Outlook 2005: A future of uncertainty

The combination of plunging equity markets and falling long-term interest rates that hit pension funds from 2000 to 2003 has been called a "perfect storm" by many observers. But anybody who has read the book or seen the movie by that name can tell you there were no survivors.

In 2004, there were plenty of survivors, belying the perfect storm theme. But another tempest is developing, and the question now is whether there will be any defined benefit plans.

This time, though, the threat stems more from volatility of pension contributions, tougher accounting standards and a harsh regulatory environment than from deteriorating markets.

In 2004, the tide turned for defined benefit plans. Officials at United Airlines, Chicago, said the company needs to terminate its severely underfunded pension plans to survive. The plans, with a combined $6.9 billion in assets, were only 55% funded as of Dec. 31, 2003, according to a federal filing. The Pension Benefit Guaranty Corp., facing its own $23 billion deficit, moved to shut down the $2.8 billion United pilots' plan, which is 49% funded, according to PBGC estimates.

Ryan ALM Inc., New York, estimates that, overall, pension funding ratios did not improve much or even deteriorated slightly, depending on which measure is used. Overall, the firm estimates that most U.S. pension funds are about 60% funded.

Meanwhile, in December, International Business Machines Corp., White Plains, N.Y., closed its controversial cash balance plan — the next best alternative to the traditional defined benefit plan — to new employees, casting a pall over the future of these plans.

And now, all of California's public pension plans — including the giant California Public Employees' Retirement System and the California State Teachers' Retirement System, both in Sacramento — face the threat of being closed to new participants under a constitutional amendment backed by Gov. Arnold Schwarzenegger.

This threat isn't confined to U.S. shores. New accounting standards that require U.K. pension funds to value their liabilities at market rates, along with the desire to invest assets in line with liabilities, could push U.K. pension funds to lower their equity allocations further.

U.K. plans had an average 63% of assets invested in stocks as of Dec. 31, 2003, down from 73% in year-end, according to Greenwich Associates Inc., Greenwich, Conn. Even before the new accounting rules took effect, 47% of U.K. plans had been closed to new members, Greenwich reported.

European Union states will also adopt tougher accounting rules this year, though they would still allow some smoothing of liabilities. Plus, member states will have to rewrite their pension legislation to conform with new EU standards that take effect this September.

"You would have to be a saint as an employer" to continue to maintain defined benefit plans in light of new accounting and regulatory issues, said consultant Koen De Ryck, Pragma Consulting, Mechelen, Belgium.

Nor did markets provide much relief for pension funds in 2004. While returns were positive, they were nothing to write home about. The Standard & Poor's 500 index returned 10.9% for the year, including reinvested dividends, according to Ibbotson Associates, Chicago.

Meanwhile, U.S. small-cap and international equities provided some fillips to performance in 2004. The Russell 2000 index returned 18.3%, while the Morgan Stanley Capital International Europe Australasia Far East index returned 17.6%. Long-term government bonds returned 8.5%, Ibbotson said.

As for 2005, a new survey of 49 leading money managers by Mercer Investment Consulting shows the managers expect large-cap and small-cap U.S. stocks to return between 6.7% and 8.3%.

Reversing recent trends, growth stocks are expected to do somewhat better. Managers forecast that large-cap growth stocks will return 8.6% this year, and small-cap growth stocks, 8.3%. In comparison, the managers project large-cap value stocks will return 6.7%, and small-cap value stocks, 6.9%.

Institutional investors may get greater joy from foreign stocks. Managers predict EAFE will return 8.3% in 2005, while emerging-market stocks will return 9.5%, according to the Mercer survey.

Managers are less sanguine about bond returns. They expect the Federal Reserve will raise short-term rates by about 100 basis points by the end of 2005. Managers anticipate a paltry 2.7% return from the Lehman Brothers Aggregate Bond index, the survey found.

As a result, over 70% of managers expect to increasingly turn to alternative investments — particularly hedge funds, private equities and commodities — as ways to pick up enhanced returns.

But there are real worries as to whether alternatives can deliver the same punch to returns as in the past, especially given the amounts of money flowing into those asset classes.

What's more, hedge funds thrive on volatility, but stocks traded in a very narrow range in 2004, and they may well do the same for much of 2005. Investors may need to come to terms with lower-than-expected returns.

The flood of capital pouring into private equity — including some from hedge funds — is expected to diminish returns. The most sophisticated investors are shifting into other alternatives such as timber, farmland and natural resources, said David Larsen, partner in the trust service practice of KPMG LLP, New York.

The grass isn't necessarily greener in real estate. Given massive inflows, some institutions are selling assets. Others are including leverage and diversifying into international real estate. The net effect is making real estate riskier than it has been.

Those trends are already being noticed by top-performing college and university endowments, according to the new Commonfund Benchmarks Study.

Top-decile performers reduced alternative strategies to 36% this past year from 44% in fiscal 2003, according to the study, while U.S. equity allocations were increased to 27% from 21%, and international stocks were increased to 18% from 15%.

"Investing in hedge funds and private equity is unlikely to provide the magic solution to low returns for the bulk of investors. The returns from these areas will diminish as money inflows continue to soar," observed the Bank Credit Analyst, a publication of BCA Research, Montreal.

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