You say you want a revolution
Well you know
We all want to change the world
—JOHN LENNON/PAUL McCARTNEY
Welcome to the pension fund revolution.
If leading experts are correct, how pension funds are invested will be very different in coming decades. Instead of first figuring out asset mixes and laboriously picking managers to fill different allocations, pension funds instead will figure out a risk budget, find the best managers they can find regardless of asset class, and transport their alpha to the desired asset class exposure.
What that means: the tried-and-true active manager who closely hews to a benchmark will be out of luck, while high-octane specialists — such as hedge funds, long-duration bond managers, overlay managers and managers of specialized asset classes such as emerging-market debt and small-cap equity — will be in the catbird's seat.
While this "portable alpha" notion has been practiced for more than 10 years, notably by BP America Inc.'s pension fund, the topic now is red-hot. Thanks to a combination of falling stock markets and near-50-year lows in interest rates, the average large corporate pension fund was only 75% funded by the end of fiscal 2002, down from a mean of 116% at the end of fiscal 1999, according to Watson Wyatt Worldwide, Washington.
Now, pension industry officials are trying to rewrite their investment handbook.
The overhaul represents "the biggest changes in the institutional business" since the Employee Retirement Income Security Act became law in 1974, said Craig Ueland, president and incoming chief executive of Russell Investment Group, Tacoma, Wash. "I think we will see a profound period of change in the next five to 10 years."
"Given pressure from multiple angles — potential changes in actuarial and accounting conventions, scrutiny by analysts, the possibility of higher (Pension Benefit Guaranty Corp.) premiums for pension funds with riskier investment policies, and work by academics and consultants — I think change is not only possible but inevitable," said Laurence Siegel, director of investment policy research for the $9.9 billion Ford Foundation, New York. Mr. Siegel made his comments in an e-mail response to questions from Pensions & Investments.
"This will tend to put a cap on the nascent bull market, as pension funds sell into strength and buy bonds and TIPS (Treasury inflation-protected securities) to defease their liabilities," Mr. Siegel observed.
No less an authority than Peter L. Bernstein, the economic historian and consultant, said the institutional investment industry is at the ramparts.
"Investment management has passed through a point of inflection," he told the Association for Investment Management and Research's annual meeting last spring. "The main message is that the way we go about earning our living is going to be different. Everything is involved, from expected returns and portfolio structures, to performance measurements and management fees."
Mr. Bernstein identified four major areas ripe for sweeping changes:
-- investment research, which will become independent and more costly;
-- indexing equities, which "is no longer such a slam-dunk" in a low-return environment;
-- active managers, who should be "free of constraints," and the true benchmark, which should be tied to liabilities; and
-- short-selling, which should be embraced, transforming the entire portfolio into "a giant hedge fund."
The winners, according to some, will be big managers offering multiple product lines and high-alpha boutiques focusing on one or two strategies. In general, observers are less sanguine about the fate of midsized managers, particularly those who try to imitate their larger brethren, and plain-vanilla indexers, because low expected returns will make their products appears less attractive.
According to some, the pension revolution might help long-duration bond managers, concentrated equity managers, overlay managers (including currency and tactical asset allocators), real estate managers and, of course, hedge fund managers whose ability to produce alpha looks increasingly sexy in a low-return era.
By no means, however, does a consensus exist that the world-shattering change is upon us. The institutional investment industry is split between a new breed saying the old ways are history, and a critical old guard, suspicious of the newfangled financial engineering.
T. Britton Harris IV, president of Verizon Investment Management Corp., Stamford Conn., who oversees $60 billion in Verizon retirement-plan assets, said whether major change occurs hinges on a continuation of poor financial conditions, and whether a combination of pending regulatory and accounting changes — such as ending smoothing of gains and losses in accounting ledgers and changes in funding rules — are implemented (P&I, Oct. 13).