WASHINGTON - A slew of pension-related legislative proposals being debated in Congress, and the many more still on the drafting table, strongly suggest lawmakers intend to begin reshaping the nation's private pension system next year.
Mark Ugoretz, president of the ERISA Industry Committee, speaking at Pensions & Investments' annual investment management conference last month, said 1997 "is likely to be as critical a year for pension and savings plans as was 1986," when lawmakers revamped the nation's tax laws, slashing the amount of money companies could contribute to pension funds for middle and senior-level executives, among other changes.
ERIC lobbies on behalf of many of the nation's largest corporations.
Sen. Minority Leader Tom Daschle, D-S.D., and House Minority Leader Richard Gephardt, D-Mo., introduced in May President Clinton's pension proposals along with several of their own ideas in "The Retirement Savings and Protection Act of 1996" (P&I, May 27).
More recently, the Democratic leaders unveiled a package of tax proposals called "Families First," that includes other pension provisions they pledge to enact if their party regains control of Congress in the November election.
And there's other evidence that lawmakers are planning to tinker with the pension system:
Rep. Marcy Kaptur, D-Ohio, recently resurrected a seven-year-old bill that would force employers to share control of pension funds with employees (P&I, June 10). The 1989 bill introduced by Rep. Peter J. Visclosky, D-Ind., had been "defeated in a brutal fight on the House floor," Mr. Ugoretz observed.
Sen. Barbara Boxer, D-Calif., introduced legislation that would apply to 401(k) plans the same limitations on the ownership of employer stock that now apply to defined benefit plans.
Proposals to overhaul the nation's tax system are leaning toward one tax rate or imposing consumption taxes that are likely to make traditional pension plans less attractive by sheltering other forms of savings from income taxes. At the same time, Mr. Ugoretz pointed out, proposals to prop up the nation's Social Security system are being debated in terms of reducing the government's liability and shifting it either to working Americans, or to employers in the form of higher payroll taxes. Moreover, new Senate Majority Leader Trent Lott, R-Miss., "specifically singled out tax reform - which will include pensions - for his own agenda for 1997," Mr. Ugoretz pointed out.
Reps. Nancy Johnson, R-Conn., and Earl Pomeroy, D-N.D., have co-sponsored legislation that would establish a federal commission on retirement savings and, the legislation that has bipartisan support, "seems likely to succeed," Mr. Ugoretz predicted.
Alicia Munnell, now a member of President Clinton's Council of Economic Advisors, gained notoriety years ago for her proposal that pension fund assets be taxed. When she originally was appointed to the Clinton administration three years ago as assistant secretary of the treasury, her boss, Treasury Secretary Lloyd Bentsen, made it clear he disagreed with any such idea. But "Secretary Bentsen is now Mr. Bentsen and the 'tax the trusts' proposal is still very much alive," Mr. Ugoretz warned.
No proposal in itself is significant, Mr. Ugoretz said. "But if I were an investment manager, and if pension legislation were a stock, and if I were looking for signs of significant movement in that stock, I suggest to you that these would qualify for anybody's 'watch list,' They are on ours."
Nor has the Department of Labor's approval of socially linked investing by pension funds disappeared. While while some Republican lawmakers, under the leadership of Rep. Jim Saxton, R-N.J., succeeded last year in blocking the DOL's promotion of such investments, "it is likely the administration will renew pressure on social investing" if Democrats recapture either chamber of Congress, Mr. Ugoretz speculated.
And while a bill streamlining pension fund paper work requirements finally has a good shot at being enacted this year, Mr. Ugoretz's association intends to push for even more clearing of the regulatory underbrush with a laundry list of proposals it will announce early next month.
While Mr. Ugoretz prepped conference attendees for the upcoming legislative and regulatory agenda, several money managers and pension executives talked about ways to take advantage of specific situations to manage risk and still get great returns.
Matching assets and liabilities
Despite very strong markets, pension funds have had varying overall results - mostly because of the rise in liabilities during strong market runs, said Lawrence N. Bader, senior consultant at William M. Mercer Inc., New York. According to Ryan Labs Inc., New York, 1995's total returns of 29.1% on pension assets invested in the stock market failed to keep pace with the 41.6% increase in liabilities. One way to combat the problem is to try to find some way to synchronize liabilities with asset returns to contain any further decrease, he said.
William F. Quinn, president of AMR Investment Services Inc., Dallas/Fort Worth, said being overfunded limits his company's ability to grow, purchase equipment and remain competitive with other airlines that do not offer a defined benefit plan to employees. In AMR's business, it's essential to coordinate pension fund policy with company goals to stay competitive.
Matching assets and liabilities is an essential corporate strategy for AMR, because many of its competitors offer defined contribution plans and don't have the costs that come with defined benefit plans, Mr. Quinn said. Mismatching assets and liabilities drives up defined benefit plans' operational costs; plans then need to make up the difference through contributions, which eat at the company's total profits.
AMR oversees the pension assets of American Airlines, including its $4 billion defined benefit plan.
AMR has used hedged asset liability optimization or a HALO bond fund with an 18-year duration to help meet its goal of maintaining reasonably stable pension costs. Setting aside money in such a bond fund, with assets earning fairly stable long-term returns to pay off pension benefits due several years away cushions the company from having to later make up for any shortfalls in its pension fund, he said. The bond fund also protects the firm from a ballooning pension fund liability if interest rates drop because the value of the bonds moves up correspondingly. The fund "makes sure the assets and liabilities increase or decrease in tandem with interest rate changes," Mr. Quinn explained.
Granted the company has given up the potential to earn vastly more on its assets invested in stocks but, at the same time, AMR also has limited its downside risk from liabilities soaring in the case of declining interest rates.
If interest rates sag, the company still will come out ahead because its liabilities will drop in tandem, Mr. Quinn explained. When the company set up the bond fund in 1987, the company's accrued pension liabilities amounted to $1.5 billion and its pension fund was fully funded. Instead of stashing the entire $1.5 billion in the dedicated bond fund, AMR set aside half in bonds with an 18-year duration, giving the firm the flexibility to invest the remaining half in other assets with a higher upside potential.
With the use of the dedicated bond fund, AMR reduced the pension fund's operating expense to $1,900 per employee in 1995 from $2,940 per employee in 1981. The expense represented 3.6% of the company's payroll, down from 8% in 1985, or 1.2% of the revenue in 1995 compared with 2.9%.
Matching assets and liabilities stabilizes pension costs, limits the credit risk to the company and allows the pension fund to be more aggressive in other areas such as international equities, emerging markets and private equity investments, he said.
"This allows us to be very active participants in the broader marketplace," Mr. Quinn said, adding that emerging market investments comprise 5% of AMR's fund, while private equities comprise about 8%.
Managing political risk
When devising a strategy to manage risk, very few pension executives consider political liabilities that undoubtedly need to be controlled, said Ash Williams, director of operations at Schroder Capital Management International, New York.
There are several types of risk - outside the realm of money management issues - that need to be addressed. While many of the political risks directly affect public funds, elements do apply in the private sector, said Mr. Williams, formerly executive director at the $68 billion Florida State Board of Administration, Tallahassee.
It's important to identify each type of risk that may affect the operation of the fund and to have a control in place to manage it, he said. For public funds, it's important administrators know the governing process and work with legislative officials to prevent asset raids and to promote legislation that would improve funding levels.
Maintaining a working operation during natural disasters also is imperative, Mr. Williams said. The Florida State Board is in the hurricane beltway and could be knocked out of business if controls were not in place to prevent the board's shutdown during a natural disaster. The building housing the board is able to generate its own electricity and water "even if everything in Tallahassee shuts down," Mr. Williams noted.
Human resource risk also is an important factor. Mr. Williams asked the group whether their compensation schemes would prevent valuable staff from being poached by competitors. Another factor to consider is losing key staff members to injury or sickness; plan sponsors need to consider how operating responsibilities are parceled out among employees. Mr. Williams advised plan sponsors alter their management strategy with the tools available to get the right professionals.
Lastly, Mr. Williams said pension executives need to know more than their investment managers' investment track record. Fund officials need to select managers wisely to avoid any surprises. Especially in the public fund sector, a manager's blunder will turn directly back at the pension executive, he warned.
New investment options
As pension funds expand their search for ways to bolster returns while stamping out risk, a frontier institutional investors are just beginning to explore is the syndicated corporate loan market, said Virginia M. Henneberry, managing director at ING Capital Advisors, a New York-based subsidiary of ING USA.
Traditionally, these loans tended to be offered by banks, which would then parcel out pieces to other banks to lower their risk. But attractive returns on such loans have drawn institutional investors such as insurance companies, hedge funds, and mutual funds in recent years, she said.
In particular, the lack of liquidity and absence of debt ratings in the private corporate debt market that deterred institutional investors in the past no longer are factors. There are now a number of indexes to measure risks and returns of such loans, such as the Citibank Loan Index introduced in February 1993, which quantifies the historical performance of corporate loans on a monthly basis going back to 1988.
Then too, the market has expanded rapidly, to $1.5 trillion last year, with institutions picking up as much as $800 billion, most of it investment grade. And institutional investors can count on protection through provisions in the loan contracts - so their principal is safe. And since the loans usually are backed by corporate assets, investors can sleep well.
The returns on such corporate debt usually are a variable premium over the benchmark London interbank offered rate, depending on the creditworthiness of the borrower, as well as fees and how soon the loan actually is paid off. Such investments also offer institutional investors protection because their returns are independent of trends in the stock and bond markets.
Such investments, which would be broadly classified under alternative investments, could be used to replace long- or short-term Treasury securities and high-grade corporate bonds, she said.
So what's the downside of investing in such bonds? "It is very difficult to invest in the market because it's very time-intensive, credit-intensive and the loans are very complicated," she noted.