NEW YORK - Diminished resources, the expectation of lower returns and an emphasis on cost containment will influence the pension fund executive's job as the industry enters the next century, industry executives assert.
Speaking at Pensions & Investments' Fifth Annual Investment Management Conference, both pension executives and money managers urged a more aggressive approach to asset allocation and closer attention to plan funding levels.
Resources will be scarce because of corporate downsizing, plus plan sponsors won't be able to count on boosting the funded status of their plans by a continuation of high investment returns.
Robert Maynard, chief investment officer of the Idaho Public Employees' Retirement System, Boise, compared pension fund management in the past to the proverbial way of checking if spaghetti was cooked: throw it against the wall and see if it sticks.
In the past, he said, pension executives could take advantage of double-digit returns to concentrate instead on managing their funds and funding cost-of-living increases.
That's changing, he warned, with a return to more normal, single-digit returns and more normal volatility.
At the same time, state legislatures and other funding sources are turning up the heat to reduce pension plan contributions in order to balance their budgets. Actuaries, on the other hand, are pressuring plan sponsors to drop discount rate assumptions used in calculating pension liabilities, he added.
Leslie Smith, director of trust investments of Agway Inc., Syracuse, N.Y., used the hypothetical example of a sponsor whose plan is 125% funded using an 8% discount rate. If that rate is revised to 6.5% and the plan assets perform 10% below previous levels, funding drops to 97%, she said.
"This is scary, slippery stuff," said Ms. Smith.
One of the toughest jobs a pension executive has is to sell the importance of pension funding to chief financial officers and Wall Street, speakers said. Plus, staffing is low. "We've lost the personnel fight in the pension fund area and we don't have the people to bring this to the CFO level," said Cynthia Steer, director of pension investments for United Technologies Corp., Hartford, Conn.
Execs need to push message
Pension plans have a tough job to do to convince chief financial officers, who are paid to pay down corporate debt and add to earnings, and not for pre-funding the company pension plan, she said. The returns in the 1980s let management go on for years without worrying about funding pension plans, but she warned "the story of '94 will be different from '93, when the market treated us well."
Pension executives have to bring the potential for shortfalls and their urgency to management's attention, said Ms. Steer.
"This is not a tomorrow question, it's a periodic question," she said.
The funding pressures will result in more non-U.S. investments, greater emphasis on simplicity in plan structures, less passive management and more pressure on active managers, said Idaho's Mr. Maynard.
U.S. investments have been popular in the past because pension liabilities are tied to U.S. interest rates, but that connection is inefficient because actuarial adjustments usually lag interest rate changes, said Mr. Maynard. Pension plans should not be so dependent on U.S. assets in case inflation returns, but should rather invest in assets not so tightly correlated to the U.S. interest rate, he added.
At the same time, sponsors are seeking to simplify plan structures to make it easier to explain to participants what their strategy is, how it works and why it does or doesn't perform, said Mr. Maynard.
Funds increasingly will move assets to one-stop shopping providers and managers with global and international capabilities, he said.
The range of active managers is spreading, and fund executives will have to learn to explain complex investment issues simply, said Ms. Smith. She recommended visiting managers and watching them at work to gain more information on their activities.
"Open up your pores and sit there," she said. "It's amazing what you will learn."
Relationship management between fund executives and their money managers will change, Ms. Smith said. Instead of whittling down fees in contract negotiations, executives will demand more products and expertise from managers.
Roles will blur further
Several of the speakers said the lines between pension executives, consultants and managers will continue to blur, and there will be an increased emphasis on performance among all three.
"Mediocrity will be forced out .*.*. because you won't have double-digit returns to hide under," said Narayan Ramachandran, managing director of Rogers, Casey & Associates Inc., Darien, Conn.
While passive investment continues to work as a long-term investment strategy and is not expected to lose much ground, active managers will be under more pressure from clients to produce better returns and reduce volatility, said Mr. Maynard.
The choices when structuring pension fund management - choosing active or passive and internal or external - are driven by the question of what is the minimum amount of cost a fund would incur to produce incremental returns, said Keith Ambachtsheer, whose Cost Effectiveness Measurement Inc., Toronto, evaluates the management quality of asset pools.
Mr. Ambachtsheer noted his annual survey of U.S. and Canadian funds found little difference in excess returns above the benchmark between internally and externally managed active stock and bond portfolios. The internally managed domestic stock portfolios generated a median excess return of 0.4%, while the median excess return on externally managed domestic bond portfolios was 0.5%
Big difference in costs
On the other hand, Mr. Ambachtsheer said the survey shows a significant difference on the cost side.
The median costs of externally managed active assets were substantially higher than those for internal management, 40.4 basis points for domestic stocks and 22.6 basis points for domestic bonds, compared with 5.9 basis points and 3.5 basis points, respectively, for internal management. The median costs for passive management were 5 basis points for externally managed stocks and 6.5 basis points for bonds, vs. 1.1 basis points for internal management for both stocks and bonds.
Considering the efficiencies in the market, investors choosing active managers are betting they can beat the odds, said Robert Arnott, president and chief executive officer of First Quadrant Corp., Pasadena, Calif. Money managers owe it to themselves to find out where their strengths lie in finding market inefficiencies they can use to produce incremental returns, he said.
Some of those inefficiencies are created by a "hierarchy of pressures" leading from company management to plan sponsor to money manager. For example, he noted, it was those pressures that caused many to exit the stock market after it dropped in late 1987 "after the losses had already occurred," he said.
James B. Simpson, treasurer of Sandoz Corp., New York, said his organization learned a few lessons on rebalancing asset allocations when it undertook a major study of its investment policy in 1989. Sandoz wanted to diversify, broaden its market exposure, and use a disciplined rebalancing strategy "to take the emotion out of our asset allocation."
What it learned was the keys to successful asset allocation include thorough analysis and extensive manager searches, a disciplined approach to investment policies and rebalancing, strict enforcement of managers' investment guidelines and a measure of luck.
Alternative investments pushed
During several panels, speakers championed real estate, emerging markets and the careful use of derivatives as possible ways to allocate assets to boost returns and control portfolio volatility.
Emerging markets have been a particularly hot topic in the last year, said Allan McKenzie, investment director of Scottish Widows Investment Management Inc. Edinburgh, Scotland. Seeing triple-digit returns in the stock markets of some developing countries, many investors rushed into a "feeding frenzy" of indiscriminate buying near the end of 1993, said Mr. McKenzie.
But, having voiced some questions about the hype surrounding emerging markets, he went on to add there are strong arguments for investing in such stories. The emerging markets' growth potential is greater relative to that of the industrialized countries, he said. Countries such as Malaysia and Mexico have young populations, growing capital and growing inflows of foreign capital.
"With all this dynamism, change and growth, the developed world seems pedestrian," said Mr. McKenzie.
But he cautioned investors must be prepared and must develop a long-term investment strategy before venturing into those markets.
"Do the homework, identify the benefits and attractions of investing in these markets, but understand the risks," he said. Those risks include political, currency and accounting factors that vary from country to country, he added. They all have to be factored in before making the decision and the emerging market investment must stand on its own merits.
Several speakers urged diversification across several emerging markets to dilute the risks and improve returns.
"These countries and markets don't move as one," said Ralph Layman, executive vice president-international equities of General Motors Investment Corp., New York. "A good emerging markets manager who diversifies across countries will do much better."
The $26 billion GM Pension Trust has $665 million of its assets in emerging markets, or approximately 3% of its total assets, invested across 20 markets, said Mr. Layman.
There is a great variety of styles among emerging markets managers, but country selection has the greatest impact on the portfolio's performance, said Julie Dellinger, executive director of the Montgomery County Employees' Retirement System, Rockville, Md. She added commingled accounts generally offer more diversification and their fees, although higher than those for separate accounts, are not that much higher.
Comparisons hard to make
Ms. Dellinger said her fund was faced with a variety of questions regarding implementation of its emerging markets allocation, many of which were similar to the issues faced in the selection of a small-capitalization stock manager. She noted that, when gauging performance, peer group comparisons are not meaningful because it is hard to find a peer group to compare against, and most managers have relatively short track records in this area.
The $1 billion Montgomery County fund began investing in emerging markets in March, and has targeted 10% of its assets to that class.
There is a degree of political uncertainty in a number of countries where elections are coming up, said GM's Mr. Layman. Those countries include some of the hottest emerging markets, such as Mexico, Argentina and Malaysia. But as a whole, GM executives remain bullish on Mexico, believing the government of president Carlos Salinas will "pass the baton peacefully" after the upcoming elections, he said.
Derivatives still valid
While emerging markets have benefited from publicity, derivatives are a different case, according to several speakers. Panelists at a session on derivatives bemoaned recent news stories highlighting large losses incurred on derivatives by institutional investors, saying the instruments are still valid vehicles for pension plans.
Derivatives allow plans to customize investments, attain unique market access and realize cost savings in areas such as fees and cross-border taxes, said Steve R. Vinson, division executive of the global risk management-structured investment products division of Chase Manhattan Bank, New York.
A survey of institutions by Chase found half of the sponsors polled are using some type of structured equity product in their funds, said Mr. Vinson. Thirty-one percent are using equity swaps, OTC derivatives or hybrid debt instruments, he said. The funds typically use derivatives as overlay strategies to hedge, enhance returns, gain market exposure, equitize cash flows and smooth the move of assets between managers in transitions, said Mr. Vinson.
Among the 46% of sponsors who said they don't use derivatives, the main reason cited was a lack of knowledge of the products, said Mr. Vinson. In addition, some public funds either are forbidden to invest in derivatives or have not explicitly approved their use, he said.
Before investing in derivatives, plans have to consider several criteria, said Mr. Vinson. They must evaluate derivatives' price relative to other ways to access the desired market, how unique is the market access the plan is gaining, the credit risk of the counterparty in the transaction, the plan's comfort level with the credibility of the dealer handling it, and the limitations of the research and consultant assistance they should expect for such a complicated vehicle.
Plan executives have to keep in mind the liquidity of the instruments might be reduced the more tailored they are to the plan's needs and that there might be a number of complicated contractual issues involved, he said.
In most of the recent cases of derivatives losses, the instruments were not at fault, but rather the problems were related to oversight and control over the management of the instruments, said Paul Gottlieb, partner and head of the derivatives group of Seward & Kissel, New York.
"I believe this negative press ... will ultimately prove positive," he said. Thanks to the much-publicized derivatives of woes of Bankers Trust Co. and Procter & Gamble Co., among others, many segments of the financial community have come to understand derivatives better, and managers are better aware of the need for guidelines and control over trading, he said.
Real estate 'misunderstood'
Like derivatives, real estate is another misunderstood area that can add value to a portfolio, said panelists.
Real estate already is in many portfolios in ways sponsors don't know about, such as mortgage-backed securities in fixed-income portfolios and commercial mortgages in asset-backed bonds, said Jacques N. Gordon, head of portfolio strategies and research in the New York office of LaSalle Advisors.
That underlines a "new paradigm" where the traditional ways of investing in real estate - one property at a time in either all-cash transactions or traditional mortgages - are being replaced by a matrix of real estate investment trusts and mortgages, he said. The various vehicles allow sponsors to invest in combinations of equity or debt in the public and private markets through commingled funds, unrated mortgage pools, mortgage-backed securities and several REIT vehicles.
"Think of real estate as the old wine in the cask that's being put into new bottles," said Mr. Gordon.
Commercial mortgages are gaining popularity as investments among pension funds, which now make up only 3% of the commercial mortgage market, said Quentin Primo III, co-chairman of Carter Primo Chesterton L.P., Chicago.
Commercial mortgages have shown higher and more stable returns with lower risks than other assets, said Mr. Primo. He noted that, for the 20 years through 1992, commercial mortgage returns were 10.1%, better than real estate equity and long-term bonds, with only a 6% standard deviation and risk equal to that of A-rated corporate bonds. On the other hand, he warned they don't offer the same liquidity as the corporate debt market and require a significant commitment in investment management staff or outside advisers from the sponsor.
"There are opportunities if you have an adviser who can separate the wheat from the chaff," he said.
Going from the specific to the general, several speakers challenged upcoming trends, such as the replacement of defined benefit plans with defined contribution plans and the assumption that pension assets are a drain on the federal budget.
No drain on U.S. budget
Sponsors must challenge the notion that pensions are the largest tax expenditure in the federal budget, which have led to a surge in legislation "to feed an ever-hungry federal deficit," said James Klein, executive director of the Association of Private Pension and Welfare Plans, Washington.
Pension contributions are recaptured later in the form of taxes paid when the benefits are paid out to retirees; considering the low level of personal savings in the United States, the federal government should accept the temporary revenue loss, said Mr. Klein. Seeing the expenditure as $4 trillion that will be taxed later, rather than as a $56 billion annual tax loss helps put the debate in a different perspective, he added.
Several speakers differed on the question of whether the universe of defined benefit plans is "dying," as Mr. Klein put it. "I don't see any enthusiasm in establishing new (defined benefit) plans," he said.
Statistics from the Pension Benefit Guaranty Corp. do not show the defined benefit segment dying off, said Dallas Salisbury, president of the Employee Benefits Research Institute, Washington. He continues to see Internal Revenue Service data showing new plans are being formed.
W. Gordon Binns, the retiring president of General Motors Investment Management Corp., New York, and vice president and chief investment officer of General Motors Corp., Detroit, worried about the trend among companies of replacing defined benefit plans with defined contribution plans.
Mr. Binns weighed in in favor of "the old, traditional three-legged stool concept," saying it is not right for employers to shift the investment risks completely from themselves to their employees. Trying to coach workers who may have limited education to reach the level of sophistication necessary to make investment decisions can be a shortsighted and ultimately costly approach, he said.
The question of defined benefit and defined contribution plans is "a time bomb for the social coffer," said Agway's Ms. Smith. There are limits to how much sponsors can rely on defined contribution plans, she said.
"We're going to find this will hit the fan when the people ... who need more and saved less will begin to retire," she said. 45
