Four striking trends
Our latest comprehensive study of US investment management reveals four trends worth highlighting for European institutional funds and investment managers:
q defined contribution (DC) plan use continues its rapid growth;
q cash balance plan use is increasing still more sharply;
q indexation is becoming a more credible option; and
q while several asset allocation shifts are of potential significance, private equity is the investment medium of the moment.
Defined contribution: seismic shift
DC plans represent a far larger proportion of pension investment in the US than anywhere else. Our research shows that 34% of sizeable corporations in the UK use this system, but virtually 100% of comparable companies in the US do so. Indeed, executives at US corporate pension plans estimate that 60% of their pension assets will be DC by 2005, and that by 2009 no less than two thirds will be – with only one third in remaining defined benefit (DB) plans.
This is an almost complete reversal of the situation at the beginning of the last decade. In 1990, only 31% of comparable assets were in DC and 69% in DB. Why the change? DC plans in the US were kickstarted by a change in the Internal Revenue Code that allows ‘thrift’ or savings plans to be converted into retirement plans. This yielded several benefits to both employees and sponsors. For the former, the assets are highly portable; for the latter, the contributions are predictable – and often meaningfully lower than they would be for a DB plan. As a result, DC plans are experiencing positive net cash flows while their DB counterparts – as they mature – are not.
While these advantages will also appeal to corporate managers in Europe, two features of DC-type plans merit consideration:
q The success of DC is fundamentally due to their ‘tax-appeal’ for employees. In America, tax authorities allow individuals to make tax-advantaged contributions to their plans which then trigger matching contributions by their employers.
q Our studies show DC plan management in America is increasingly concentrated with managers which offer not only superior investment performance but are also skilled in communication and participant record-keeping. Banks and insurers which used to dominate the pension business have not been as successful at this, whereas mutual-fund managers which are proficient in the systems and services that provide participant support are doing very well. Building and maintaining such a capability is not cheap, but will need to be part of the skill set of any competitor who wants to tackle the potentially enormous European market.
Cash balance plans: a sudden sharp increase
Like DC plans, cash balance plans offer features that appeal to employees and plan sponsors alike. For the former, assets are again portable, offering more recruiting appeal than traditional plans for younger employees who may value job mobility over security. For the latter, contributions are again predictable.
In 2000, the proportion of large to mid-size US companies using cash balance plans has risen from 8% to 12%. Moreover, where cash balance plans were almost exclusively favoured by very large companies before 2000, last year usage spread to their smaller counterparts. At companies with plans of $100m–250m in plan assets, the proportion using cash balance jumped from 4% in 1999 to 9% in 2000.
Indexation: no ‘duffer’s choice’
Two aspects of US pension fund indexation merit special attention from European institutional funds and managers:
q The proportion of these funds’ indexed domestic equities to total domestic equities (40%) is considerably higher than the proportion of their total indexed international equities (20%) to total international equities.
q The proportion of US pension funds’ indexed domestic equity assets to total domestic equity is considerably higher than the comparable proportion in Europe. In the UK, it is just 28%, as opposed to 40% in the US. On the continent, the proportion of total indexed securities, including bonds and international equity, is only 9%.
Indexation is clearly seen as a credible option for investing a bigger portion of a typical US pension fund’s equity assets. This is because the efficiency of the US market, combined with the powerful principle of regression to the mean in investment performance, has made active investing more difficult. Few active core managers can claim to have beaten the market – consistently and after fees – over a prolonged period. Indexation appears a safer option, and when its case is made by such authorities as Jack Bogle of Vanguard and Greenwich’s founding partner, Charley Ellis, it is no longer seen as “the duffer’s choice”. More investors see it as a genuine intellectual choice in the core-satellite approach many sponsors now follow, with indexation as part of the core and higher-octane-performance style-biased mandates as the satellites.
Asset allocation: private equity and international up, bonds and active domestic equities down
Another intellectual option for US plan sponsors is private equity – although it is not an option available to all. The proportion of total pension assets allocated to this medium jumped from 2.1% in 1999 to 2.9% this year. Some 30% of funds are now users, and the spectacular returns obtained by some of them are making it one of the most widely discussed investment media on Wall Street. However, it is unlikely to become a major investment class for a couple of reasons:
In the first place, even in the US the number of potentially spectacular venture capital deals is limited. The fact more money is chasing these deals has two related consequences: The overall quality of deals is going down, and, as a result, so are average returns.
Concomitantly, the better private equity managers are increasingly reluctant to take on new clients. Private equity, in fact, is a sector where marketing is topsy-turvy. Whereas in most US pension business virtually all managers are willing to break down doors to get mandates, in private equity they limit the number of clients they accept and dictate the terms on which they do business.
A second macro area gaining favour is international investment. The proportion allocated by US pension funds to foreign stocks rose from 10.6% in 1999 to 12% in 2000, despite the fact that, in dollar terms, equities in all major markets outside the US have performed even less well than the Dow Jones and the S&P 500 (though not as badly as Nasdaq). Despite the rise, it is worth pointing out that, in comparison with other sophisticated American institutional investors, pension funds are relatively lightly invested in non-US equity markets. While DB plans have 15% of their assets in foreign equities, DC plans have just 3% – so the aggregate is only some 10%. Even this selective 15% figure is low compared with UK pension funds’ 25% investment in foreign equity and the 20% of continental institutions.
The shift into international equity has occurred primarily at the expense of the two traditionally largest investment sectors:
q US pension-fund investment in actively managed domestic stocks, which had been rising quite steadily through 1998, has fallen over the past two years. From a peak of 27.9% two years ago, it had dropped to 26.6% by the fourth quarter of 2000. When coupled with passively managed allocations, the overall domestic equity proportion has declined slightly over the same period.
q US pension-fund investment in domestic bonds is also down, in stark contrast to the most recent situation in the UK but in line with what appears to be the trend on the continent. Over the past 10 years, our research has shown the proportion of US pension assets in fixed income falling steadily, from nearly 35% to just over 22%.
John Webster is a partner of Greenwich Associates in Greenwich, Connecticut