Defined benefit assets for the largest 200 pension funds surged more than 800% during the 20-year period ended 2001 - to $3.6 trillion - a growth pattern so powerful the top 200 funds alone could represent nearly 35% of the nation's total gross domestic product.
The "most dramatic" change in the "composition, scope and management" of pension funds since 1981 was astronomical growth in international investments, to approximately $272 billion in 2001 from just $2.5 billion in 1981.
Those are among the findings from an analysis of pension data by Thomas J. Healey, an advisory director at Goldman, Sachs & Co., New York, and professor at the Center for Business and Government at the Kennedy School of Government at Harvard University, Cambridge, Mass.
Using data collected by Pensions & Investments for its annual survey of the largest pension funds for the 10- and 20-year periods ended 2001, Mr. Healey and research associate Rossen Rozenov also found:
* public funds grew nearly twice as fast as corporate plans during the 20-year period;
* internally managed assets fell to 32% of total defined benefit plan assets during the 20 years, from 41%;
* private equity grew to 5% of the total assets, from essentially zero at the beginning of the period studied;
* defined benefit assets for the largest 200 pension funds more than doubled between 1991 and 2002, from $1.7 trillion to $3.6 trillion, and jumped a "spectacular" 800% from $494 billion in 1981;
* indexed assets increased about 164%, to $732 billion from $277 billion in 1991;
* investments in international equities jumped from just $52 billion in 1991 to $238 billion in 2001, an increase of nearly 355%; and
* the difference in asset allocation between corporate and public funds essentially disappeared during the 20 years ended 2001.
Twenty years ago, the percentage of all equities in pension fund portfolios was about 40%, increasing to 57% by 2001. That increase was largely due to expected returns in the equity market, he noted in an interview.
The remarkable increase in international investments is "harder to explain," according to the study. During the 1980s, international stocks outperformed domestic stocks, but returns on foreign equities were rather poor during the 1990s. Yet pension fund allocations to international securities "continued to grow steadily both in absolute and in relative terms," according to the study.
One possible reason for the increase is that pension funds were seeking to diversify and minimize concentrated risks. Mr. Healey said in an interview that asset allocation models developed by consultants and academics are partially responsible for the rise in international investments.
All go international
The largest pension funds' investments in international stocks and bonds stood at $2.5 billion in 1981 and reached $68.2 billion by 1991. By 2001, the total climbed to $272 billion. "Indeed, virtually all funds had assets deployed in international stocks and bonds by 2001, with an average allocation of about 16%," the report said.
Because large pension funds follow "methodical" asset allocation models and rebalance on a regular basis, Mr. Healey said asset allocation models steadily earmarked a major percentage to international securities. "It is policy driving it (the allocation to international investments). But the starting point has to be the 800% growth in assets," he said, in addition to efforts to reduce overall risk and strive for a higher degree of diversification.
The growing use of international securities generally coincided with an overall increase in equity allocations by the top 200 pension funds during the period.
"While 20 years ago the share of equities in pension fund portfolios was only a little above 40%, by 2001 assets allocated to stocks had jumped to 57%. Conversely, the share of bonds dropped from 38% to 31%," the paper said. "The explanation for this shift is simple - returns on investments in equity substantially exceeded those for bonds and cash equivalents, and pension funds adjusted their strategies to take advantage of the bull market."
According to Mr. Healey's analysis, indexed assets held by the top 200 funds grew by a factor of 50 between 1981 and 2001. The use of indexed funds increased from 3.5% of total assets to nearly 26% in 2001. Only 34 funds reported investments in indexed assets in 1981, according to the Healey analysis, with AT&T Corp. holding nearly half the $13.8 billion total. In 2001, 130 of the top 200 plans reported investments in indexed funds, and the 10 largest investors were public funds, according to the analysis.
"I'd say that after the growth in international investments, the next most significant finding is the increase in indexed assets," said Mr. Healey, who surmised that a substantial portion of assets managed internally are indexed.
However, the study showed that while the total dollar value of assets managed internally by the top 200 funds increased between 1981 and 2001, to $931 billion, the percentage of internally managed assets dropped to 32% in 2001 from 41% in 1981.
"It is worth noting that in 1991, public funds predominantly engaged in in-house management, with only three corporate funds in the top 25 internally managed," the report said. "By 2001 the situation hadn't changed greatly."
The Healey analysis shows that public pension plans grew more rapidly than corporate plans between 1991 and 2001. In 2001, for instance, combined assets of the top 10 public funds were $813 billion, or about 23% of the total for the top 200 funds. In 1981, the top 10 public funds represented 22% of the total. In comparison, the 10 largest corporate funds totaled about $541 billion, or 15% of the top 200, in 2001, down from 24% in 1981.
"A likely explanation for the differences in growth is corporate downsizing, a maturing work force and early payment of benefits to facilitate early retirement in the corporate sector as opposed to a younger and growing labor force in the public sector," the study said. It also noted that the number of employees in state and local government increased 38% between 1981 and 2001, while employment in the "goods production sector" -where most corporate plans belong -declined as the labor force gradually moved into the service sector of the economy.
Mr. Healey uses the largest public and corporate plans - the California Public Employees' Retirement System and General Motors Corp. - to illustrate the point. CalPERS made pension contributions of $14.8 billion between 1997 and 2001 while paying benefits of $24.7 billion, a negative cash flow of $9.9 billion. GM, on the other hand, made contributions of $8.7 billion and benefit payments of $28.9 billion, for a negative cash flow of more than $20 billion during the same period.
Using CalPERS and GM as proxies "helps explain several phenomena," the Healey paper said. "First, the fact that both corporate and public funds are growing more slowly than implied by investment performance is due mainly to their large benefits payments and the resulting negative cash flow. Secondly, the data help explain why public funds are growing faster than corporate funds."
Another "significant change" in pension investments during the two decades was the "disappearance of the difference in asset allocation between corporate and public funds," the paper said. "In 1981, public funds were very much geared to fixed-income instruments, while corporate funds leaned heavily toward stocks. By 2001, the situation had changed markedly: both types of funds had virtually identical, equity-heavy asset allocations."
In an interview, Mr. Healey said the issue of convergence hasn't occupied as much industry attention as other issues, but is significant. Convergence of asset allocations, he said, "is the combination of academic work and consultants' work on asset allocation. ... It's remarkable that everybody is doing it the same way. You just hope it's right," he said. Nobel laureate Harry Markowitz, the father of Modern Portfolio Theory, "deserves the Nobel for developing something everyone in a $3.6 trillion industry uses today."
"What I think is happening," said Mr. Healey, "is that 10 years ago the common wisdom was that individuals were too risk averse and leaned too heavily on GICs. A couple of things happened; people listened and became less risk averse as the markets moved up. The other factor was company stock. If you have a stock allocation of 60% stocks, 30% was in a diversified equity portfolio and 30% was company stock."
According to the Healey paper, the shift by defined benefit plans toward equities boosted the overall asset growth, which was nearly three times higher in the 1980s than in the 1990s despite the bull market of the '90s.
The dichotomy "is likely the result of 1) pension holidays due to good performance so that relatively small amounts of new cash were placed in pension funds, and 2) maturation of the labor force covered by defined benefit plans so that pension benefit payments rose dramatically."
Noting that the past 20 years were "fabulous ones for pension funds," with rising stock prices, the lack of inflationary pressures and low interest rates, Mr. Healey said in his paper, "the next 20 years may be considerably less positive." Problems looming on the horizon include "troubled stock markets as well as interest and inflation rates with considerable upside risk, coupled with a maturing labor force, all of which will create substantial new funding requirements for both corporate and public pension funds."