Revisiting Corporate Pension Fund Allocation

The party ended with a bang last summer. Financial executives in charge of corporate pension plans had looked like heroes without much effort for several years. But after three consecutive years in which even the S&P 500 index registered 20%-plus returns, the index dropped 10% in third-quarter 1998, with the trough almost 20% below peak. The market falloff signaled a need to look at corporate-level financial planning. Other market indices, especially foreign markets, fared worse than the S&P index, casting doubt on the conventional wisdom that diversification offers a safe harbor in troubled markets. Nor did the indices fully reflect the breadth and depth of the damage. Over 75% of NASDAQ-traded stocks fell more than 30% from their highs for the year. At times only long-term U.S. Treasury bills offered any shelter, and even their yields dipped below 5%. For many pension plan sponsors and their management committees, the 1998 third quarter could not end too soon.

Pension plan sponsors and others with fiduciary responsibility for corporate pension money now need to consider their investment strategies with extra care. Don Trone, president of the Investment Management Council (IMC) in Lafayette, California, a consultant to investment advisers, is coauthor of the best-seller The Management of Investment Decisions . He suggests that investment committees follow a well-defined sequence whether they are starting new plans or managing existing ones (see exhibit 1) and that they stick to their written policy. The Big 5 accounting firms have made use of this sequence and have used other components of IMC’s services in their investment consulting practices, Trone says.

EVALUATE THE PLAN’S CURRENT POSITION
Investment committee members should look into all aspects of the plan, covering its investment strategies, current holdings, the company’s anticipated contributions and the plans disbursements. Because each plan has a unique set of participants, the most appropriate investment strategy may vary widely between plans. Trone cites the example of a company where most employees are relatively young. Because the pension plan at a young company will not incur large distributions for many years, the committee can prudently consider less-liquid, long-term investments. In contrast, a mature company’s plan faces more constraints. At a steel mill, where the likelihood is that you have more money going out of the plan than coming in because your workers are older and many may already be retired, you clearly have a time horizon of less than five years, Trone says. Your choice of asset classes will be significantly hamstrung. The most appropriate classes will be fixed income and cash.

At this point, the investment committee can compare the plans existing investment allocations with projections appropriate for its requirements. If the steel mills pension funds are entirely invested in technology stocks, or the funds from a high-tech start-up with no participants over 30 are entirely in Treasury bills, a fiduciary has a responsibility to act.

Once the investment committee has identified the appropriate asset classes, it should determine allocations among those classes. In this stage, actuarial assumptions and projected investment results all but determine the investment mix that the fund managers must adhere to.

Actuarial reviews are available from several sources. The larger consulting firms advising investment committees frequently bundle actuarial and other services (investment consulting, record keeping, etc.). These firms also unbundle the actuarial services if requested. Most metropolitan areas also have several independent actuaries.

The actuarial firm presents its analysis to the plans investment committee, which can modify the actuary’s recommendations, although those modifications may be limited by the plans circumstances.

The fiduciary should take an active role in defining these assumptions, which usually are disclosed in the footnotes of public companies annual reports to shareholders, as required by FASB Statement no. 87, Employers Accounting for Pensions .

For instance, if the actuaries determine the plans required rate of return is 7% and long-term bonds yield under 5%, the plan cannot invest solely in bonds and earn the desired return. This means the plan sponsors must consider other asset classes, such as stocks, that historically have provided higher returns than bonds. Because the majority of plans currently use assumed returns in the 7%8% range, stocks typically are included in the plans portfolio to boost its overall return. For defined benefit plans, the floor for the minimum equity exposure will be decided by the actuary, Trone says. Of course, the actuarial assumptions only imply a specific asset allocation given an actual investment context. Given the actual long-term rate of return for stocks and recent bond yields, if the actuary assumes a return of 7.5%, for example, from a statistical standpoint that number establishes a minimum equity floor of approximately 30%40% of the plan assets.

PORTFOLIO DESIGN
After the investment committee has ratified the actuarial assumptions, it should set a target range for each class of investments. For most plans, the primary investments are stocks, bonds, cash and, in some cases, real estate. The goal is to divide the pie between these asset classes, with a little give and take for each class.

For example, the range for equities could be 55%65%, with bonds at 25%35% and cash holdings at 5%10% (see exhibit 2). Within each class, the plan can further diversify its holdings among different subclasses. The plans equity positions can include large-, mid-, and small-cap stocks, with further diversification possible by holding international stocks. Fixed-income holdings can include guaranteed investment contracts (GICs) and government, corporate and foreign bonds. Larger plans also might hold real estate investment trusts or invest directly in properties and mortgages.

Although diversifying a plan to include some higher return asset classes increases the plans return directly, it also reduces the risk of the entire portfolio because the asset classes are not perfectly correlated. Third-quarter 1998 results demonstrated that benefit: Although stocks lost value, bond prices increased as interest rates fell. Correlations can increase or decrease over time, but historically diversification has reduced portfolio risk.

Some experts suggest setting target asset-allocation ranges rather than fixed-percentages. Ted Schwartzman, a principal with Hewitt Associates, benefit and compensation consultants, in Rowayton, Connecticut, says using ranges instead of fixed targets gives a plan more flexibility. If you decide to start with 60% equity and 40% fixed income, well probably have a range around that of plus-or-minus 5% or 10%, Schwartzman says. That range gives us the discipline to keep coming back to the target position. So when equities are doing well and we go through the top end of the range, we pull it back and become a little conservative by reducing the amount in stocks. In contrast, Schwartzman points out, when stock prices fall, as they did in third-quarter 1998, and a plans allocation slips below the target range, the plan will sell fixed-income securities and buy stocks to get both asset classes back within their target ranges.

As the plans equity exposure increases, so does its volatility. Gus Fleites, a principal with State Street Global Advisors in Boston, which manages over $450 billion of assets, points out that choosing an investment mix requires trade-offs. First, which asset mix allows me to meet the actuarial objectives to fund the plans liability? Fleites asks. Second, which mix does that with a volatility that we as a firm are comfortable with? Everybody recognizes that if you are investing for the long term you should put 100% of your money into equities. But if you do that, you will experience significant swings in the value of the pension plan, which could lead to financial obligations on the company’s part in meeting the actuarial objective rate of return.

As Fleites notes, volatility from a large equity exposure can cause the value of a plans holdings to fluctuate significantly. If the portfolios value falls too much, this can have undesirable consequences; in certain cases, FASB Statement no. 87 requires plan sponsors to reflect unfunded pension liabilities on the balance sheet.

The plan sponsors broader business needs also factor into the allocation decision. Schwartzman believes investment committees must consider multiple issues. It’s a balancing act for plan sponsors, he says. They want to make sure the assets are there for the plan participants and beneficiaries when the obligations come due, but the corporation’s goal is to try to minimize the impact of non-income-producing programs, such as pension plans, on the company’s financial results.

STAYING THE COURSE
Most market observers consider the markets recent slippage corrective in nature, not the start of a bear market. Nonetheless, the swift, volatile stock market retreat caused widespread concern among pension plan sponsors, all of whom are looking at their asset allocations in light of recent market volatility, says Tom Pipich, an investment consultant and principal with Buck Consultants, actuarial benefits consultants in Pittsburgh. Losses can do that. At the very least it has made everybody stop and ask, Are we comfortable with where we are?

When turbulence hits, pension beneficiaries once happy with what appeared to be foolproof investment strategies can become disgruntled quickly with results that make the strategies look considerably less astute. For financial executives serving on investment committees of their companies’ pension plans, and for those who advise clients on their plans, the question naturally arises: Should we change the plan investment strategy and reduce our exposure to stocks? While it may be natural to reconsider a plan’s investments during down markets, it is a mistake to focus exclusively on the recent performance of a particular asset class. One common mistake an investment committee might make is to reverse the decision-making hierarchy. They start the process by focusing on the hot managers, Trone says. By doing so, they abdicate decisions to a stranger about the most important things they have to manage, time horizon and investment strategy.

The recent high-profile problems at Long Term Capital are a case in point. While no prudent pension fund fiduciaries placed their faith in these famous market gurus, plenty of ordinarily conservative bankers did. Says Trone, You ask the people who put money into that, Why did you select Long Term Capital? Every answer was, Because of the people involved. In other words, the investors reversed the hierarchy; they chased the people without ascertaining the strategy or the time horizon that would be used by Long Term Capital to manage assets.

The advisers interviewed for this article reported that very few of their clients were panicky over the markets recent actions. As Louis Finney, director of capital markets research at William H. Mercer Investment Consulting, Inc. in Chicago, an actuarial and human resources consulting firm, points out, sophisticated investors, such as those that manage corporate pension funds, understand that markets are volatile. I tell clients that when the program was designed, we recognized there could be this sort of volatility, Finney says. It’s not an extraordinary event; its one we should expect every once in a while; we just haven’t seen it in a long time.

Monica Jelley, CPA, a banking industry consultant in Baton Rouge, Louisiana, serves on the AICPA investments committee, which oversees the Institutes $60 million of pension-plan assets. She agrees with Finney’s comments. So much has been said about volatility in the past six months because the market has been going down. Volatility works both ways, though. When stock prices went up very rapidly, that was volatility also. But nobody worries about it until prices start going down.

A more immediate concern should be that the lessons of diversification are fading. As exhibit 3, shows, large-cap U.S. stocks have been the stellar performers in recent years. Based on these results, some plan sponsors are expressing a desire to abandon small-cap and international stocks. But if history holds any lessons for investors, that could be a mistake. We see many plan sponsors questioning the diversification benefits of smaller company and international stocks, Schwartzman observes. They are looking to increase their commitments to larger cap U.S. equities or moving further to indexing. But I would cite that 10 years ago the opposite was true. Japan and the non-U.S. markets looked so strong, and the United States seemed to be the laggard. Plan sponsors were asking us the opposite question: Should we be reducing our U.S. exposure in favor of Europe and Japan, for example? It would have been the wrong time to do that a decade ago, and we think it’s the wrong time to abandon diversification today.

PUT IT IN WRITING
After the allocation range is set for each asset class, the investment committee needs to develop an investment policy statement (IPS) for the plan. The IPS serves four basic purposes. It

• Sets objectives for the plan by defining expectations, risk and return objectives, and investment guidelines.
• Defines the asset allocation policy by identifying the asset classes the plan will use.
• Establishes management procedures for selecting, monitoring and evaluating the plans asset managers.
• Determines communications procedures among all parties involved with the plan.

Norman Boone and Linda Lubitz, coauthors of the Investment Policy Statement Guidebook software that walks pension investors through this process (see resource list) point to several benefits of a properly composed IPS. It

• Compels the investment committee to be more disciplined and systematic in its decision making.
• Clarifies the plans objectives and expectations, reducing misunderstandings among the parties involved.
• Specifies procedures for decision making and implementation.
• Establishes a record of decisions.

Boone stresses that the statement is not optional. The IPS was required initially by ERISA and now by the Prudent Investor Act, so any time a fiduciary relationship exists, a policy on how you go about the investment process is required, he says.

An IPS also can help an investment committee stick with its original decisions when markets get volatile. As the CFO, you won’t have people coming to you and screaming, We’ve got to get out of equities, because the committee has thought through those issues, Lubitz says. And if someone comes back and sues the plan, saying, You earned only 7% in a 13% environment, as long as the plan is following reasonable, established procedures, that case will get thrown out of court every time.

SELECT THE MANAGERS
The plan administrator selects money managers according to the guidelines laid out in the IPS and gives them funds to invest. Larger plans frequently hire investment consultants to assist them with this stage. Whether you use a consultant or conduct your own research, Trone recommends that it evaluate the following factors in considering investment managers:

• Overall performance numbers. What results has the manager produced net of fees? Does the manager consistently produce above-average results or does performance vary sharply year to year?
• Performance relative to assumed risk. A high-risk portfolio should produce above-average results; otherwise, why accept the risk? Ideally, a manager produces results above the level expected from the portfolio. Ask the prospective manager (or the consultant) for the portfolios alpha and Sharpe ratio , two widely used measures of risk-adjusted return.

  An alpha above zero indicates that the investment manager produced a greater return than expected, given the portfolios relative risk to the overall equity market, as measured by the S&P 500. The Sharpe ratio measures a portfolios return relative to its risk (standard deviation); a higher ratio indicates a better risk-adjusted performance.

  Don’t use the Sharpe ratio to compare managers in different asset classes, though, such as comparing a bond manager to one who invests in emerging markets.

  While the ratio is useful for intra-class comparisons, it can produce misleading results between classes because it favors less volatile portfolios.

• Performance among peers. How well has the manager performed vs. others who follow a similar investment style? Don’t focus solely on short-term rankings; consistency also is important.
• Managers adherence to stated investment style. Does the manager stay within the parameters described in the IPS? If your growth stock manager gets nervous and starts buying value stocks, the plans portfolio will shift away from the original mix. Look for long-term dedication to maintaining an investment strategy.
• Bull- and bear-market performance. As we were reminded last fall, the stock market suffers occasional pullbacks. How well does the manager perform in rising and falling markets?
• Performance of key decision makers. This step requires an investigation of the money managers business practices. Has the company’s management roster been stable? How has the company handled its growth? Does the manager have any conflicts of interest with affiliated businesses that could affect your account?

DONT FORGET TO MONITOR THE MANAGERS
In a perfect world, the markets would behave and the managers would produce the results expected of them. Of course, reality usually refuses to cooperate, requiring a plan sponsor to monitor the plans performance regularly. How frequently should you monitor a plan? And, just as important, what events should trigger corrective actions?

Current case law requires at least a quarterly review of the plan. However, best practices suggest more frequent monitoring may be warranted, especially in volatile markets. According to Trone, officials at the Department of Labor, which oversees pension plans, have told him privately that if conditions warrant, you should monitor as frequently as necessary to be sure you are abreast of the activities of the managers you hired.

Trone suggests that sponsors monitor plans on three levels (see exhibit 4). First, determine whether the manager is still adhering to the strategy established in the IPS. For example, if you hired a value-stock manager, is that manager following a value strategy as defined in the IPS? Look through the portfolio. Have any growth stocks slipped in, improving performance but increasing risk?

The need for vigilance increases if the manager’s primary market is down significantly. There is a very strong temptation for managers to pull out of a bear market to make their short-term performance look better, Jelley says. But if you’ve given that manager a mandate to be in equities, for example, you must hold their feet to the fire. You can’t let them fudge what market to be in, because that’s the overall determination you need for your entire fund.

The monitor should compare the managers performance with a recognized industry benchmark, such as the S&P 500 index. To make the comparison fair, be sure the benchmark is appropriate. Comparing a value manager with the S&P 500 is not fair in all market conditions, for instance. Value stocks outperformed the S&P 500 during the mid-1980s, but underperformed the index in the late 1980s and early 1990s. For periods when an asset class diverges from the S&P 500 or other major market indices, using a customized benchmark, if one is available, allows more accurate comparisons.

The monitor should compare the manager with his or her peer group: value manager vs. value manager. There is a practical problem with monitoring a manager’s performance against its peer group over a short time period, however.

Data on peer groups typically are generated quarterly, causing a delay in the evaluations. Furthermore, most managers outperform one quarter and underperform another. There is no need to switch managers unless he or she underperforms for over a year.

Under normal circumstances, managers should rebalance the portfolio frequently. Investment committee members should look at this when they meet. However, technology has made real-time monitoring possible, which can trigger more timely adjustments in volatile markets. Such a check should reveal when the portfolio has slipped outside the ranges established in the IPS and should remind the managers to rebalance the portfolio as soon as it exceeds set parameters.

A well-designed IPS also can indicate when the investment committee should make changes beyond periodic rebalancing. The IPS should include guidelines for discharging managers who, for example, depart radically from their original investment styles or consistently lag behind their peers. Specifying such possibilities and the appropriate action in the IPS can speed response time and minimize deviations from the plans objectives.