Amid an enduring bear market and declining interest rates, pension plans face a funding crisis. Companies are trying to invest their way out of the problem, but are they taking on too much risk in the process?

By Justin Dini
January 2003
Institutional Investor Magazine

Call it the great pension gap of 2003.

Reeling from a one-two punch of declining interest rates, which increase plan liabilities, and nearly three years of falling equity values, which depress returns on plan assets, corporate pension funds find themselves in their most precarious financial straits since the 1970s. As of September 30, 2002, the average corporate pension plan was only 77 percent funded, according to benefits consulting firm Towers Perrin. That’s down dramatically from a 100 percent funding level at the start of 2002 and is a far cry from the 132 percent funded status -- an all-time high -- that prevailed back when stock markets were soaring in March 1999. Coming into this year, corporate defined benefit plans must make up a combined deficit of $243 billion, the biggest on record.

“Since 1974, when Congress passed ERISA, the industry hasn’t had an experience like this one,” says Meredith Brooks, managing director of institutional investment services at Tacoma, Washingtonbased consulting firm Frank Russell Co. “To have interest rates and stock prices both declining may be unprecedented.”

The impact is profound -- and costly. Broadly, falling interest rates and stock prices deepen anxieties about the country’s retirement security; on a narrower level they force companies to dig into their pockets and increase their plan contributions to close the funding shortfalls or risk running afoul of ERISA and tax regulations. Some, like Hewlett-Packard Co. and Honeywell International, are using cash; others, such as Goodyear Tire & Rubber Co. and Navistar International Corp., are contributing company stock; and a few, like IBM Corp., are using a combination of the two.

The success or failure of pension funds’ new investing strategies will go right to the bottom line. In 2001, when pension plans were still flush, $5.4 billion in aggregate pension profits flowed into the operating income of Standard & Poor’s 500 index companies, according to a recent UBS Warburg study. In 2002, the report estimates, pension losses drained $8.2 billion out of operating profits; it predicts that such losses will grow to $11.2 billion this year.

As they scramble to cope with this unfolding nightmare, plan sponsors are deploying a range of strategies to boost portfolio performance, manage liabilities and -- so they hope -- secure the safety of their employees’ retirement funds. Some corporate plans, like American Airlines’, are now altering their asset allocations in line with the markets several times a year, instead of just once. Many sponsors are looking for savings, such as lower investment management fees and fewer managers, wherever they can find them. Most significant, many are pursuing more-aggressive investment strategies, pressing into alternative assets like hedge funds in a reasonable -- albeit potentially risky -- effort to bolster returns. “Plan sponsors have concluded that they have to invest their way out of their problems,” says Brooks.

Certainly, there’s no simple solution to the current dilemma. “If your strategy is too conservative, there’s a risk that you don’t generate enough returns to stay fully funded,” says Christopher McNickle, a managing director at consulting firm Greenwich Associates, of the move into alternative assets, while noting that “there’s more potential for problems. These are risky asset classes.”

Corporate plans aren’t alone in their need to seal funding gaps. The portfolios of public funds have also been hit hard. Although state plans enjoy more flexibility in the rules that govern how they account for their pension plans -- they often use numbers that are at least 18 months out of date, and they have greater latitude in their interest rate assumptions -- they, too, have suffered. More than half of all public pension plans are underfunded, chiefly because of steep stock market losses, according to consulting firm Wilshire Associates. For states that increased public employee pension benefits in recent years, the pain is especially acute (Institutional Investor, November 2001). Many states and cities are now being forced to make contributions to their retirement systems even as they face mounting budget deficits. Like their corporate counterparts, a substantial number of public plans are revising their investment strategies in a bid to boost returns.

The risks they court are real, but so is the need for stronger portfolio returns. According to a recent Credit Suisse First Boston study of S&P 500 companies, about 90 percent of the corporations with defined benefit plans, some 360, were underfunded to some extent -- and virtually all of them are looking for higher returns. Consulting firm Ryan Labs reports that in the first nine months of 2002, pension plan liabilities grew at a 20.02 percent clip, while assets lost 16.4 percent of their value. That’s why the average pension fund is, by the most recent measure, only 77 percent funded.

“Sponsors are realizing that it’s going to take more than a diversified portfolio of beta to match their assumptions,” says Frank Russell consultant Jeffrey Geller. “That’s why there’s a search for alpha going on.”

Old Economy companies are the most aggressive; they’re the ones most likely to have traditional defined benefit plans. If these plan sponsors are not moving into hedge funds, they’re probably at least thinking about it. In June, Nestlé USA decided to allocate 5 percent of its $1.7 billion in pension assets to a hedge fund of funds, the first of its kind in the portfolio. General Motors Corp. has also recently tiptoed into hedge funds for the first time. Other companies reportedly considering a similar move include Caterpillar, Delta Air Lines and International Paper Co.

Alternative investments aren’t a new asset class for plan sponsors, of course. As of December 31, 2001, the average corporate pension fund kept 7.6 percent of its portfolio in alternative investments, according to Greenwich Associates. Most of those holdings were in real estate and private equity; hedge funds claimed just 0.3 percent of total assets. In the past, pension funds steered clear of hedge funds for several reasons: their inherent riskiness, their lack of transparency and their high management fees.

That is changing fast. Says Frank Russell’s Brooks: “Hedge funds are definitely on the agenda for every pension plan. But unless they understand the risks, the lack of transparency and the costs, they shouldn’t go near them.”

Real estate is also attracting a growing number of pension fund investors, in no small part because of the double-digit returns delivered by real estate investment trusts in 2001 and 2002. A recent case in point: Avon Products’ $420 million defined benefit plan is reportedly considering adding, for the first time, a 5 percent allocation to real estate and private equity.

Advocates say that alternative assets provide diversification as well as the promise of strong returns that do not correlate with stock market movements. Still, some analysts fret that pension funds could be jumping in just as the sector is topping out. “In real estate and hedge funds, a bubble could be growing,” says Barclay Leib, founder of Sand Spring Advisors, a Morristown, New Jerseybased hedge fund consulting firm.

This pension funding crisis has been brewing for the three years the stock markets have been declining, but it has only now come to a boil because of the peculiarities of pension accounting, which allow companies lots of leeway in determining their liabilities.

In performing their annual assessment, typically completed in January, of a pension plan’s status, actuaries make a series of assumptions. First, they examine the plan’s total assets and calculate its so-called market-related value. Rather than use the simple market value of the assets, which can fluctuate considerably from year to year, companies rely on a moving average, generally taken from a three- to five-year period.

Once the asset value is determined, actuaries multiply that number by an expected rate of return to come up with a projected value of the assets over the plan’s lifetime. From 1991 through 1996, according to Bear, Stearns & Co., most plans assumed an average return of 9 percent, meaning they multiplied their assets by 9 percent. Since 1997 companies have on average assumed a 9.2 percent return, according to CSFB.

The greater the estimated return, the greater the plan’s contribution to company profits. Take IBM. In 2001 the company employed an expected return on pension assets of 10 percent. That assumption produced a $4.2 billion (by multiplying IBM’s smoothed asset base as of the beginning of 2001 by 10 percent) expected return on plan assets (plus an additional $140 million in other pension gains) for 2001. That year the costs associated with maintaining the pension fund were $3.2 billion (plus $80 million in other pension losses). Subtract the $3.2 billion from the $4.2 billion, and you get roughly $1 billion in pension profits, which flowed into the company’s net income of $7.7 billion. In 2002, IBM sliced its expected return to 9.5 percent, which the company said cut 2002 profits by $350 million.

In 1998 and 1999, when the S&P 500 index was gaining upwards of 20 percent a year, a 9.2 percent assumption seemed conservative. In 2000 and 2001, with the S&P off 10 percent and 11.9 percent, respectively, it seemed more than a little optimistic. In 2002, with the S&P off a further 22 percent, such a return assumption still seemed rosy, even though bonds, which make up an average 35 percent of pension portfolios, have been doing well. (The Dow Jones corporate bond index was up 8.5 percent through mid-December.)

Under increasing investor scrutiny, many corporate actuaries began to reduce their plans’ expected rates of return at the start of last year. Lowering the actuarial assumptions, of course, cuts into company profits. At the start of 2002, General Electric Co. reduced its expected return from 9.5 to 8.5 percent; Dow Chemical Co., from 9.5 to 9.25 percent; Whirlpool Corp., from 10.5 to 10 percent; and Goodyear, from 10 to 9.5 percent.

More corporations are expected to join the parade. IBM is looking to trim its expected rate of return again this month, says company spokeswoman Carol Makovich. “We are looking at reducing our expected rate of return for 2003 to somewhere in the range of 8 to 8.5 percent,” she says. IBM estimates that the move will reduce 2003 operating income by roughly $700 million, though, according to Makovich, the company expects “to more than offset this impact through $900 million in productivity savings from the restructuring we took in the second quarter.” Others considering reducing their projections include AMR Corp., BellSouth Corp., SBC Communications and Verizon Communications.

Yet companies may not be going far enough, some actuaries contend. “In a world where even the ten-year bond is yielding less than 4 percent, an 8 percent return assumption is very aggressive,” says actuary Jeremy Gold, who runs New Yorkbased consulting firm Jeremy Gold Pensions.

No less controversial is the calculation of plan liabilities. Actuaries begin by estimating a plan’s future obligations: What benefits must employees be paid when they retire? Once each obligation is determined, actuaries must calculate its present value. To come up with that number, they work backward using the discount rate, which represents the interest rate at which pension obligations could be effectively settled. The Securities and Exchange Commission says the discount rate should approximate the interest rate on Moody’s Investors Service Aa-rated corporate bonds. For much of the 1990s, the average discount rate hovered at roughly 7 percent; in 2000 it stood at 7.51 percent, according to consulting firm Watson Wyatt Worldwide.

Since then, of course, interest rates have fallen. When the discount rate goes down, the present value of future liabilities increases, since the funds are expected to earn a lower rate of return going forward. As a result, companies must set aside more money to pay off future benefits.

ERISA requires companies to keep their plans at least 90 percent funded. If funding falls below that level, corporations must make contributions to bring it back up, usually over a period of three to five years. Watson Wyatt estimated that about 30 percent of corporate pension plans would require such assistance in 2002; this year the total might reach 65 percent. Companies can delay the move in the hope that markets will rebound, but many of them will have made some contribution for last year.

For example, IBM announced last month that it will make a $3 billion contribution, half in company stock and half in cash, to its pension fund to bring it back to fully funded status. (As of year-end 2001 the fund reported assets of $38.5 billion.)

Goodyear, the Akron, Ohiobased tire manufacturer, will also kick money into its $4.2 billion pension fund. The company reported that its year-end unfunded liability would probably be between $1.9 billion and $2.2 billion -- roughly double where it stood at the end of 2001. The net effect? Goodyear will have to contribute as much as $550 million to its pension fund by 2004. Some of that will be in company stock.

In early November, Navistar put 7.75 million shares of company stock into its $2.8 billion (as of December 31, 2001) pension plan. The company did not simply contribute all the shares; instead, it sold some of them to the plan, with the cash to be repaid to the fund over time.

ERISA allows companies to keep up to 10 percent of plan assets in company stock. But pension officers will likely move cautiously before they decide to dump stock into their plans to make up their funding shortfalls. That’s because, après Enron Corp. and WorldCom, investors are leery of anything that even suggests accounting sleight of hand. “Using company stock as a plan contribution is pretty much frowned upon by the Street and by institutional investors,” says Frank Russell’s Brooks. “It’s seen as a sign of desperation.”

Under Statement of Financial Accounting Standards 87, companies with underfunded plans may also face serious charges against shareholder equity. That may prove to be the case for United Air Lines, whose application for a $1.8 billion federal loan guarantee was rejected in part because the Air Transportation Stabilization Board “has substantial concerns about the underfunded status of United’s pension plan,” as explained in the board’s letter to UAL Corp., United’s parent. As of December 31, 2001, the plan was underfunded by $2.52 billion, according to UAL’s annual report.

In October, AMR Corp., which operates American Airlines, said that if its actual investment returns for 2002 continued to fall and interest rates remained at current levels, the company would have to shell out a “significant” amount of cash to fund its plan liability. CSFB projected that the shortfall could reach $3.3 billion by the end of 2002, and AMR says that funding the liability will likely result in a pretax charge of more than $1 billion to stockholder equity.

Like many corporations with a weakened pension fund, AMR is shifting its investment strategy in an effort to boost returns, although the company is moving more cautiously than some. William Quinn, president of AMR Investment Services, which oversees the company’s pension fund, is contemplating making a small investment in convertible bonds. The portfolio’s current breakdown: 40 percent in corporate bonds, 30 percent in U.S. stocks, 20 percent in EAFE stocks, 5 percent in emerging markets and 5 percent in private equity. Any allocation to convertibles would come out of the U.S. stock portfolio, Quinn says.

Market volatility has also inspired AMR to rebalance its holdings more frequently. “It used to be that we’d rebalance maybe once a year. Now we’re rebalancing two or three times a quarter,” says Quinn. For now the company is steering clear of hedge funds. “There are still transparency problems with hedge funds, there are still risk-control problems with hedge funds, and there are still extraordinarily high fees.”

Many of his peers apparently disagree. “Pension managers are groping for any investment vehicle that may help them stagger to a 9 to 10 percent annual return,” says Sand Spring’s Leib. “If a pension makes only a 2 percent allocation to hedge funds today, I expect that to grow to a 5 to 20 percent allocation in the next few years.”

In addition to infusing its $8 billion pension fund -- which CSFB estimates is underfunded by $2.1 billion for 2002 -- with $200 million in cash, Caterpillar is reportedly mulling a hedge fund investment to boost returns and help keep the plan fully funded. The company said that it may have to take an aftertax charge of $1.8 billion to shareholder equity at the end of 2002.

GM, which estimates that the unfunded liability of its $67 billion pension fund could rise to about $23 billion by the end of this year, recently revised its asset allocation targets to include a 1 percent position in hedge funds. W. Allen Reed, chief executive of General Motors Asset Management, which oversees GM’s pension fund as well as those of other companies, says that the hedge fund allocation is not intended to stem the growth of the company’s pension liabilities, however.

“GMAM has developed highly structured investment programs that are aimed at increasing alpha and lowering tracking error over the long term,” Reed says. “We’re hiring the best and brightest managers, who, in our view, will offer superior returns in a risk-controlled environment.”

In a recent report, Putnam Lovell Securities estimated that public and private pension funds will dramatically boost their hedge fund investments -- from $87 billion at the end of 2001 to $527 billion by 2010.

Even if the growth rate is less dramatic, Sand Spring’s Leib, among others, worries that pension funds may be helping to cause the next hedge fund blowup. “The alternative investment industry currently feels a bit like Iomega in 1995 -- the first signs of froth are appearing,” he says.

One alternative to chasing alpha, of course, is reducing liabilities. In the most dramatic scenario, a number of companies may decide that their defined benefit plans pose too great a burden, and they’ll seek ways to replace them. “Companies are taking a hard look at the structures of their benefit plans to see if they can really afford them,” says Towers Perrin’s chief actuary, William Gulliver.

In November, Delta Air Lines, which anticipates taking a charge of 28 percent to its shareholder equity as a result of its unfunded plan liability, announced that, to reduce some of its pension costs, it will set up a cash-balance plan as a new retirement program. A cash-balance plan is a hybrid, a cross between a 401(k) and a traditional defined benefit plan; a recent change in Treasury Department regulations has made it easier for companies to convert defined benefit plans into cash-balance setups. They’re relatively inexpensive for a plan sponsor to maintain because they require the employee to assume most of the investment risk. Over the next five years, Delta expects to eliminate about $500 million in pension expenses.

That’s not an insignificant sum for this plan sponsor, which is scrambling, like most of its industry peers, to shore up its suddenly beleaguered retirement fund.

The party’s over Three years ago, just before the end of the 1990s bull market, nearly 60 percent of respondents told this magazine that they did not expect to make a net contribution to their defined benefit plans in 2000. How times have changed.

With pension assets declining for the third year in a row, thanks to a relentless bear market, 65.6 percent of respondents to this month’s Pensionforum aim to make a net contribution to their plans in 2003. And the pain is only beginning: 52.2 percent of respondents say they expect annual contributions to increase over the next three years.

Given plans’ exposure to U.S. stocks -- an asset class battered as much as any -- the need for more cash should not be a surprise: Almost 96 percent of respondents say their allocation to U.S. equity exceeds 30 percent.

Plan sponsors appear to be using a variety of strategies in light of the poor investment outlook for the market: Twenty-two percent of respondents, for example, say their allocation to actively managed domestic stocks will probably be higher this year than last year. Almost 15 percent say their international equities will likely increase. And 13.3 percent say their allocation to private placements will probably be higher, versus just 1.3 percent who say they will probably reduce their exposure to that asset class. In this environment, which strategy will work is anyone’s guess.

Do you expect to make a net contribution to your plan in 2003?

Yes 65.6%

No 34.4

Did you contribute in 2002?

Yes 66.7%

No 33.3

If you plan to make a net contribution for 2003, what percentage do you expect to put into each of the following investments?

Actively managed equities:

None 19.7%

1 to 10 percent 14.8

11 to 25 percent 11.5

26 to 50 percent 39.3

More than 50 percent 14.8

Equity index or semipassive funds:

None 33.3%

1 to 10 percent 20.0

11 to 25 percent 26.7

26 to 50 percent 13.3

More than 50 percent 6.7

Actively managed bonds:

None 25.0%

1 to 10 percent 11.7

11 to 25 percent 26.7

26 to 50 percent 35.0

More than 50 percent 1.7

Bond index or semipassive funds, or dedicated or immunized bond portfolios:

None 78.9%

1 to 10 percent 10.5

11 to 25 percent 5.3

26 to 50 percent 3.5

More than 50 percent 1.8

High-yield bonds:

None 79.7%

1 to 2 percent 13.6

3 to 5 percent 6.8

More than 5 percent 0.0

International or global equities:

None 35.6%

1 to 5 percent 20.3

6 to 10 percent 25.4

More than 10 percent 18.6

International or global bonds:

None 88.3%

1 to 2 percent 0.0

3 to 5 percent 8.3

More than 5 percent 3.3

Real estate:

None 86.4%

1 to 5 percent 6.8

6 to 10 percent 5.1

More than 10 percent 1.7

Cash equivalents:

None 70.7%

1 to 2 percent 17.2

3 to 5 percent 5.2

More than 5 percent 6.9

Balanced accounts:

None 100.0%

1 to 10 percent 0.0

More than 10 percent 0.0

Emerging markets:

None 78.0%

1 to 2 percent 13.6

3 to 5 percent 8.5

More than 5 percent 0.0

Private placements, including venture capital:

None 78.3%

1 to 2 percent 13.3

3 to 5 percent 3.3

More than 5 percent 5.0

Tactical asset allocation or market timing:

None 90.2%

1 to 2 percent 1.6

3 to 5 percent 3.3

More than 5 percent 4.9

Financial futures:

None 96.7%

1 to 2 percent 1.7

3 to 5 percent 1.7

More than 5 percent 0.0

Commodity futures:

None 100.0%

1 to 2 percent 0.0

3 to 5 percent 0.0

More than 5 percent 0.0


None 96.7%

1 to 2 percent 3.3

3 to 5 percent 0.0

More than 5 percent 0.0


None 98.3%

1 to 2 percent 0.0

3 to 5 percent 0.0

More than 5 percent 1.7

Oil and gas partnerships:

None 98.3%

1 to 2 percent 0.0

3 to 5 percent 1.7

More than 5 percent 0.0

Workouts and bankruptcies:

None 93.4%

1 to 2 percent 4.9

3 to 5 percent 1.6

More than 5 percent 0.0

Including your expected contribution (if any) and other shifts in allocation, how is your 2003 asset allocation likely to compare with that of a year earlier?

Domestic actively managed equities:

Higher 22.0%

Lower 16.5

About the same 61.5

Domestic passively managed equities:

Higher 15.9%

Lower 14.8

About the same 69.3

Domestic actively managed fixed income:

Higher 11.0%

Lower 20.9

About the same 68.1

Domestic passively managed fixed income:

Higher 3.8%

Lower 9.0

About the same 87.2

International equities:

Higher 14.6%

Lower 3.4

About the same 82.0

International fixed income:

Higher 2.5%

Lower 3.8

About the same 93.7

Real estate:

Higher 12.2%

Lower 8.5

About the same 79.3

Cash equivalents:

Higher 5.9%

Lower 9.4

About the same 84.7

Balanced accounts:

Higher 0.0%

Lower 2.9

About the same 97.1

Emerging markets:

Higher 9.3%

Lower 1.3

About the same 89.3

Private placements:

Higher 13.3%

Lower 1.3

About the same 85.3

High-yield bonds:

Higher 6.5%

Lower 6.5

About the same 87.0

Futures and options:

Higher 4.2%

Lower 0.0

About the same 95.8

What is your fund’s current allocation to U.S. equities?

None 0.0%

1 to 20 percent 0.0

21 to 30 percent 4.3

31 to 40 percent 28.0

41 to 50 percent 35.5

51 to 60 percent 20.4

61 to 70 percent 9.7

More than 70 percent 2.2

What is your fund’s current allocation to U.S. fixed income?

None 1.1%

1 to 20 percent 8.6

21 to 30 percent 41.9

31 to 40 percent 33.3

41 to 50 percent 15.1

More than 50 percent 0.0

How do you expect your annual contribution, in dollar terms, to change over the next three years?

Increase 52.2%

Stay about the same 29.3

Decrease 8.7

Can’t say 9.8

©Copyright 2003 Institutional Investor, Inc.

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