There is, of course, no magic formula for optimizing pension plan results. However, a number of strategies have proven to be helpful in refocusing a pension plan to achieve results that are more beneficial to both participants and sponsors.
This article will address 10 of these strategies, and add one for global plans. Some of these suggestions might seem obvious, others might be controversial, but they represent what we believe are -- or should be -- best practices for a well-run, large pension plan.
Pay more attention to plan objectives and to plan liabilities when making strategic investment decisions.
It seems clear that plan objectives should be set first and that investment strategy should follow. However, objectives might differ company by company, e.g., whether it is more important to avoid future cash calls by the pension fund or more important to minimize pension expense (or maximize positive accounting earnings).
Furthermore, changes in plan demographics, pension regulation, and accounting and tax rules might require plan sponsors to focus more on plan liabilities than they appear to be now. For example, a downsizing that sheds a significant percentage of active workers, while retaining all of the retirees, can dramatically change the plan's funded ratio and shorten liability duration, leading to a change in the optimal asset allocation. In addition, decreased interest rates, even if accompanied by moderately attractive returns, could result in sharp increases in required contributions because plan liabilities likely will increase faster than plan assets.
A Goldman Sachs survey of the asset-liability modeling practices of 35 of the 50 largest corporate pension plans revealed that plan sponsors appear to downplay plan liabilities when making investment decisions.
* Almost 70% of the surveyed funds that actually perform asset-liability modeling studies said the results were similar to those of an asset-only study.
* Although almost 70% of the respondents said they never even consider bond portfolios with durations longer than the typical aggregate bond market indexes (five years), the vast majority said they would invest in longer duration fixed-income instruments if they wished to better match plan assets and liabilities.
Make risk management as important a mission for the chief investment officer as investment selection.
Both the huge size of many pension funds and the increasing variety of potential investment pitfalls demand that risk management become ever more important in protecting the health of a pension plan. In recent years, CIOs have focused on investment selection and returns. Going forward, they also will need to concentrate on developing systems for identifying and dealing with external and internal risks before those risks become unmanageable.
Many companies' pension assets are large compared with their total stock market capitalization, corporate assets and net income. Consequently, pension risks can have a significant impact on the plan sponsor. Also, most pension plans have grown dramatically in size while actively participating in new markets and instruments, so that many of the risks faced by pension plans are fairly new. The CIO needs to ask which risks have the potential to be catastrophic and which do not. Risk management does not necessarily mean spending millions of dollars. Often, it means implementing good practices in risk control and sticking to them.
Focus on improving the consistency -- rather than increasing the amount -- of alpha.
Alpha often is viewed as a measure of the amount of value the CIO and staff have created in the company's "pension" business. An increase in alpha can reduce the long-run cash cost of running the plan. The CIO can increase the consistency of alpha by producing moderately positive alpha on a regular basis, instead of attempting to maximize long-run alpha by investing in strategies that intermittently earn very large excess returns followed by periods of below-benchmark returns.
Trustees worry about erratic performance. If the plan's investment strategies generate large amounts of alpha only intermittently, the trustees might press for changes in the plan's investment strategy during periods of adverse experience. This can make it difficult to maintain a disciplined investment policy. Further, staff might be diverted from value-added activities by added requirements to justify past investment decisions or oversee underperforming managers. One way to address this concern is a sharp focus on an active manager's information ratio, i.e., the measurement of return added per unit of risk taken.
In implementing a strategy of enhanced consistency, the CIO may either increase investments in risk-controlled active management or increase the use of transportable alpha strategies. Risk-controlled active management focuses on taking moderate bets against the index in an attempt to generate alpha consistently. Transportable alpha attempts to focus on selecting managers and strategies where the CIO expects to earn the greatest amount of alpha per unit of risk. The "transportation" moves that alpha into the desired asset allocation using relatively simple and inexpensive tools such as swaps or futures contracts. For example, the alpha earned by a small-cap stock manager could be transported onto the return of a bond index.
When considering how much to focus on the consistency of alpha vs. the amount of alpha, CIOs might want to answer two questions:
* What is the tolerance of the plan's investment committee for variability in alpha?
* What is the available tradeoff between the amount of alpha and the consistency of alpha?
Use global tactical asset allocation to take the best advantage of managers' investment expertise and their capability to add value.
Given sufficient discretion and risk guidelines, GTAA managers often can add more return per unit of risk than many traditional investments. This might be because it is easier to pick countries than to pick stocks, and because international markets often are less efficient than U.S. markets. For the three years ending June 30, 1997, 81% of active international equity managers and 66% of active international fixed-income managers beat the Morgan Stanley Capital International Europe Australasia Far East and Salomon Non-U.S. Government Bond indexes, respectively.
The attractive risk-adjusted returns of many GTAA managers are not surprising because these managers can make many small, uncorrelated bets around the world and their positions typically are well diversified.
A CIO considering global tactical asset allocation should ask two questions:
* What benchmark should the GTAA manager be given?
* How much discretion and tracking error should the manager be allowed?
Learn to live with change at the best investment managers.
Two common aspects of change are particularly relevant for CIOs. First, as part of industry consolidations, many leading investment management firms have been acquired by other firms. This process is accelerating. Second, the long bull market is leading to a lot of turnover, especially among "star" portfolio managers.
CIOs should consider the key question when evaluating change at a manager: Will the change be disadvantageous to the plan? In many instances, it might make more sense for sponsors to learn to tolerate a level of personnel change that would have been unacceptable before. The pace of industry consolidation and "star" manager turnover is likely to continue. Terminating managers and moving assets are expensive steps that take time and do not guarantee other changes will be avoided. Further, change can be advantageous. An acquired firm might gain additional expertise or might be able to reduce fees because of economies of scale. Also, the turnover of a manager of a quantitative portfolio is clearly less important than the turnover of a manager of a portfolio that relies heavily on qualitative judgments.
Consider hedge funds that use equity "market neutral" strategies.
In recent years, hedge funds have become an increasingly prominent part of the lexicon of investing, with assets likely totaling more than $400 billion. The strategies and performance of hedge fund managers have gained wide attention, never more so than in 1998 when market volatility resulted in high profile financial debacles. Understandably, hedge funds generally are associated with highly leveraged speculation.
However, there are hedge funds that are categorized as "market neutral" or "relative value" in investment strategy. The returns of these funds essentially are uncorrelated with benchmark indexes and therefore can offer plan sponsors an excellent means to diversify traditional portfolios and to improve risk-adjusted returns. They also have performed well when equity markets were declining.
Market neutral funds invest in fixed income or equity instruments but are not dependent on the general direction of market movements. Many of the most conservative hedge funds are found in this category. Fund managers exploit market inefficiencies, looking for disparities in pricing relationships between instruments with similar pricing characteristics (e.g., bonds vs. swaps). They use primarily quantitative security selection techniques that attempt to isolate alpha and to reduce beta exposure by balancing long and short market exposures.
Within the market neutral category is a subset of funds, identified as "absolute return" funds, that place particularly strong emphasis on the disciplined use of investment and risk control processes, and as a result consistently have generated returns that have both low volatility and a low correlation with traditional equity and fixed-income benchmarks.
Provide liquidity and be paid for it.
Pension funds are in an enviable position. Assets have increased quite dramatically, and as a result funds may "own" liquidity for which they have no immediate need. Many participants in the capital markets where the investment horizon is short are willing to pay a premium for that liquidity. Pension funds might be able to exploit this excess liquidity and their long-term investment philosophy to increase returns in two ways.
The strategic approach:
* The most common example of getting paid for taking illiquidity is an investment in private equity.
* Most "off-the-run" Treasuries yield more than "on-the-run" Treasuries with no increase in credit risk; if held to maturity, this can represent additional return.
* A fund might also decide to buy privately placed debt rather than publicly traded debt.
* Replacing an index fund with an "index-plus" fund guaranteed by a major financial institution.
The opportunistic approach, where the pension fund may be able to identify short-term opportunities and to act on them:
* An example would be the substantial illiquidity in the U.S. fixed-income markets in the summer and fall of 1998 where shrewd investors found that providing new money was rewarded with spreads that were multiples of historical levels.
* Around the same time, demand to borrow Hong Kong stocks caused pricing to increase by more than 1,000 basis points (annualized) in the securities lending market. Some borrowers were willing to lock in these spreads for a considerable time period.
Become more attuned to any tactical trading opportunities that exist.
As an example, economists and strategists debate whether the markets and economies of emerging Asia were, in 1998, at or near the bottom of an unprecedented decline (see accompanying table). Now could be a classic contrarian opportunity.
The key ingredients for renewed growth in emerging Asia are still present: low taxes, a high savings rate, a strong commitment to education, and a propensity to work hard and rely on the family rather than on a state welfare system. Recent events might motivate a move away from the informal, personal way of doing business that traditionally characterized Asia, and toward more formal, sophisticated business relationships.
It is anticipated that demand for capital will outstrip supply as economies recover, making for a far more favorable supply/demand ratio than in the United States. These developments likely will provide good opportunities for special investments, including private equity.
Before investing in emerging Asia, a CIO should ask whether the plan's investment committee will be able to maintain its commitment to the investment if the region has a particularly long recovery period in which returns are especially volatile. A less risky approach might be investments in distressed Asian debt.
Use strategic partnerships to more effectively leverage suppliers' strengths.
Rapid plan asset growth is requiring CIOs to either increase the number of managers or award larger investment mandates to each manager. Because manager proliferation is costly and stresses limited staff, adding more managers is probably not in the interest of most plans. Awarding larger investment mandates can provide additional benefits.
In recent years, a number of CIOs have established successful strategic partnerships with investment managers and broker dealers. In a typical arrangement, the fund awards multiasset class assignments to the managers and uses performance fees to align interests. In return for the large assignments, each manager provides significant resources to supplement the fund's internal staff, with the goal of improving total performance. CIOs generally seek three capabilities in strategic partners: a range of well-managed core strategies; advice on strategic asset allocation; and advice on long-term goals and objectives.
Before considering strategic partnerships, a CIO should look at three issues.
* How large are the potential benefits to the plan from such a partnership? For example, strategic partnerships are particularly valuable when a plan has some internal asset management operations.
* Will the plan be able to attract quality strategic partners? Because the best investment managers have a finite capacity for strategic relationships, only the largest (or early moving) funds may be able to attract the best partners.
* What skills does the CIO need from potential strategic partners?
Use more performance-related compensation for both the CIO and staff.
How does the plan sponsor best focus the attention of the pension fund's staff on achieving performance goals?One way might be to expand use of performance-based compensation. Specifically, to what extent should the CIO and staff receive bonuses for plan returns exceeding an appropriate benchmark?
Performance-related compensation can offer three significant benefits:
* It can be used to clearly and directly align the interests of the CIO and staff with the interests of the fund.
* It can be used to clearly communicate the fund's mission to those executing that mission, in that it is flexible and can be structured to provide concrete incentives for desired results.
* It can be one way to retain talent. Without some method of paying for performance, the fund might lose its most talented employees.
Compared to the alternative of outsourcing asset management, providing performance-related compensation is a particularly attractive option.
Key questions about performance-related compensation are:
* can it be structured to encourage just the right amount of risk taking but no more; and
* can the fund provide a sufficient amount of performance-related compensation to retain key employees without catapulting the pay of top performers to levels that are not acceptable to either trustees or senior management.
Properly constructed, performance-related compensation can be the linchpin that facilitates the successful implementation of all 10 of these strategies to refocus the plan for better results.
And, for corporations with global pension plans:
Manage the company's pension plans as uniformly as possible around the world.
Most foreign subsidiaries manage their pension plans independently of the parent, often performing asset allocation and manager selection differently. Yet, the company's shareholders ultimately are responsible for a shortfall in any of the company's pension plans regardless of where the plan is located.
By increasing uniformity in global pension management, plan sponsors can realize economies of scale and also leverage the parent company's expertise to enhance portfolio performance at subsidiary plans. This strategy also can permit integrated and centralized risk control, which is certainly desirable from the point of view of the shareholder.
Strong continuing commitment of senior management plus concentrated effort are necessary pre-conditions to ensuring local management understands the importance of more centralized control and actively seeks to make it work.
A good starting point is a company-wide review of the policies and procedures of every one of the worldwide plans, followed by analysis of those that deviate from global best practices.
Thomas J. Healey is managing director at Goldman, Sachs & Co., New York.
