Pension fund investing is being reinvented.
Three years of a bear stock market that has depressed portfolios, along with low interest rates that have jacked up pension liabilities, are causing pension executives to re-examine fundamental premises. Now, say the experts, pension executives are increasingly shifting focus to the plan sponsor's ability to pay benefits and to smooth out volatility in pension contributions, even if long-term returns are sacrificed.
The implications for how pension portfolios are constructed are dramatic. Here's what's on the table:
c Extending the duration of bond portfolios or boosting core fixed-income to hedge against plan liabilities;
c Shifting into alternative assets to enhance returns and increase diversification;
c Lowering allocations to U.S. equities to gain greater diversification elsewhere; and
c Increasing use of overlay strategies to shift market exposure and portable alpha strategies to marry the best managers with desired asset classes.
The bottom line, said Keith P. Ambachtsheer, president of K.P.A. Advisory Services Ltd., Toronto, is that "a systemic change in the financial world is taking place, leaving no equity risk premium and turning investment management into a risk management discipline."
Subhead goes here
The response, for many, is a return to asset-liability management. Briefly popular in the late 1980s under the guise of "surplus management," the concept was made superfluous by the raging 1990s bull market.
The surpluses are largely gone now, and pension executives who choose to ignore this reality do so at their own peril.
Robert Arnott, chairman of First Quadrant LP, Pasadena, Calif., said he knows one pension executive at a midsized corporate fund who is being forced out after 20-plus years. That's despite achieving top-decile performance in 2002 and top-quartile performance for the past three- and five-year periods. The problem: Even top-decile performance last year was negative, and the plan now is underfunded. For many public companies, that can involve a charge against earnings.
Pension executives know they have to do something.
Of the 200 largest U.S. pension funds, the median pension plan was estimated to be only 71% funded at the end of 2002, based on projected benefit obligations, down from 117% five years ago, according to J.P. Morgan Fleming Asset Management, New York.
"To get to fully funded over five years, it (the average pension plan) would need something like a 20% growth rate," said Karen McQuiston, head of Morgan Fleming's strategic investment advisory group. That kind of growth can be achieved only through a combination of market returns, excess returns and contributions, she noted.
Subhead goes here
"It's hard to see any asset class that will bail them out," said Roy Henriksson, director of research for Resolution Capital LLC, New York, a hedge fund manager. Mr. Henriksson co-wrote a seminal 1988 study on surplus management with Martin Leibowitz, now vice chairman and chief investment officer at the Teachers Insurance and Annuity Association-College Retirement Equities Fund, New York.
It's time for plan sponsors to pay the piper.
"Pension funds never were free. They were just in a Rip Van Winkle kind of sleep, as far as contributions are concerned," said Robert Hunkeler, vice president-investments for International Paper Co.'s $5.5 billion pension fund, Stamford Conn.
Once defined benefit plans become fully funded again, some experts believe many will be frozen or terminated.
Whether that's true remains to be seen. But it's clear that pension executives are exploring a combination of methods to both dampen contribution volatility and boost returns in a period of lowered expectations for both stock and bond markets.
Recent studies by Goldman, Sachs & Co., New York, and Morgan Fleming confirm the shift is under way.
Goldman Sachs officials found that pension executives are more focused on improving the pension fund's total return and less focused on relative performance. The winners: more mandates for absolute-return strategies (including hedge funds and market-neutral approaches); high-yield fixed income; international stocks; global asset allocation; and emerging markets. The loser: U.S. equity exposure, which was decreased slightly.
Meanwhile, a poll of 80 institutional investors by Morgan Fleming found that 30% of sponsors are making changes in their strategic asset mixes; 40% are thinking of making changes; and 30% are standing pat, Ms. McQuiston said.
Subhead goes here
Joseph Nankof, principal at Rocaton Investment Advisors LLC, Darien, Conn., said sponsors are looking at defensive moves such as extending bond duration, as well as offensive strategies, to boost returns.
Longer term, the result could be a substantial paring of domestic equity holdings. A typical pension fund might have 50% of assets in the U.S. stock market and 25% in the U.S. bond market, leaving 25% of assets "to eke out some diversified return," Mr. Nankof said.
He suggests a pension fund could allocate one-quarter of its assets to bonds as a conservative bet and the remaining three-quarters to other asset classes with low correlations, including U.S. stocks, developed-market stocks, emerging market equities, high-yield debt, emerging markets debt, private equities and hedge funds.
"The concept of spreading the dollars much more evenly across these different asset classes seems to be very intuitively appealing," he said.
Shorter term, many pension executives are considering extending the duration of bond portfolios to better match plan liabilities.
"Over time, the difference in the duration of the liability of the pension fund and the bond benchmarks has widened quite substantially," noted Christopher P. Dialynas, managing director at Pacific Investment Management Co., Newport Beach, Calif.
The duration of the Lehman Brothers Aggregate Bond index is now less than four years, down from 4.8 years in 1980, he said. During that period, the average duration of a pension fund's liability has increased to about 14 years, from six. "That's a huge mismatch," he said.
Subhead goes here
Many pension executives, however, are holding off until long-term interest rates rise about 150 to 200 basis points from 40-year historic lows. "It still feels a lot like walking the plank in the current interest-rate environment," said Watson Wyatt's Mr. Hess.
"A lot of them are hesitant about it because of the perception that interest rates are at a cyclical low, and they're bound to rise. Some of them go ahead and do it, some of them don't; some will average in over time," said Louis Finney, senior consultant at Mercer Investment Consulting, Chicago.
One pension fund that has used overlay strategies to extend its bond portfolio's duration is International Paper. Mr. Hunkeler used two overlay managers to extend the duration of the fund's $1.2 billion developed-market fixed-income portfolio to 10 years from four, to better match the fund's liabilities (Pensions & Investments, Dec. 23).
"I wouldn't be surprised to see more and more plan sponsors considering using overlay strategies on not just the fixed-income portfolio, but on the entire portfolio," Mr. Hunkeler said.
The advantage, he said, is "you kill two birds with one stone." First, the plan gets a better match of assets with liabilities, without disturbing the underlying asset mix or managers. Second, the plan sponsor's returns can still be compared with those of its peers.
The renewed focus on asset-liability management means many pension executives will have to go it alone - something they've historically been loath to do.
"It means getting away from an asset-only mindset, away from a relative performance or peer comparison focus," said Michael Litt, partner and client investment strategist at FrontPoint Partners LLC, a Stamford, Conn.-based absolute-return manager.
"What I am hoping you would find would be more willingness by plan sponsors to look different from their peers. People would say, `Based on my situation, my beliefs, the interests of the plan beneficiaries, this is the right allocation for us,"' said Rocaton's Mr. Nankof.