Managers: focus on return

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Last year US pension funds’ median return was 11.7% for corporate and 12.5% for public funds, according to Russell Mellon universes performance data – a good result.
But it is the legacy of the past five years that has done the damage, with annual returns averaging just 3.6% for corporate and 4% for public over this period.
In fact, figures quoted by asset manager PIMCO put the estimated funded ratio of corporate plans at 85.8% end 2004, compared with 86.8% a year before.
“You might think that when the markets bounced back it would do wonders for the funding status, but in fact it has not,” says Christopher Keating of Fidelity Management Trust Company in Boston.
Most DB funds in the public and corporate sector have adjusted the figure of expected returns from the assets. Most of these project 8-8.5% pa retuns overall from assets, well above the 6% figure that appears in most forecasts.
Keating explains that funds keep to the higher rate as the contribution rate would need to be increased to reflect the lower expected returns as a smoothing mechanism. “This smoothing effect gives the fund grace time to recover from market downturns and to dampen upturns and spread any adjustments over time,” he points out.
The smoothing process, which protected funds in the recent market falls, can cut in the other direction, he says. “Smoothing made pension funds look as if they were still quite healthy in 2001.” But in a market upturn, we see the other side of the coin. “When the duration is lengthened out, the negative effect is still coming home to haunt the funds.”
Even with increased returns and contributions by corporate employers, liabilities have continued to grow. According to PIMCO, this is mainly because of falling interest rates.
The public sector has borrowed billions in pension obligation bonds, which are aimed at meeting their liabilities. “If they borrow 6% and only obtain 5% returns on the portfolio, they have made their situation worse,” says Fidelity’s Keating.
As in Europe, more attention is being paid to the liability-side. Here the authorities did provide some relief before the Presidential election, by moving the discount mechanism from treasuries to the corporate bond rate and this helped plans look somewhat healthier.
“Funds have moved from just looking at the asset side of the ledger. The importance of the liability side has been growing on us, with the realisation that we should be tying the asset allocation more directly to the stream of liabilities,” says Keating. But moves to mark the liabilities to market values as is happening in Europe under international accounting standards are just a matter of talk so far in the US.
Bernard Winograd, president and chief executive officer of Prudential Investment Management in Newark, says: “I do not think it will ever become widely popular to invest pension plans by simply matching their liabilities. This is unlikely to be anything other than a minority view.”
At Goldman Sachs Asset Management in New York, managing director Kurt Winkelmann, acknowledges an increased interest in liabilities issues, but sees this coming primarily from corporate plans. “I have talked to a number of public pension plans about treating the liability stream as the true benchmark. This is not something they are comfortable with.”
Where funds have looked seriously at it, it has been on a trial basis. “We have had discussions with clients about incubator portfolios, where clients start by dedicating small parts of the portfolio to try out the idea.
“We take a well-specified investment problem relating to liabilities. This can be done as representation for the entire liability stream or to pick a specific cohort group.” By putting some money to work, you can see how the whole process functions, says Winkelmann.
The main emphasis within the DB spectrum system is still to generate the additional returns needed to match the 8 to 8.5% return plan sponsors expect to make.
“The pensions question is dominated by returns,” maintains Prudential’s Winograd. Pension funds are looking for new ways to make money to achieve the required return. “But there is increasing recognition these returns are going to be hard to make. The current debate is more about how to take more risk.”
For the larger plans it is impractical to believe that most returns can only come from market exposure. “Most big plans are trying to work out how to obtain this as cheaply as they can. Hence the interest in indexing and enhanced indexing,” Winograd says.
He is sceptical as to how far hedge funds can play the role expected of them. “You cannot put as much money into the hedge fund infrastructure as people are trying to put, as there are not enough arbitrage opportunities and not enough skill to satisfy everyone.”
His solution is to “go off the beaten track”. “People are looking at the private market counterparts of every public market. This is something they should be doing. We believe you obtain a premium for being active in private markets. People should be paid for anything that is illiquid.” He warns not everything in the private markets will be a sound proposition.
Goldmans Winkelmann says clients are much more explicit about the alpha dimension. “Investors have an increased appetite for taking increased active risk.”
With tracking errors coming down in traditional areas, the issue is one of giving managers more latitude to take more active risk. “One way is to relax the long-only constraint and to work with managers equally comfortable with the underweight as the overweight side. This enables the risk levels to be scaled up without a corresponding deterioration in the expected alpha.” This concept is now percolating around both the fixed income and equity markets, Winkelmann adds.

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