Learning from disaster

From the energy crisis of the 1970s to the financial crisis of 2008 to the ongoing pension funding crisis, the past 40 years have seen crises driving the invention of new ways to protect plan assets.

As each of the financial crises shed light on new aspects of investment risk, investment professionals responded at various times by decreasing equity allocations in favor of diversification, finding new ways to hedge risks, updating technology and operational capacity and — eventually — putting further pressure on plan sponsors to replace pension plans themselves with defined contribution models that pushed investment, longevity and other risks onto participants.

Crisis has been a regular character in the history of Pensions & Investments, going right back to the start. Among the first interviews with a fund executive published in P&I at the end of 1973 was with Rodger Smith, manager of manufacturing firm Allis Chalmers' $10.5 million in internally managed pension plan assets.

The pension plan at the time had an allocation of 70% in common stocks and 30% in cash.

Mr. Smith responded to questions regarding the impact of the energy crisis: “We got a little itchy when the market was going up in October, but 1974 looked dim, so we kept 30% in cash.”

The days of a simple 70/30 asset allocation are long gone. Things have gotten considerably more complex since then, with far less invested in equities.

According to P&I survey data of the 1,000 largest retirement plans, as of Sept. 30, 1972, the average aggregate asset allocation was 69.8% equities, 26.1% fixed income, 2% alternatives, 1.4% other and 0.7% cash. As of Sept. 30, 2012, the average aggregate asset allocation was 48.7% equities, 27.3% fixed income, 20.4% alternatives, 2.2% cash and 1.4% other.

While pension funds have reduced their exposures to equities, they have not been able to protect themselves completely from volatility.

“The problem I think is that the waves (of liquidity in the monetary system) keep getting bigger. The system's not any more stable than it was,” said Carl Hess, New York-based global head of investments at Towers Watson & Co., in a recent interview. “Now there's even more money sloshing now. The global interconnectedness is even greater than before, and there's a butterfly effect.”

“Even 20 or 30 years ago the derivatives market was nothing like it is today,” said Michelle Clayman, managing director and chief investment officer of New Amsterdam Partners LLC, New York. “There were options and futures, but there weren't all these amazingly complex instruments that you have in all different kinds of markets because back in the day ... if you looked at most U.S. plans, they were 60/40 U.S. stocks/bonds; now you look at them (and) their asset allocations are totally different.”

The added complexity has given plan executives new ways to hedge risks, and it's all been driven by crises.

For example, pension funds that employed portfolio insurance had to find new ways to hedge risk following the failure of many portfolio insurers after the Dow Jones industrial average plummeted 508 points, or 23%, on Oct. 19, 1987. Most portfolio insurers had difficulty executing dynamic hedging, the selling of futures short to create a synthetic put option, which protects the underlying value of the portfolio.

Following the crisis, plan executives and managers tried to come up with new ways to hedge risk. Some managers promoted the idea of using actual put options and employing tactical asset allocation strategies.

The Boston Co. moved most of its $300 million under portfolio insurance to several different strategies including TAA.

Another plan that began selling futures was the San Diego Gas & Electric Co. pension fund, with $298 million in assets. When it started using portfolio insurance in October 1986, the pension fund increased its allocation to domestic equities to 68% from 60%. After discontinuing its portfolio insurance program, it began selling futures as a way to hedge risk (P&I, April 18, 1988).

One would-be crisis in the last 40 years that had tremendous impact despite never materializing was the Y2K scare. However, it might have had a significant effect in getting plans away from equities.

Many governmental and corporate resources in 1999 were spent overhauling computer systems that had been programmed for two-digit year figures to avoid massive nationwide computer failures at midnight on Jan. 1, 2000. The crisis, within money managers and in the wider economy, did not result in any major disruptions to computer systems.

Thirty-five percent of money managers surveyed by Merrill Lynch & Co., London, in 1999 said Y2K would be a “significant issue” in their stock selection.

Y2K “did have an impact, just not the one we were thinking about, not the one that people were expecting,” said Erik Ristuben, Seattle-based chief investment strategist at Russell Investments. “If you think about it, bubbles need fuel and I kind of think of Y2K as the nitrous oxide for the tech bubble. It wasn't the base fuel, but it was the thing that supercharged the motor.”

“People became very complacent about equity risk. In conjunction with that you have this massive amount of tech spending by corporations and governments preparing for Y2K (providing an) earnings pop for tech companies. The last bit of extra fuel that popped the bubble,” Mr. Ristuben said.

The complacency he referred to contributed to the decline of the defined benefit plan.

Plan sponsors “used to think that because you could invest in equities, which have a higher expected rate of return, the cost of defined benefit plans was lower. But what was being ignored was that the reason equities have a higher expected rate of return is because there is a risk premium,” said Richard Berner, Morgan Stanley's chief U.S. economist (P&I, April 18, 2005). “That risk has got a cost. When you factor in that risk cost, the price of defined benefit plans is much higher than everyone was assuming.”

At its peak, in 1985, there were 112,208 corporate defined benefit plans insured by the Pension Benefit Guaranty Corp. By 2012, about 24,000 single-employer plans and 1,500 multiemployer plans were insured by the agency.

The decline has led to a greater crisis in some people's minds than any crisis to which employers responded by closing and freezing their plans.

“If I look back over the last 30-ish years or so, the real crisis was not the tech crisis or the crash of '87. From my perspective, it has been the dismantling of the proverbial three-legged retirement stool,” said Robert Hunkeler, who has been the vice president of investments at International Paper, Memphis, Tenn., since 1997.

“The notion of a three-legged stool, where the government, the employer and the individual worked together to reach a common goal, really made abundant sense. We've essentially weakened one of those legs,” Mr. Hunkeler said.

The three-legged retirement stool consists of Social Security, employer-provided retirement plans and personal savings.

“(It's the result of) rather shortsighted thinking of any number of players in this pension game. You could point your finger at the government or regulators, you could point the fingers at FASB, other academics who took a very academic view of how assets and liabilities should be measured without focusing on the long-term societal benefits of a more balanced retirement system,” Mr. Hunkeler said.

“The DB pension system is a voluntary system. If you make the system unattractive enough companies simply won't support them,” Mr. Hunkeler said.

While employers were moving away from DB plans in the middle of the 2000s, it was the financial crisis of 2008 that changed the industry forever.

“I've been in the industry for 28 years and all other crises are dwarfed by 2008, and for me the biggest impact in terms of 2008, in terms of planning and preparing for potential crises, 2008 really highlighted the need to think about liquidity in your plan,” Russell's Mr. Ristuben said. “(Before then,) in terms of investment structure, a lot of investment ideas made sense in every context except related to liquidity.”

After years of talking about liability-driven investing, it took the financial crisis to make pension funds fully embrace the idea of derisking.

“Essentially they're saying, "Never again!'” said Edgar Sullivan, whose 20-plus-year career at General Motors Asset Management included duties as managing director of multiasset investment strategies. He is currently a senior strategist on the advisory and solutions team at SECOR Asset Management, New York.

“Most pension funds, DB plans, are now frozen. They don't have to worry about future increases. With that, it makes a much stronger case for derisking.”

In the wake of the financial crisis, General Motors Corp., the largest U.S. corporate pension plan, has taken the lead in derisking following its purchase of a group annuity contract for its 118,000 retirees in its $33 billion U.S. salaried DB plan in June 2012.

With the latest crisis, employers are on the move to get out of the pension business entirely. What kind of world emerges after the next crisis remains to be seen.