PENSIONS 2008 - The Sweet Hereafter

Never has the defined benefit market been more unappealing. So why are so many money managers rushing to get a piece of the action?

By all accounts, traditional pensions are dying on the vine. Big companies like General Motors Corp., IBM Corp. and Verizon have closed their plans to new employees and invested the bulk of their plan assets in high-grade bonds to ensure reliable income streams for existing beneficiaries. More than half of all assets in corporate defined benefit plans, which provide retirees with regular payments based on their years of service, will either be frozen or designated to be terminated by 2012, according to consulting firm McKinsey & Co. Public employee retirement plans are under pressure from government budget crunches and taxpayer unease with growing liabilities. McKinsey projects total defined benefit assets to increase by just 1 percent in the next five years. That’s bad news all around — for workers, heads of pension plans and, not least, their outside asset managers, who earn far lower fees on conservative bond portfolios than they do for managing stocks and other higher-risk, higher-return investments.

And yet, amid all these signs of decline, however, asset management firms are rushing into the defined benefit business. Some, like mutual fund firms Eaton Vance Corp. and OppenheimerFunds, are relatively new to the arena. Others, including Fidelity Investments, are redoubling their long-standing efforts. What’s the excitement? They’ve all discovered a surprising upside to the woes of conventional pension plans: Even as companies freeze assets and devote more of their portfolios to a collection of ultrasafe fixed-income securities, they are moving other assets into higher-risk investments, such as hedge funds and private equity. Unlike bonds, these alternative investments are highly profitable for asset managers. Getting a piece of the action on these allocations is one of the biggest opportunities in recent years for the money management industry.

“Yes, defined benefit plans are freezing at record rates, but there is still a considerable amount of money to be managed,” says Mark Anson, president of Nuveen Investments’s investment services group, the Chicago asset manager’s institutional arm. “And it will be a long, long time before they pay off their liability stream. There’s plenty of opportunity for money managers to help asset owners grapple with liabilities and develop more alpha-generative, higher-risk investments.”

Asset managers are hoping that new mandates from defined benefit plans will help them grow alternative-investment businesses that specialize in such increasingly popular products as hedge funds, short-extension mutual funds, customized portfolios and international funds. The opportunity is potentially enormous: Pension plans have increased their collective allocation to alternatives every year since 2001, according to the Committee on Investment of Employee Benefit Assets, a group of big defined benefit plans. And McKinsey estimates that at least $1 trillion of the $2.3 trillion corporate defined benefit market will be invested in entirely new products by 2012.

Catering to defined benefit plans gives retail-focused firms a cost-efficient way to diversify into a more stable business. The mutual fund industry is growing more competitive, scale-intensive and subject to pricing pressure and volatility of assets as individual investors chase performance and hot styles. Pension plans and other institutions, on the other hand, tend to hold investments through choppy markets and shifting style trends.

“It’s important for money managers to have a diversified book of business,” says Kurt Winkelmann, managing director of Goldman, Sachs & Co.’s global investment strategies unit, which advises pension plans. “In that context DB plans represent sizable mandates, sticky assets and attractive clients.”

CHANGES IN THE DEFINED BENEFIT MARKET Are Not a new phenomenon, but they have recently gained momentum, as a host of regulatory, accounting and economic changes have prompted companies to freeze or shut down their plans. Traditional pension benefits for private sector workers have been dropping steadily since 1980, when companies began to favor 401(k) plans and other defined contribution schemes. The number of full-time employees covered by defined benefit plans has fallen by half during that time, to about 21 million. Regulation is also playing a part. Starting this year, the Pension Protection Act of 2006 requires companies to fully fund their defined benefit plans and limits them from averaging assets and liabilities. As a result, companies will have to fund shortfalls with cash contributions, potentially leading to lower and more volatile earnings. In late 2006 the Financial Accounting Standards Board began requiring public companies to report pension surpluses and shortfalls on their balance sheets, a rule that was designed to improve shareholder disclosure but that also introduced new earnings volatility. A further-reaching FASB dictum, expected to be implemented over the next three years, will force companies to immediately recognize pension gains and losses on their balance sheets. All of these factors, especially the accounting changes, give companies the incentive to freeze their plans so they can lock in bull market gains and surpluses.

But these same changes are also causing plans to alter their approach to asset allocation in ways that create moneymaking opportunities for asset managers. Some are employing liability-driven investing strategies, which align outflows to retirees with income from bonds and other fixed-income instruments. In the U.K., where similar accounting changes have been mandated, the British Telecom Pension Scheme was one of many plans that shifted into fixed income to match the duration of assets more closely with liabilities that increased dramatically under the new accounting regime, says Anson, who joined Nuveen in September from Hermes Pensions Management, which handles the BT plan. At the same time, BT took a novel approach to investing surplus money that didn’t need to generate income, by shunning traditional stocks and bonds in favor of alternatives. Anson expects the same to happen in the U.S.

“We had to fund that deficit and shift asset allocation to address the funding dilemma,” he says. “With the new accounting regulations, the need for LDI becomes much more acute.”

LDI forces pension funds to think about four broad categories of exposure, says Goldman’s Winkelmann: hedging interest rates, international investments, such “chronically mispriced” asset classes as small-cap stocks and emerging markets, and skill-based strategies, including hedge funds and private equity. “LDI gives you a framework to evaluate other investment opportunities,” he notes.

Consultants who advise plans on LDI generally target returns of 3 percentage points above liabilities, which usually hover around 4 to 5 percent of assets annually. One way to achieve that growth with a relatively small portion of a fund’s assets is to boost the allocation to global markets. Major plans are already moving in this direction. The California Public Employees’ Retirement System, for instance, is scaling back its investments in U.S. equity in favor of international and global. Consulting firm Callan Associates’ survey of U.S. pension funds showed an allocation of 47 percent to domestic equity and 18 percent to international equity as of June 30, but the international percentage is growing quickly. A number of consultants expect U.S. domestic equity to eventually slide down to about 25 percent, with international equity rising proportionately.

THE FIRMS PUSHING INTO THE DEFINED benefit space are varied in type and strategy. Most are retail-oriented outfits seeking to expand comparatively tiny institutional units. These firms covet institutional assets because they tend to stick longer than retail money does, and thus their acquisition costs can be recouped over a longer period.

Many believe they need to tweak their existing infrastructure and strategies only slightly to attract institutional assets. Eaton Vance, for example, is using existing portfolio managers to expand its institutional business, which now accounts for about 4 percent of its assets, as part of a larger strategy to grow from $150 billion to $500 billion in assets. Others have made acquisitions to boost their efforts. Nuveen in April bought equity manager HydePark Investment Strategies, whose Richards & Tierney consulting arm specializes in structuring institutional portfolios, including measuring liabilities. Nuveen hopes that having such capabilities in-house will help win more mandates for Anson’s institutional unit, which houses $39 billion of Nuveen’s $170 billion in total assets and is its fastest-growing business.

Some big managers in the defined contribution market, which sprang up as an alternative to conventional plans, are going after defined benefit clients. Principal Financial Group, the biggest provider of 401(k) target-date funds, has added $18 billion of pension mandates since the middle of 2007 and views growing its institutional business as critical to achieving its goal of doubling assets, to $500 billion, within five years, says Patrick McNelis, head of institutional advisory services. Leading 401(k) manager Fidelity in 2005 created Pyramis Global Advisors to jump-start its lagging institutional business. Fidelity is investing $100 million in Pyramis, opening offices in London and Hong Kong and launching a range of long-short products. Vanguard Group, in keeping with its low-cost principles, is offering institutional index funds with expense ratios as low as 2.5 basis points. But it’s also pursuing the defined benefit business of 401(k) clients, pitching itself as a trusted adviser that can manage assets and provide day-to-day services like processing checks for beneficiaries. Vanguard recently upgraded its recordkeeping technology so defined contribution customers that also hire the firm for their conventional plans can view consolidated information on the portfolios.

“If someone has us on the DC side, we have their trust and confidence,” says Jeffrey Molitor, head of institutional asset management at Vanguard.

Using recordkeeping and other services to pry loose management mandates could prove effective. As plans increasingly employ more-complex investments and need to tightly manage liabilities and balance-sheet risk, many will choose to outsource asset allocation, recordkeeping and even liability management.

“There will be convergence between the roles of fiduciaries and managers,” says Carl Hess, Americas practice leader at consulting firm Watson Wyatt Worldwide. “Given what it’s going to take to manage a plan, sponsors are going to want to outsource many of the services to third parties.”

Still other firms are using strong track records in global products to win LDI mandates, hoping that such gains will fuel their nascent alternative- investment units. OppenheimerFunds and MFS Investment Management are leveraging strong performance in non-U.S. equity mutual funds into new global defined-benefit mandates. MFS’s institutional business has grown by 64 percent in two years, largely on the strength of international mandates, and now represents $28 billion of the firm’s $204 billion in total assets, says retirement division chief Carol Geremia. In September the Boston-based money manager created a subsidiary, Four Pillars Capital, to seed hedge fund managers. “You can’t ignore the growth of the alternatives business,” says Geremia.

Along with other firms in this camp, Vanguard has developed a long-duration portfolio and is touting it as an alternative to derivatives and other complex securities, particularly for smaller plans. Principal has been marketing non-U.S. and real estate portfolios.

Plans are also turning to such customized strategies as concentrated portfolios that own a small number of securities, as well as more-esoteric infrastructure and commodity investments. Chuck McKenzie, CEO of OppenheimerFunds’ OFI Institutional division, says its commodities strategy — initially launched as a mutual fund — has been in high demand among plan sponsors. The firm customizes the strategy for institutions to reflect their investment guidelines or various benchmarks. OFI also is launching a concentrated “best ideas” commodities fund, as well as long-short stock funds designed to generate hedge-fund-like returns. “We’re ramping up the leverage and bets to help us produce more alpha,” explains McKenzie.

Still, managing money for pension plans is complex and won’t work for every firm. To get new business, upstarts have to wage expensive battles to wrestle it away from competitors. And the steady, long-term nature of institutional assets makes them as difficult to move as they are desirable. In addition, though most pension plans are well aware that they need to employ new approaches such as LDI, change may come slowly. Experts say that even at this point, LDI is more talked about than implemented.

Long-established institutional managers aren’t taking the incursions of retail firms lying down. James Francis, CEO of Paradigm Asset Management Co., an institutional firm in White Plains, New York, with $1.2 billion under management, says he’s defending his turf by revamping all of his quantitative strategies so they hold fewer stocks and are less aligned with the performance of major indexes. “We’re concentrating our alpha bets because that’s what our defined benefit clients want,” says Francis.

“It’s a take-away business,” says McKinsey partner David Hunt. Those that do the taking away can build client bases that will ultimately buy high-margin alternative products. Alternative investments are clearly where the industry is going; their lucrative fee structures —and promises of outsize returns — are too enticing.