27
Pension Funds Need MORE Management MANAGEMENT

Retirement plan sponsors abdicated most policy decisions to investment managers over 40 years ago. In too many cases they get the “same old” Procrustean policies. As clients, endowments and pension sponsors have had important contributions to make and should have asserted them because each individual or institution investor is different from others, so their investment policies should be different, too.

With so very much at stake, the apparent modesty of senior executive time and attention devoted to the strategic management of employee benefit fund assets and liabilities—even at large and sophisticated corporations—is disturbing. Recent comprehensive research shows that corporate pension executives delegate most of the responsibility for both asset management policy and portfolio operations to investment managers. The wisdom of this conventional practice deserves searching re-examination, particularly in view of the massive amount of money involved.

In terms of both assets and contributions, employee benefit funds are becoming increasingly important in corporate finance. Employee benefit fund assets of large corporations now total more than $200 billion, including about $160 billion in pension funds, $26 billion in savings and thrift plans and $16 billion in profit sharing plans. Another $74 billion of pension obligations are not yet funded, although 38% of this amount represents already vested benefits.

To put these gargantuan sums into perspective, consider that total pension obligations of large corporations equal 32% of stockholders' equity; and annual employee benefit plan contributions averaged 20% of corporate profits in 1977—up from only 5% in 1950, 11% in 1960 and 17% in 1970. Not only are the amounts large, they are different. They represent a new financial phenomenon—growth liabilities. Pension fund assets, contributions, and obligations continue to grow more rapidly than the companies that sponsor them.

ERISA vests the primary fiduciary responsibility for managing these assets in the corporation sponsoring the plan. Yet, over 60% of the 1,000 companies surveyed by Greenwich Associates delegate to managers policy control over such basic dimensions as cash reserves, equity portfolio diversification, portfolio turnover, and bond maturity schedules (see Table 27.1).¹ And the trend is toward more delegation of these basic powers of portfolio policy to investment managers. In fact, larger corporations, which are typically more assertive with suppliers, delegate more policy authority to managers than do smaller companies. Delegating operating authority, however, does not dispose of policy responsibility.

Executives say they are getting more actively involved in setting investment policy, but they say so in decreasing numbers. In 1975, 54% of the executives surveyed said they would get more actively involved; in 1976, the percentage dropped to 44% and by 1977 only 33% said they would get more actively involved. The executives' statements (summarized in Table 27.2) reveal only two areas in which an increasing percentage of executives specified the investment policy that managers were to follow—amounts invested in real estate and amounts invested in foreign securities.

The Challenge of Modern Capital Theory

A profound confrontation has developed between traditional concepts of investment management and a relatively new theory based on extensive capital market research. The debate between the advocates of the two schools of thought, “traditional” and “modern,” covers each of the main dimensions of investing: whether to diversify broadly or to concentrate on selected investments, whether deliberately to minimize portfolio turnover as an unrewarding and largely unnecessary cost or to accept it as a minor cost necessary and incident to the pursuit of significant opportunity; whether to change portfolio risk or volatility over the market cycle or to hold it constant, whether to change the stock-bond ratio or cash reserves or to hold them constant throughout the ups and downs of the market, whether the objective of investing is to manage reward or to manage risk.

The dispute may occasionally seem academic and at other times almost polemic but, despite such distractions, modern capital theory and its practical application will be of great and basic importance to corporate employee benefit funds and their effective management in the decades ahead. Corporate executives must decide for their own funds where they stand in this debate. (Of course, not to decide is to decide.)

Among the broad cross-section of senior investment officers of major investing institutions 59% felt that it was unrealistic to expect most institutions to beat the market averages, while only 16% agreed that index funds—designed to replicate the market averages—would outperform the institutions. The two views do not square—except with the impressive 59% of the institutional investors who say they would oppose considering the use of index funds for pension funds. (An interesting challenge to pension executives is the resistance of senior corporate management to indexing. Of the pension executives surveyed, 62% said senior management would be reluctant to index, and 61% said senior management is less interested now than it was a year ago.)

Perhaps it is unfair to expect practitioners of the established school of investment management to sponsor the new contender, but it is disconcerting to see these professionals so antagonized by the relatively innocuous idea of using index funds for a portion of pension assets. After all, index funds are only the simplest technique making use of the splendid methods by which modern capital market theory enables investment managers—quite possibly for the first time—to control portfolios and to obtain reliably intended results. Realistically, the “debate” about index funds is already over. More than a third of the pension funds with assets of more than $250 million are already using index funds; most of these companies expect to use index funds more extensively in the future, and nearly half the companies not yet indexing expect to begin soon.

A far more comprehensive, and therefore threatening, prospect facing the traditionalists is the use of tools based on modern capital market theory to design portfolios deliberately differentiated from and carefully controlled in relation to the market averages. When it becomes more widely recognized that investment managers and their clients can obtain results that are highly predictable, given the investment environment, the importance of policy setting and the impact of explicit accountability will rise rapidly. Many investment managers are not well prepared to accept this accountability.

Contrary to conventional expectations that thoughtful investment counseling between managers and clients can lead to investment policies that meet the particular funding and financial characteristics of each employee benefit fund and each plan sponsor, research reveals no significant differences in portfolio composition due to any of the following, presumably basic, policy considerations—size of company, size of plan, percentage of plan participants now working versus retired, benefit formula, average age or length of service of participants, or actuarial interest rate assumption.

These considerations can matter, but only if corporate executives vigorously represent to their investment managers the special characteristics of their company and their plan at the time basic investment policies are being formulated. Corporate pension and profit-sharing funds are subject to too many differences of resources, constraints, and intentions to be treated in what appears to be such a Procrustean manner.

Conclusion

The competence most needed in the management of employee benefit funds is not more investment management, but more management management. It is hard work, but unlike portfolio management, which is apparently difficult to do well, it can be done well, and the rewards can be very large.