First General Motors Corp. decided to make life a little tougher for its future retirees. Now it’s about to do the same for its money managers.
On January 1, the Detroit automaker froze its defined benefit pension plan for 33,000 salaried workers, cutting benefits for some employees and shifting others into a less costly 401(k) plan. Then in March, GM disclosed that it would dramatically slash the amount of stocks it owns, cutting its equity allocation by 20 percentage points and increasing its fixed-income allocation by the same amount. By the end of the year, GM plans to shift some $21 billion into bonds, costing its investment managers millions of dollars in fees.
There is good reason for the carmaker’s suddenly conservative investment posture. After three years of falling stock prices and declining interest rates, the company had to borrow about $13.5 billion in a landmark 2003 bond offering to prop up its badly underfunded pension plan. It poured money into stocks and alternative investments, such as hedge funds and private equity, seeking — and getting — strong performance that gave the $101.4 billion plan a $16 billion surplus at the end of last year. Now GM aims to avoid such unpredictable swings in funding.
“The corporation is trying to lower the volatility of that surplus over time,” says Nancy Everett, president and CEO of General Motors Asset Management Corp., the GM subsidiary that looks after the pension fund and invests most of its assets with external money managers.
More companies could soon follow GM’s lead. Even as surging stock markets and favorable interest rates have restored the health of many plans, defusing fears of an imminent nationwide pension crisis, companies are looking to batten their hatches by freezing or even terminating plans. Roughly 20 to 25 percent of the nation’s $2.3 trillion in corporate defined-benefit-plan assets had been frozen by year-end 2006 — meaning some or all employees had stopped accruing benefits — enabling companies to rein in their pension costs. In the next five years, that figure could rise to 40 to 60 percent of defined-benefit-plan assets, McKinsey & Co. estimates. The consulting firm also expects the percentage of assets from terminated pension plans that are managed by insurance companies, which typically pay them out to beneficiaries in the form of annuities, to rise from less than 5 percent of total pension assets to as much as 20 percent. By McKinsey’s estimate, then, only 20 to 40 percent of pension assets would remain in active plans.
Once such freezes and terminations were the hallmark of troubled businesses. But today they come mostly from financially stable companies, including Verizon, Citigroup, Hewlett-Packard Co., IBM Corp. and Goodyear Tire and Rubber Co. Typically, such companies switch their workers into defined contribution 401(k) plans, which are less costly.
Ironically, the pension freezes are being driven in part by reform that was originally intended to strengthen defined benefit plans. Last August, President George W. Bush signed into law the Pension Protection Act of 2006, which phases in tighter pension funding rules and will require plan sponsors to value their pension assets and liabilities more frequently, beginning in 2008. The legislation will bring more transparency to pension finances, but it will also make funding requirements more costly and unpredictable.
“The Pension Protection Act effectively sounds the death knell for defined benefit plans,” says Robert Pozen, chairman of Boston-based MFS Investment Management.
New rules handed down by the Financial Accounting Standards Board are only adding to the pressure on companies. Until last year plan sponsors could report the net funded status of their pension plans in balance-sheet footnotes and temper, or “smooth,” swings in the value of their pension assets and liabilities by amortizing gains and losses over a variable period, typically ten to 15 years. Now they must use the current market value of assets and liabilities to measure a plan’s funded status and run it through the balance sheet, potentially reducing the company’s net worth. In the next three to four years, FASB is widely expected to extend mark-to-market pension accounting to the income statement, a move that could make corporate earnings more volatile.
Whether companies with frozen pension plans will follow GM’s lead and dump equities isn’t clear yet, but few doubt that the trend will usher in sweeping changes in the way that they manage their assets. “The ground is shifting,” says Alec Stais, chief investment officer of the multiproduct investment group at Goldman Sachs Asset Management. “This is a fundamental shift in pension investing.”
The implications are profound for the U.S. money management industry, which grew up side by side with defined benefit plans. The number of corporate plans has dropped precipitously, and defined benefit asset growth has slowed dramatically in recent years as defined contribution plans and the mutual fund business have notched explosive increases. Nonetheless, the nation’s corporate defined benefit plans had some $2.3 trillion in total assets at the end of last year and accounted for about 44 percent of the private sector retirement landscape, according to Cerulli Associates, a Boston-based consulting firm.
“Even though the defined benefit business is in a long, slow decline, it’s important to recognize the assets will hang around for many years to come,” says Cerulli analyst Daniel Lucey, who covers the retirement and insurance industries.
For decades the most profitable part of the business belonged to traditional, long-only equity managers. No longer. Industry experts predict that these managers will have to adapt or suffer as pension funds reduce purchases of stocks and shift into fixed income, lifting profits for bond houses. At the same time, hedge funds, private equity shops and other alternative managers stand to gain handsomely as pension funds chase alpha.
This is already happening, but the pace is expected to quicken. McKinsey estimates that long-only equity managers will see their fees drop from $2.6 billion in 2006 to $2 billion or less in 2012. Driven by asset growth and increased flows to investment strategies with higher fees, overall money management fees from defined benefit assets will climb from $9.4 billion to $11.8 billion, McKinsey estimates. Meanwhile, fixed-income fees will rise from $1.3 billion to $1.8 billion. Managers of hedge funds, private equity and other alternative products will see spoils grow the most dramatically, with management fees rising from $3.8 billion to $6.5 billion. (The remaining share of fee revenue will flow to passive and quantitative managers.)
Farsighted money managers are not sitting pat. Many have sprung into action in anticipation of new demands from corporate defined benefit clients — and new challenges from competitors. Firms like State Street Global Advisors and Eaton Vance Corp., both based in Boston, and San Francisco–based Barclays Global Investors are introducing new fixed-income products that help pension funds reduce risk by aligning their liabilities with coupon and principal payments. Many firms, including J.P. Morgan Asset Management in New York, are incubating new absolute-return strategies aimed at pension funds. And predominately institutional money managers that have traditionally focused on pension funds, such as New York–based AllianceBernstein, are plunging into the defined contribution market, going toe to toe with the mutual fund industry.
“You have to go back 30 years to the advent of the Employee Retirement Income Security Act to see a similar level of innovation,” says McKinsey’s Janice Revell, a retirement specialist in the firm’s wealth practice who recently co-authored a report on the future of the private sector defined-benefit-plan market.
Perhaps no firm is more conscious of the stakes than Fidelity Investments, which at the end of last year managed $705.5 billion in retirement mutual fund assets and about $149 billion in institutional assets. In 2005 the Boston money manager spun the institutional business into a separate unit, called Pyramis Global Advisors, which is developing more than a dozen product proposals focused on market-neutral and long-short equity strategies that could hold great appeal for corporate pension funds. Fidelity well knows how and why the defined benefit business is changing. Effective May 31 the firm will shut down its own fully funded defined benefit plan for about 32,000 Fidelity employees, pay out existing benefits and boost its 401(k) match and health benefits.
Pension plans and the money management industry came of age together, beginning just over 50 years ago. Today’s institutional money managers are less and less dependent on assets in defined benefit plans, which in recent years have grown at a compounded annual rate of 5 percent, compared with 8 percent for defined contribution assets and nearly 12 percent for mutual fund assets. Still, the symbiotic relationship between pension plans and money managers continues to help nurture the major innovations in portfolio management.
The first private defined benefit corporate pension plan in the U.S. was established in 1875 by American Express Co., which paid benefits annually from earnings. It wasn’t until 1948, however, that unions won the legal right to include pensions on the collective bargaining agenda — and began pressuring management to set aside money to fund future obligations. At the time, pension funds were invested mostly in bonds. But in 1950, U.S. Steel Corp. became one of the first plan sponsors to realize that equity returns would be critical to fulfilling rapidly growing pension promises and funded a big move into stocks, according to an account by Michael Clowes in The Money Flood: How Pension Funds Revolutionized Investing.
That same year, GM agreed in union negotiations to set up a pension plan for hourly workers and also created a noncontributory plan for its salaried workers. Like U.S. Steel, the automaker was an early proponent of stocks and became one of the first plan sponsors to hire multiple external managers when it engaged seven trust banks to invest its defined benefit assets.
The foundation of the modern asset management industry took shape over the next few decades, as money poured into defined benefit plans. Assets rose from $14.3 billion in 1949 to $212 billion in 1970; by then, nearly half of the $171 billion not held by insurers was invested in stocks. Trust banks won business because of the reputations they had built managing money for wealthy individuals, while Wall Street firms, which had begun catering to institutions’ need for high-quality research and trading facilities, also began setting up money management units. Mutual fund companies started to compete successfully for defined benefit business. Entrepreneurial money managers soon began breaking away from banks and brokerage firms to set out their own shingles.
“Most of the de novo start-ups were three to four guys,” says Charles Ellis, who in 1972 launched Greenwich Associates, a research firm in Greenwich, Connecticut, that caters to institutional investors.
Pension funds helped revolutionize the practice of investing. They embraced these upstart firms, becoming early adopters of the groundbreaking academic theories developed by Harry Markowitz, William Sharpe and others that came to be known as Modern Portfolio Theory. “We were making a bet on the fact that academic principles could be used to successfully manage money,” says Dean LeBaron, who in 1969 co-founded Batterymarch Financial Management, one of the pioneering boutiques.
The 1974 Employee Retirement Income Security Act, the nation’s first comprehensive pension reform law, was a boon to independent money managers, which performed better than bank trust departments and insurers following the bear market in large-capitalization stocks that had begun a year earlier. ERISA required companies to fund ongoing pension costs and take steps to close unfunded liabilities. It also established a tougher fiduciary standard, directed pension plans to diversify their portfolios and permitted pension managers to delegate fiduciary responsibility to money managers that registered with the Securities and Exchange Commission. In its wake pension funds added managers and expanded into new asset classes like real estate and global stocks.
Still, in an eerie foreshadowing of the Pension Protection Act of 2006, ERISA proved to be a double-edged sword. Scores of companies shut down their pension plans rather than face up to the tough new funding requirements. In the nine months after the legislation was signed into law, the Pension Benefit Guarantee Corp. — the government entity established by ERISA to take over pension plans from troubled companies — was socked with 5,000 terminations, according to The Money Flood.
Pension plan terminations continued in the 1980s, albeit for different reasons. High interest rates reduced the present value of pension obligations, creating surpluses that companies could recapture and use for restructuring or acquisitions simply by shutting the plans down and paying out benefits, typically in the form of annuities. Corporate raiders targeted companies with overfunded plans, using the surpluses to pay off debt associated with their leveraged buyouts. (Congress put an end to this practice in 1990 by imposing a 50 percent excise tax on reclaimed surpluses.)
The birth of the defined contribution 401(k) plan, which was formally recognized by the Internal Revenue Service in November 1981, dramatically slowed the advance of corporate defined benefit plans. With the unionized workforce declining and workers becoming more mobile, many corporations began offering 401(k)s. Not only were the plans cheaper to administer, they also shifted the bulk of the financing and the investment risk to employees. Meanwhile, as Congress, regulators and the courts sought to strengthen defined benefit plans, the costs and administrative burdens they imposed created further disincentives to offer them. Global competition and rising health care costs also chipped away at corporate management’s support for traditional pensions.
Nonetheless, defined benefit plans remained the bedrock of the money management business through most of the 1980s, until the widespread adoption of 401(k)s and the raging bull stock market, which began in August 1982, made mutual funds more attractive. From 1985 to 2000 the number of corporate defined benefit plans fell from 170,000 to 49,000, whereas the number of 401(k) plans jumped from 30,000 to 348,000. Although defined benefit assets more than doubled, to $2.0 trillion, 401(k) assets increased nearly 12-fold, to $1.7 trillion. Mutual funds were also on a tear, with assets rising from $495.4 billion to nearly $7 trillion during the same period.
The bear market of 2000 to 2002 and its aftermath were particularly damaging for defined benefit plans. With stocks plunging and the U.S. Federal Reserve Board dramatically cutting interest rates, pension liabilities soared, forcing many U.S. corporations to kick in substantial amounts of cash to fund their plans. From 1980 to 2000, pension contributions averaged about $30 billion a year. But in 2002 and 2003, companies had to kick in close to $100 billion annually, according to the Center for Retirement Research at Boston College.
“Plans went from being well funded to underfunded, and from not needing to make a contribution for many years to having to make a balloon payment,” says T. Britton Harris IV, who stepped down as chief investment officer of Verizon’s defined benefit plan in 2004, nearly two years before the company announced that it would partially freeze the plan. Such contributions were “a shocking number for a lot of people,” adds Harris, who is now CIO of the Teacher Retirement System of Texas.
Since then the financial health of many corporate defined benefit plans has substantially improved, thanks to strong equity returns and last year’s rise in interest rates. In 2006 the aggregate ratio of pension assets to liabilities for companies in the Standard & Poor’s 500 index increased from 93 percent to 101 percent, according to Wilshire Associates, the first time corporate plans achieved full funding since 2001.
Still, the trend to freeze defined benefit plans continues unabated, driven by pension reform that raises the costs and risks for companies with such plans. Among its many provisions, the Pension Protection Act increases the premiums that companies must pay to the Pension Benefit Guarantee Corp., makes the calculation methodology for the value of pension liabilities more accurate and both tightens the criteria and compresses the time period for smoothing the value of assets and liabilities, from five years to 24 months. The law also requires plan sponsors to phase in full funding over a seven-year period. (Exactly when the clock starts ticking depends on such factors as the plan sponsor’s industry and the degree to which its plan is underfunded.)
If recent experience in the U.K. is any guide, FASB’s move to extend mark-to-market pension accounting to the income statement — an initiative known as “FAS Phase Two,” which is expected to bring the U.S. into line with international accounting standards — is likely to have a big impact on plan freezes. In 2003 only 30 percent of defined benefit plans in the U.K. were frozen. But by 2005 the percentage had doubled, to 61 percent, in anticipation of the rule that required U.K. firms to recognize pension costs at market value on their income statements. “[Freezes] ramped up very quickly,” says McKinsey’s Revell, who sees the same trend unfolding in the U.S.
Many industry observers agree. “When we asked CFOs and CIOs to identify their top pension plan worry, nearly 40 percent said their No. 1 concern was FASB Phase Two tinkering with the income statement,” says Peter Chiappinelli of Pyramis Global Advisors, referring to a survey of 214 plan sponsors that his firm recently conducted. If plan sponsors have to contend with more volatility in earnings, many more will freeze their plans, he predicts.
A world in which half or more of all pension plans are frozen — and in which pension liabilities must be reflected more accurately in companies’ financial results — is far different from today’s.
“Plan sponsors need a new way of defining risk,” says William McHugh, head of J.P. Morgan Asset Management’s strategic investment advisory group, a unit that advises pension funds. “Standard deviation of return and surplus volatility really are not viable terms anymore.” Instead, he says, risk needs to be addressed in terms of the potential threat that pension liabilities pose to three key corporate finance metrics: shareholder equity, cash flow and earnings.
Some plan sponsors, such as Fidelity, have decided that it is better to terminate their plans than contend with the new realities. But for most companies, that is an expensive option. Under the law accrued benefits must be paid out to employees, so plans must be fully funded or have the cash on hand to pay the difference between assets and liabilities.
When plan sponsors terminate, they typically distribute benefits in the form of single-annuity policies for vested employees. That too comes at a price: Because insurers charge high fees and employ conservative demographic assumptions, the cost to annuitize a plan can be anywhere from 10 to 25 percent of the plan’s fully funded value, according to Scott Jarboe, an actuary at Mercer Human Resource Consulting in Washington.
Thus many plan sponsors would prefer to freeze their plans and wait until interest rates rise further — and the value of their liabilities declines — before terminating and annuitizing benefits. A case in point is Charlotte, North Carolina–based Coca-Cola Bottling Co. Consolidated, the second-largest Coca-Cola bottler in the U.S. Last June the company enhanced its 401(k) plan and froze its fully funded $160 million defined benefit plan, ending benefit accruals for the 4,500 of its 6,100 employees who participated in the plan. If interest rates rise 150 to 200 basis points, notes Tripp Deal, Coca-Cola Bottling’s treasurer, the company will consider shutting down the plan. “I would envision that at some point we would try to buy annuities and close it on out,” says Deal.
Pension freezes largely come in two varieties. To mitigate the negative impact on employee morale, many companies opt for a partial, or “soft,” freeze in which benefit accruals are ended for a segment of the workforce, typically new hires and those with relatively less seniority. Managing these plans is similar to running an active plan in that some employees still accrue benefits and pension liabilities continue to rise, albeit at a slower pace. A more dramatic move is a “hard” freeze — such as the one implemented by Coca-Cola Bottling — in which all employee benefit accruals are ended.
In either case, companies reduce their pension liabilities, but only to a certain degree. That’s because future obligations are based on actuarial assumptions involving many factors, including employee turnover and mortality rates, that are subject to change.
In an era when more plans are frozen, contribution requirements are more volatile and pension investment results have a greater impact on corporate bottom lines, there will be greater demand for new sources of alpha. “You’ll see higher allocations to hedge funds, real estate, private equity and oil and gas,” says J.P. Morgan Asset Management’s McHugh. When it comes to equity allocations, he predicts that the search for alpha will lead plans to adopt market-neutral products and other emerging alternative strategies, such as 130-30 portfolios, which use leverage to invest 130 percent long and 30 percent short.
As a frozen plan closes in on full funding, however, the sponsor must reduce risk. Given that liabilities behave like fixed-income assets — declines in interest rates drive up their value — pension funds are likely to shift their allocations toward bonds and fixed-income derivatives. According to the recent survey of more than 200 corporate and public plan sponsors by Pyramis Global Advisors, 52 percent of those that expect to maintain their plans — and 61 percent of those that have implemented or plan to implement a freeze — intend to increase their fixed-income allocations to reduce volatility.
Robert Brunn, director of investor relations at Ryder System, a Miami-based truck rental and supply-chain management company, likens managing a frozen defined benefit plan to running a target-retirement-date mutual fund, in which equities are gradually cut back in favor of bonds as the investor grows older. Next January, Ryder will freeze its $1.42 billion defined benefit plan, which is 93 percent funded, and shift 80 percent of the employees who participate into a 401(k) plan. As a result of this move, the defined benefit plan’s liabilities will have a life span of about 65 years. Brunn says that gives Ryder plenty of time to figure out how best to reduce risk over time by adjusting its asset allocation, which is currently 77 percent stocks and 23 percent fixed income and other investments.
For many plan sponsors the need to reduce risk is leading to a surge of interest in liability-driven investing. LDI describes a range of strategies, from extending the duration of bonds in a plan’s portfolio to matching the size and timing of each liability to a coupon or principal payment, an approach known as “full immunization.”
LDI strategies hold particular appeal for frozen plans, especially those that are fully funded. “If the market values of assets and liabilities move in tandem, cash contributions and accounting expenses will be stable and risk greatly reduced,” explains Mercer’s Jarboe.
LDI strategies are also an antidote for a counterintuitive risk that is unique to frozen plans: generating unusable investment surpluses. In an active plan surplus investment gains can be used to cover ongoing accruals (and a portion flowed through the income statement). But in a plan that is fully frozen, there are no ongoing accruals, and the surplus cannot be returned to the corporation unless the plan is terminated, and even then, only at great cost, given the taxes.
The cost of generating unproductive surpluses may strengthen the case for cutting a frozen pension plan’s risk profile. “You can go into a risk-reduction strategy and find that your economic cost doesn’t increase much at all, because all you were doing with a risky portfolio was generating a lot of unproductive surplus,” says Robert Aglira, who runs a new unit at Mercer that helps corporate plan sponsors contend with such issues.
How quickly pension fund managers embrace bonds and LDI strategies depends on interest rates, the funding status of their plans and a host of other factors that are unique to each plan, such as its size relative to the sponsor’s assets and earnings from its core business. With rates still near historically low levels, many plan sponsors are reluctant to give up the equity premium by shifting substantial assets into bonds. “You are going to create a lower return for yourself,” says Ryder’s Brunn.
James Pisano, group vice president and an actuary in the benefits department of Atlanta-based SunTrust Banks, typifies this wait-and-see approach. Earlier this year SunTrust announced that it would freeze its defined benefit plan on January 1, 2008, for employees with fewer than 20 years of service. The $2.2 billion defined benefit plan was 22 percent overfunded at the end of last year and holds 80 percent of its assets in stocks and 20 percent in fixed income. But SunTrust may shift its allocation to reduce risk, says Pisano, if the FASB rule on mark-to-market accounting makes the bank’s earnings more volatile.
Like a lot of pension fund managers, Pisano figures that SunTrust has at least a couple of years before it will come under pressure to commit to a change in asset allocation strategy. Still, the actuary says he is already starting to take a look at new LDI and portable-alpha strategies, and he anticipates that a new range of investment products will soon become available. “I’m sure we would be open to what’s out there,” he says.
New demands from pension funds are already sending shock waves through the money management industry. The convergence between traditional and alternative managers is sure to gather speed, and large firms with strong product development capabilities and a deep talent pool are likely to fare better than small firms, industry observers say. “In the institutional market scale does matter,” says McKinsey consultant Salim Ramji.
Still, experts like Ramji believe that pension reform has thrown the corporate defined benefit market wide open. “Just like in evolution, it’s the firms that adapt the fastest that will be the most successful,” he says.
Perhaps no firm has taken that message more to heart than J.P. Morgan Asset Management, which manages $1.01 trillion in assets, including $540 billion in institutional assets. In early 2004, when unfavorable market conditions were roiling plan sponsors, the firm organized a forum for a dozen of its largest pension fund clients and discovered a deep sense of unease about pension risk and the coming regulatory changes.
“People were doing a lot of soul-searching,” says John Garibaldi, who runs the money manager’s strategic client group and co-heads a committee that develops new products for institutional investors.
Over the next two years, J.P. Morgan began adding the investment capabilities that its clients were starting to look for. In September 2004 the firm acquired a majority interest in Highbridge Capital Management, a hedge fund manager that now oversees $16.6 billion in assets. In July 2006 it beefed up its strategic investment advisory group that serves pension plans, endowments and foundations by bringing over William McHugh, who had served as CIO of JPMorgan Chase & Co.’s $12.7 billion defined benefit plan, and treasurer of two other defined benefit plans before that.
“When Bill came on board, nobody else was talking about meshing pension plan financials with corporate finances,” says Garibaldi, “Very few people had his experience of day-to-day managing of pension plans.”
In February the firm introduced a new analytical framework designed to quantify the risks that a pension fund’s asset allocation can pose to shareholder equity, cash flow and earnings. Backed by computer models, the framework enables plan sponsors to measure the impact of their allocations under various macroeconomic scenarios and business conditions and explore the effects of extending the duration of their bonds, decreasing equities, increasing alternatives or even setting up a 30-year interest rate swap overlay.
Consider a corporation that has $10 billion in shareholder equity and a $15 billion fully funded pension plan with 60 percent held in stocks and 40 percent in bonds. In a 2002 market scenario, when stocks fell 22 percent and ten-year Treasury yields dropped from about 5 percent to 4 percent, the company would suffer a $3.2 billion hit to shareholder equity from losses at its pension plan, according to the J.P. Morgan model. Using long-duration bonds and interest rate swaps to create a liability matching strategy would cut that loss to $1.1 billion, but poor equity returns would still be a drain on company financials. That risk could be contained, however, by moving 20 percent out of stocks and into real estate, hedge funds and private equity, which would reduce the drain on shareholder equity to just $440 million.
“If what happened in the three years from 2000 to year-end 2002 were to repeat itself today with current allocations and with the new accounting and funding rules,” says McHugh, “it would have a devastating effect on corporate finances.”
Analyses like this have led J.P. Morgan to predict that within five years the typical defined benefit plan will have 25 to 35 percent of its assets in alternative strategies, up from about 8 percent today. To capitalize on this opportunity, the firm has launched 15 new investment strategies in the past two years. “Where we have long-only competency, we’re expanding it to 130-30, or we’re concentrating the portfolio,” explains Garibaldi. The next step, he says, is to combine the firm’s highest conviction strategies in traditional and alternative asset classes globally and package them in a series of “best ideas” portfolios designed to provide consistent, absolute returns. Garibaldi expects these new portfolios to be introduced in the second half of the year.
Fidelity’s Pyramis, which managed $105 billion in equities and $41 billion in fixed income at year-end 2006, is also ramping up product development. Young Chin, who became the money manager’s first CIO in March 2006, is incubating more than a dozen product proposals and aims to introduce three to five new strategies this year, with a second wave of new products expected to follow in 2008. Like J.P. Morgan, the firm has been focusing on market-neutral and other absolute-return equity strategies.
“All of our long-short strategies have a fundamental underpinning, so they’re still playing to our strengths,” says Chin. Before joining Fidelity, he served as president and CEO of Gartmore Global Investments and co–global CIO for equities of Gartmore Group, based in Conshohocken, Pennsylvania.
As these and other long-only money managers work to counter the likelihood of erosion in their core equity businesses by launching absolute-return products, they will increasingly compete with hedge funds, which are “salivating over the prospect of institutional investors making big allocations,” says Daniel Celeghin of investment consulting firm Casey Quirk & Associates. “Institutional investors control a huge amount of assets that have been only marginally allocated to hedge funds so far, so the potential for growth is huge.”
Of course, hedge funds must also change their ways to please pension funds, which value transparency, low fees, solid risk control and client service. Not all hedge fund managers are willing or able to make accommodations. “Many hedge funds don’t fully appreciate that pension plans are fiduciaries,” says Jane Buchan, chief executive officer of Irvine, California–based Pacific Alternative Asset Management Co., a fund of hedge funds that manages $8.5 billion and has worked with institutional clients since it was founded in 2000. Buchan say Paamco tends to favor less-volatile hedging strategies and is thus well positioned for the new investing environment. “There will be huge demand for conservative hedge fund strategies because of the changes in pension regulations,” she says.
One major player that is attracting its share of institutional mandates — despite a reputation for secrecy — is New York–based Renaissance Technologies Corp., which uses sophisticated computer programs to trade in markets ranging from equities to commodities to futures and options. In August 2005 founder James Simons launched the Renaissance Institutional Equity Fund, a long-short product that employs a longer holding period than the firm’s spectacularly successful flagship fund, Medallion, and maintains a 100 percent net long exposure to the market. So far the fund has attracted $20 billion in institutional money, and Renaissance figures the fund has a capacity of $100 billion.
The rapidly growing defined contribution market is one place where traditional institutional money managers won’t have to face off against hedge funds in the quest for new sources of growth — at least, not yet. Many firms are piling into the market, driven not only by the Pension Protection Act’s chilling effect on traditional pensions but also by a series of provisions in the law that make it much easier for 401(k) plan sponsors to automatically enroll their employees. Removing the hassle of signing up for a plan has been shown to dramatically increase participation rates, and the act is widely expected to kick-start defined contribution asset flows in the coming years.
“We are finding that major corporations that have recently frozen or are contemplating freezing their defined benefit plans are suddenly turning their attention to their DC plan,” says Richard Davies, who runs the defined contribution services unit at AllianceBernstein. The firm oversees a total of $726 billion, of which 60 percent is from institutions. “There is a unique window where our major clients are going to be radically rethinking their DC plans, and we want to be part of that discussion.”
AllianceBernstein figures that within ten years as much as 60 cents of every defined contribution dollar could reside in the default investment option that employers can choose for their employees. To capture this business, Davies is building an 18-person team that will help the firm’s 25 senior defined benefit salespeople in the U.S. target the 48 corporations that are current defined benefit clients and that each have more than $500 million in assets in their pension plans; some but not all of these companies have defined contribution plans.
“It’s really about bringing the DC expertise into the much larger institutional sales organization,” Davies says of the effort.
The firm’s defined contribution sales pitch centers on its significant investment in research on optimal asset allocation for retirement plans. In the target-date mutual funds that the firm introduced in 2005, participants at age 65 would have an equity allocation of about 65 percent, versus some 35 percent in target-date funds managed by other firms, such as Fidelity, Davies says. AllianceBernstein also recently launched a series of target-date funds structured as collective investment trusts, which have lower fees than mutual funds.
On the fixed-income side of the money management business, many firms have already launched liability-driven investing products. State Street Global Advisors, which manages $1.6 trillion in institutional assets, and Barclays Global Investors, which manages $1.5 trillion, both rolled out new offerings last year. BGI’s PensionSpan initiative is designed to help sponsors of small- to midsize frozen plans manage their assets and liabilities. “There is a whole segment of the pension universe that is underserved,” says Matthew Scanlon, who runs BGI’s institutional business in the Americas. “We believe LDI will be adopted quicker by these plans.” With PensionSpan, BGI manages the assets and acts as co-fiduciary.
Smaller players are also entering the LDI market. A case in point is Eaton Vance, which manages just $6 billion in institutional assets. In June 2005 the firm brought in two seasoned LDI managers from State Street Research and Management (now part of BlackRock), Jeffrey Rawlins and Daniel Strelow, who now co-head the firm’s liability-based solutions group. Their flagship product, introduced in January 2006, includes exposure to high-yield, bank loan and global macro strategies along with investment-grade corporate bonds and such structured products as asset-backed securities and collateralized mortgage obligations.
Eaton Vance is confident that its eclectic fixed-income offerings will give it a competitive advantage with pension clients outside the LDI market as well. “The fixed income we have is not core and core-plus or government products,” says Lisa Jones, who heads the firm’s institutional business. “Inherent in the track record is our ability to hedge, short and find value in distressed debt and currencies. That’s the ability you want to harness — alpha plus.”
Pacific Investment Management Co. and Goldman Sachs Asset Management have been leaders in developing long-duration bond strategies. Two years ago Pimco developed a model that produces a custom long-duration benchmark for building a portfolio of bonds, swaps and futures that are tailored to a pension plan’s liability cash flows. Last August the firm also introduced two long-duration funds. It now manages $30 billion in such strategies. Like Pimco, Goldman offers longer-duration portfolios pegged to clients’ liability characteristics. Earlier this year the money manager launched a long duration, actively managed, commingled fund that invests in investment-grade bonds. The new product has attracted $500 million in client funds and commitments.
Given the radical changes in the pension landscape, the pace of innovation will only accelerate. But in many cases yesterday’s products and approaches no longer work, raising the stakes for firms that are still clinging to the old ways of serving corporate pension funds.
“You need to be more than a separate-account, long-only, traditional benchmark asset management company,” says Eaton Vance’s Jones. “You really need to look deep inside and recognize your core capabilities and create new and interesting products that may be customized.”
For many firms, adapting to the new demands of the pension world won’t be easy. But there are strong profits to be made, even in a waning business, for those who get it right.
Additional reporting by John Keefe
