dollars," she said at a recent conference.
Ms. Steer finally persuaded the UTC pension committee to lower the hedging ratio to about 40% as an interim step. She also implemented a strategy of laddered maturities, eliminating a duration mismatch on the fund's hedges.
Shelving the benchmark issue
In the rapidly evolving '90s, sticking with the conventional wisdom can hurt, Ms. Steer said. The problem with traditional benchmarks is they look backward, she added.
"To align yourself to your benchmark is inappropriate for the next three or four years."
The important issue is to look at the underlying investments and see if they make economic sense, she said.
Pension funds must get returns that are risk-adjusted, Ms. Steer added. In a low-inflation environment, real rates of returns may remain the same.
The difference in the '90s is that mistakes will not be forgiven so easily if pension executives slip up - as they did in real estate in the last decade. "Those losses will haunt you for a longer period of time than they did in the '80s."
"The objective of the '90s is not only to make good returns but minimizing your mistakes and to have a review process thorough enough and timely enough so that anomalies are caught quicker."