Stock dividends pay off for insurer’s pension fund

WESTFIELD CENTER, Ohio — Focusing on dividends paid big dividends — literally and figuratively — for Westfield Group's $135 million pension plan in 2002.

The Ohio-based property and casualty insurance company earned -5% on its defined benefit investments last year, Chief Investment Officer John M. "Marty" Haney said. That's 419 basis points better than the median rate of return for corporate pension funds in 2002, according to Wilshire Associates' Trust Universe Comparison Service.

Westfield Group also finished the year slightly overfunded, an anomaly in 2002. Only 11% of 320 corporate pension funds surveyed by Wilshire Associates as of Dec. 31 had assets that met or exceeded liabilities.

To be sure, Westfield Group has seen most of its pension fund surplus dry up in the past three years. "We have felt the pain, no doubt," Mr. Haney said. "There's no place to hide."

But Westfield Group, which manages all of its assets internally with a staff of five people, uses what Mr. Haney described as a defensive investing strategy. The company has 60% of its assets in equities and 40% in bonds, he said, making it a "plain vanilla" portfolio. Ron Stephonic manages the bond portfolio and George Wiswesser manages equities.

Of the equity portion, 82% is invested in large-cap value companies that pay dividends. These are companies like General Electric Co., Pfizer Inc., Eli Lilly & Co., Abbott Laboratories and Bristol-Myers Squibb Co., Mr. Haney said.

The remaining 18% is invested in so-called "specialty mandates" — about 8% in two international mutual funds, 4% in small-cap value equities, 4% in small-cap growth and around 2% in Standard & Poor's MidCap 400 Depository Receipts, also known as the MidCap SPDR, Mr. Haney said.

The entire bond portfolio is in investment-grade securities, and 45% are rated AAA.

It is Westfield Group's equity investing style, though, where Mr. Haney thinks his staff has added the most value. He is particularly happy with the focus on companies that not only pay dividends, but also grow those dividends at an annualized rate of around 10% per year.

Dividend-based investing is "old-fashioned, but we've always liked it because we think it's been the purest way of identifying management's confidence about the future," Mr. Haney said. "If firms are raising dividends consistently, it gives us a measure of confidence in management and where they feel the business is headed."

This disciplined and defensive style, Mr. Haney said, caused the pension fund to miss out on the raging bull market in 1997-‘98, but it has also allowed the fund to escape the "carnage" of the past several years.

In fact, Westfield Group's pension fund has outperformed corporate plans over the three-, five- and 10-year periods ended Dec. 31, according to Wilshire Associates TUCS data.

Mr. Haney said the defined benefit plan returned an annualized 2.8% for the three years ended Dec. 31, an annualized 4.9% over five years and 9.8% over 10 years. By contrast, the median pension fund in the TUCS universe returned -4.6% for three years, 3.1% for five years and 8.7% for 10 years.

Using MITTS

One relatively new investment strategy for the pension fund is market index target-term securities, or MITTS, which are essentially zero-coupon bonds that guarantee return of 100% of the principal at maturity, plus some percentage of market returns obtained using options. The concept is not new to the company; for about five years, Westfield Group has had roughly $4 million of its $2 billion in insurance assets invested in MITTS. But the strategy was added to the defined benefit plan only in the last year.

Westfield Group hired Merrill Lynch & Co. Inc., New York, to manage about $1 million in MITTS investments, which Mr. Haney said are included in the convertible bond category for allocation purposes.

MITTS comprise two separate pieces — the zero-coupon bond, which is priced at a discount to a face value of, say, $100 per unit, and an embedded option. If the bond sells at a 25% discount, the buyer pays $75 for one MITTS unit and uses the remaining $25 to buy equity index options.

Investors will not lose any of their principal when they purchase the investment from Merrill Lynch and hold it to maturity; it is guaranteed by the zero-coupon bond. If the market goes up, they participate in some of the gain — how much is determined by interest rates and volatility. If the market goes down, investors just get their principal back.

Westfield Group's MITTS use a Merrill Lynch zero-coupon bond as the underlying investment and gain exposure to the Russell 2000 index through options. The MITTS currently held mature in September 2004, Mr. Haney said.

Although developed primarily for private clients, MITTS have a practical application for tax-exempt institutional investors, said Mitch Cox, head of investment origination for Merrill Lynch's Global Private Client Group.

Institutional investors who want the protection of a zero-coupon bond but exposure to, say, the S&P 500, could buy MITTS from a firm like Merrill Lynch, provided the price is right. MITTS are listed and traded in the secondary market, allowing institutional investors the chance to pick a MITTS source that fits their needs, Mr. Cox said.

"Volatility, interest rates and other factors affect the price of MITTS, and the price at which MITTS can be acquired via the market," Mr. Cox said. "For example, changes in interest rates affect the bond-like component of MITTS, while changes in volatility can affect the equity price. At the end of the day, investors . . . can draw their own conclusions about the trading price of MITTS and select investments they think have incremental intrinsic value."

Westfield Group does not dabble in the secondary market; it holds the MITTS to maturity. In fact, the MITTS have performed well enough so far that Westfield Group plans to increase its allocation more than tenfold, to roughly $13 million.

"I think a fair analysis of these things (MITTS) will lead you to the conclusion that they do provide some worthwhile exposure to stocks with a bond floor," Mr. Haney said. "That's kind of the best of all worlds in a pension account."

Mr. Haney said the pension fund has been helped so far this year by decent equity returns. The Standard & Poor's 500 stock index is up 15% year-to-date through June 17. But he does not expect that horse to carry the fund much farther.

"Equity numbers ... look positive, but we don't feel they can be sustained based on earnings projections through the rest of the year," Mr. Haney said. "But (equities) are the best of a bad lot. People have to put their money somewhere."

Westfield Group will continue to follow its defensive investing strategy, even though some may regard it as plodding. In this case, Mr. Haney said, he would rather be the tortoise than the hare.

The "gunslingers" who made their names on 50% returns in the late 1990s "are now walking around with bodyguards," Mr. Haney said. "We believe in Modern Portfolio Theory, not so-called ‘best ideas' investing, and the cathartic purge of the last few years has proven that point."