Public pension funds slip into driver's seat

The names of most of the largest pension plans haven't changed that much in the past 40 years. Just about everything else has.

Once-dominant names like U.S. Steel and Western Electric are no longer among sponsors of top funds, victims of consolidation and big shifts in the industrial landscape. Total pension assets have soared. And the very structure of the pension system has been altered to one in which employees call the investment shots, away from one in which employers determine the investments.

Pensions & Investments has been ranking the largest pension funds by assets since 1975 and surveying them since 1978.

Through the years, corporate giants like General Electric Co., General Motors Co., International Business Machines Corp. and E.I. du Pont de Nemours & Co. regularly were among the leaders. The top public plans were found on both sides of the country — the New York State Common Retirement Fund, New York State Teachers Retirement System and the New York City Retirement Systems on the East Coast, and the California Public Employees' Retirement System and California State Teachers' Retirement System on the West Coast.

In the 1975 rankings, Sears, Roebuck & Co. was first with $2.957 billion; as of Sept. 30, 2012, Sears Holdings Corp. ranked 177th with $8.028 billion. United States Steel Corp. was fourth in 1975, with $2.286 billion; the latest survey has the steel maker at 179th at $7.987 billion. And Western Electric Co., No. 5 in 1975 with $2.236 billion, isn't even on the most recent ranking; its assets ultimately ended up combined with those of Alcatel-Lucent, which ranked 33rd with $40.961 billion.

The growth in assets has been exponential. For the plan year ended Sept. 30, 1978 — the first survey that included data from public plans — retirement assets of the top 1,000 pension funds totaled $353 billion; in the latest survey, for plan years ended Sept. 30, 2012, total assets for the top 1,000 were $7.534 trillion — more than 20 times the amount in the first survey.

In comparison, the Standard & Poor's 500 stock index was at 102.54 on Sept. 29, 1978; on Sept. 28, 2012 (markets were closed on Sept. 30 in both years), the index was 1440.67, about 13 times the level of 30 years earlier.

Along with equity gains, so many other factors have affected pension fund growth in the intervening years. There have been shifts in investment strategies, market impacts, contribution holidays, more participants, more retirees and regulatory changes.

But the largest single change in retirement funds over the past 40 years is a structural one — the move to defined contribution from defined benefit, particularly among corporate sponsors. “The widespread adoption of 401(k) plans really started during that (40-year) period, particularly since the early "80s,” said Alan Glickstein, senior retirement consultant, Towers Watson & Co., Dallas. The $2.291 trillion in DC assets for the top 1,000 as of Sept. 30, 2012, is in stark contrast to the $75 billion reported in 1985 — the first year DC assets were specifically broken out.

Case in point: In 2012, the largest pension plan in the P&I survey, the $325.7 billion Federal Retirement Thrift Plan, Washington, is entirely defined contribution.

The biggest shock to those who've worked in or with pension funds over the past 40 years is not so much the rise in DC plans but the overall decline in the number of corporate DB plans — and that those funds that still remain are either closed to new participants or frozen.

“One of the surprises in my career is the demise of the DB plan,” said Ron Peyton, CEO of Callan Associates Inc., San Francisco. He's been at Callan since 1973. “It's a very financially elegant solution to the problem of providing a retirement safety net. With a DB plan, people can live older. If you fund it appropriately, the compounding of investment returns allows you to create a fund that's pretty stable. Even when the markets fell in 2008, so what? If you've contributed enough, they're going to rebound.”

While it could be argued that the volatility of investments over the past 40 years — and particularly in the past decade — has led to the decline in the number of DB plans, another culprit was cited: regulations and laws, chiefly those involving mark-to-market accounting and disclosure of liabilities.

Forty years ago, plan management involved a few consultants, basic manager selection and an asset allocation spread among equities, bonds and real estate in what Greg Gilbert, CEO, Americas institutional, at Seattle-based Russell Investments, called a “bottom-up approach.” But with the Pension Protection Act of 2006 and accounting and disclosure changes, the approach is now “top-down,” with the emphasis on improved funded status, increased contributions and a focus on long-term liabilities. “You've added new risk and complexity to what it takes to manage these plans,” Mr. Gilbert said. “That accelerated the migration to defined contribution from defined benefit. ... It moved the discussion of pension funds from the CIO suite to the C-suite.”

“What happened to liabilities over the past 10 years?” asked Keith Ambachtsheer, president of KPA Advisory Services, a Toronto-based pension management consulting firm, and director of the Rotman International Centre for Pension Management, University of Toronto. “That's probably also grown 11 times, from above 100% funding to below 100%.” The focus on assets “hides a lot of more important things. It misses the liability question, the fact that the population is aging, meaning negative cash flow, and the implications of all that on managing risk.”

Mr. Ambachtsheer cited lower discount rates as one major cause of underfunding, but also said U.S. public plans particularly are unrealistic in their assumed return rates. “It's around 8%,” he said. “That's not realistic. Ontario Teachers Pension Plan, for example, has a 3% real and 5% nominal rate of return assumption, while the U.S. uses 8.5%.” In Canada, the rate for public plans, along with corporate plans, must be justified to government regulators; in the U.S., only corporate plans, to the PBGC, must justify the reasons for the return rate assumption.”

Russell “Rusty” Olson, an independent consultant who was director of pension investments at Eastman Kodak Co., Rochester, N.Y., from 1983 to 2000, agreed the importance of liability immunization has been one of the major changes in pension fund management over the years. “Before 1986, we didn't report liabilities in the same way; it didn't get put on a balance sheet or earnings statement,” he said. “Most corporate plans used an 8% to 9% (annualized) return assumption to calculate contributions. It seemed conservative because of high interest rates back then. But that change in accounting has had a huge impact; it's a big reason why the nature of pension funds has changed.”

But for those corporate plans that have stuck it out, they've changed incrementally, with annuitization of some pension liabilities, along with the alterations in liability and return assumptions. “Defined benefit plan changes were unique to the industry they were in,” said Ann Marie Petach, CFO of New York-based BlackRock Inc. As treasurer at Ford Motor Co. from 2004 to 2007, Ms. Petach oversaw the automaker's defined benefit pension plan, which stood at $42.3 billion as of Sept. 30, 2012. “For example, with Ford, we saw its salaried plan close and moved new employees to a DC plan, and we saw them move to more liability matching and diversified asset classes, from 60/40 to more alternatives and long duration.”

And that investment change toward matching liabilities has extended to defined contribution plans, said Scott Powers, CEO of State Street Global Advisors, Boston. “It's a new way of looking at the world,” Mr. Powers said. “If you were in my chair 20 years ago, you would have been worried about getting the best investment returns. Now it's how you're able to meet your liabilities,” which still involves strong investment performance but adds liability matching and risk management to the mix. “It's a different paradigm than 20 years ago.”

“When you look at the large companies, the number of employees doesn't matter as much as who their rivals are,” said Byron Beebe, Cleveland-based senior partner and U.S. retirement market leader at Aon Hewitt. “IBM's industry competitors have changed quite a bit, for example. Their peer group has changed as the companies have changed, and that has had an effect on the benefits they provide. AT&T as well; their wireless business provided different competitors than their traditional telephone business, and it caused AT&T to change their retirement plan makeup. The big driver in all of this is the growth of an individual company. That means many of their participants are now retirees, and they're being replaced by active participants, which means they have a lot more total participants now than before, whether in DB or DC.”

Ultimately, the corporate plans that have been among the top 20 in the past decades have held their positions simply because they're large, established firms. “The companies that have been around a long time continue to have the largest plans because they have the most retirees,” Ms. Petach said.

Added Josh Levine, New York-based managing director and head of pensions at BlackRock: “If a corporate plan is still on the list, it's not only that they have lots of retirees but also because they have been very well managed over the years.”

While corporate plans either have adapted to changes or been closed or frozen, “state and local plans have maintained the same formulas over the last 30 years,” said Mr. Ambachtsheer. But among public plans, “we might see some major changes in the next 10 years. Public plans no longer can be supported by a (benefit) payment guarantee from taxpayers,” Mr. Ambachtsheer said. “The question will be how to lower that payment guarantee with some level of fluctuation where payments are based on the ability to pay. The trick is, who will lose on this (taxpayers or participants)? Nobody likes to lose.”

As DB assets declined, DC assets have grown. Those DC plan participants, now saddled with the responsibility of making investment decisions on their retirement accounts, generally chose more traditional investments through mutual fund options their plans offered — and up until recently made the allocation decisions on their own. So for overall retirement assets, when DB and DC are combined, the smaller domestic equity investments among DB funds were partially offset by the comparatively large share of DC assets in equities — among the top 1,000 in 2012, 27.9% of DB assets were in domestic stock, compared with 38.2% for DC plans.

“We've consistently seen 60% (of DC assets) in equities, though that varies quite a bit among participants,” said Aon Hewitt's Mr. Beebe. But he and others agree the DC asset mix in the future could change as a result of more participants selecting what Mr, Beebe called “more professionally managed” options like target-date and target-risk funds. Said BlackRock's Mr. Levine: “The biggest takeaway is to bring professional management to DC plans. ... In the DC world, there's been a big learning curve with investing these assets.”

Said SSgA's Mr. Powers, “Defined contribution participants have exactly the same challenge as a defined benefit plan. You need the right return ... and you need the right funding and contributions. It's the same issue.” And target-date funds have brought the issue of professional money management for retirement “full circle,” from DB management to participant-driven allocation choices and back to professional management, he said.