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Baby steps

Pension plans are standing fast in volatile times, but subtle changes to their asset allocations could still rattle some markets.

Pension plans are standing fast in volatile times, but subtle changes to their asset allocations could still rattle some markets.

By Justin Dini
February 2001
Institutional Investor Magazine

Pension funds have always been a patient lot. And this year they're playing to form.

The historic bull market may finally have ended: Nasdaq has tumbled, and predictions of recession abound. But don't try to scare the nation's giant pension plans. Compared with skittish retail investors and sector-hopping mutual fund managers, pension fund managers remain a portrait of calm - content mostly to stick with the investment strategies they put into place in the not-so-distant past.

Take the $39 billion Virginia Retirement System. Last summer its board debated pulling back sharply on its equity holdings before deciding to leave its allocation of 70 percent intact. "This thing is like a supertanker. You can't just turn it on a dime," says Nancy Everett, the Virginia plan's chief investment officer.

"We are not believers in market timing," adds Robert Stelben, who oversees the $9 billion plan of Consolidated Edison Co. of New York. The utility will reexamine its portfolio mix in the next few months, but Stelben expects it to leave intact its basic asset allocation, which has been in effect since early 1998: 45 percent in U.S. equities, 20 percent in international equities, 30 percent in fixed income and 5 percent in alternative investments. "I don't see a year's change in the marketplace as warranting a change in our structure," he says.

Of course, standing pat on allocations can take some courage in tough markets. After all, as funds began their rebalancing process, a year-end ritual for most, many found themselves below their target for equity because of last year's market reversals. To stick to their established asset mix, they will have to start buying more stocks, even if, gun-shy, many have yet to pull the trigger.

A few funds have even become more aggressive. Last June the $90 billion Teacher Retirement System of Texas slashed its allocation to fixed income from 34.5 percent to 29.5 percent. The fund redirected its allocation to U.S. equity from 50 percent to 52.5 percent and upped its target for international equities from 10 percent to 13 percent. "The board approved these modifications to further diversify the fund," says a spokesman.

Mostly, though, to the extent that change is afoot, it's part of an ongoing movement that, on the margin, places a greater reliance on passive equity management and displays an increasing taste for alternative investments, such as private equity and hedge funds. Given the size of many of these funds, of course, even slight changes can have a dramatic effect on markets.

In a recent Institutional Investor survey of some 800 corporate and 250 public pension plan sponsors, 15.8 percent of the respondents said that they expected to increase their allocation to domestic passively managed equities in 2001, twice the proportion of those who thought they would reduce their reliance on indexing. By contrast, about 12 percent expected to increase their active equity investments, while 22 percent expected to reduce active management of funds. The main reason plan sponsors cite for a switch to indexing: Active managers can't seem to consistently beat their benchmarks.

With alternative assets, pension fund managers are hoping to generate healthy returns that are uncorrelated with the rest of their portfolios. In the investment world that's the equivalent of a free lunch, making hedge fund and private equity investment a sensible move that many plans are eager to make. According to a new survey by research group Greenwich Associates, 47 percent of pension fund respondents expect to increase their allocations to private equity, which the survey defined as leveraged buyouts and venture capital, by the middle of this year. Just 5 percent of plans expect to decrease such investments.

A number of funds, like the $56 billion Ohio Public Employees' Retirement System, are making their first foray into these alternative asset classes. "We definitely expect better returns from private equity than we do from domestic and international public equities," says Neil Toth, director of investment at the plan, which made its first commitment to private equity last year.

The interest isn't limited to big plans. Says Josh Lerner, a professor of business administration at the Harvard Business School who has studied private equity investing: "We've progressed from the pioneers - the foundations and endowments and the more sophisticated private and public pension funds. Now smaller public and private funds are beginning to invest in the class."

Nevertheless, experience indicates that pension funds would be wise to expect complications from their new investments. The hedge fund industry is already short of experienced managers, giving pension funds little choice but to invest with untested firms. And both hedge funds and private equity remain opaque, leaving investors to guess at what's happening to their money between monthly or quarterly reports. Indeed, many private equity investments are so illiquid that pension funds will have difficulty tracking their returns. Moreover, not all academics are convinced that private equity returns don't correlate with stock market performance. "If the public equity markets get killed, the private equity gets killed too," says Edwin Burton, an economics professor at the University of Virginia and the chairman of the board of trustees at the Virginia Retirement System. "Private equity is the tail on the dog."

Certainly, last year's market gave all money managers reason to indulge in some serious reflection and to dabble a bit. After all, Nasdaq plunged 39 percent, and the Standard & Poor's 500 index fell 10 percent. That was a rude awakening for pension plans that had reported a median average annual return of 18.13 percent from 1995 through 1999, according to the Wilshire Associates' Trust Universe Comparison Service.

"It was the worst year we've seen in a long, long time," sums up Tom Herndon, executive director of the Florida State Board of Administration, overseer of the state's $101 billion pension fund.

Florida follows an automatic rebalancing system and has rejiggered its asset mix twice in the past six months, once over the summer and again in early December, to reach its target allocation. In both cases, the fixed-income portion of the portfolio became overweighted and U.S. equity underweighted, so the fund adjusted accordingly. "If we run ahead of our targets, the rebalancing kicks in automatically," says Herndon. "It amounted to several hundred million dollars in each case - not a lot for a big pension fund."

In November 1999 the fund's executive staff decided to lower exposure to domestic equity, from 61 percent of the portfolio, a position that had held firm since 1996, to 55.5 percent, allocating the extra 5.5 percent to international equity and alternative investments, which include private equity. "We thought it was pretty likely that the U.S. equity market would continue to slow down," says Herndon. "We thought we might get a little pop from fixed income, which turned out to be right. We also thought we'd get a pop from international equity, which turned out to be wrong."

For now, the fund intends to stick to its current asset allocation: 55 percent U.S. equity, 25 percent fixed income, 12 percent international equity, 4 percent real estate, 2.5 percent alternative assets (private equity) and the remainder in cash.

Automatic rebalancing proved to be a boon for the $30 billion Massachusetts Pension Reserves Investment Management Board, reports executive director R. Scott Henderson. Twice in the past three years, the automatic rebalancing kicked in with exquisite timing for the fund, which, since 1996, has targeted 44 percent U.S. equity, 16 percent international equity, 25 percent fixed income, 6 percent real estate and 5 percent private equity.

It first happened when domestic equity exceeded 44 percent in June 1998. Massachusetts cut back its stock holdings just before the market tumbled with the devaluation of the Russian ruble and the collapse of Long-Term Capital Management. The second rebalancing came in March 2000, just before Nasdaq imploded. "It happened to work out for us. I wish I could say I was that smart," says Henderson. "As luck would have it, we rebalanced before the market did it for us."

Many have to make their own luck. Last year the $76.7 billion New Jersey Division of Investment took it on the chin. With a heavy concentration in growth stocks, the fund watched its U.S. equity holdings at one point decline by $7 billion, representing nearly 17 percent of its domestic equity investments, reports Maneck Kotwal, investment officer at the Trenton-based plan. As a result, it now has some 63 percent of its funds in domestic and international equity rather than its target of 65 percent. Kotwal says the fund officers have not yet decided when to restore that 2 percent shortfall. "We're still not sure if we've seen the last of the downward earnings revisions," he notes. Overall, the fund's value declined from about $83 billion at the end of 1999 to $76.7 billion at the end of 2000.

Not surprisingly, many managers have grown a little weary of trying to outthink the market, which is one reason why funds continue to cut back on active managers. One of the most noteworthy moves came about six months ago, when the $43.5 billion New York City Employees' Retirement System decided to dump its $3 billion portfolio of large-cap actively managed equity and switch to index funds, which it has favored for some time. "We compared our actively managed U.S. equity with our passively managed funds over a long period of time, and we found that our managers couldn't beat the index," says Jane Levine, New York City's deputy comptroller of pensions. As a result, passive management accounts for 92.5 percent of the fund's equity portfolio, up from about 85 percent a year ago.

Levine, however, is giving active managers another chance to prove their worth. The New York plan is in the midst of moving some 5 percent of its equity portfolio into actively managed small- and midcap stocks. "We're hoping that is a segment where active management can do well."

Last year's market decline has also complicated private equity performance: Weak IPO markets have curtailed exit strategies for venture capital investors, and leveraged-buyout funds suffered from soured junk bond financing opportunities. Still, pension plans are attracted by the historical returns: 22 percent for private equity over the past decade, according to private equity research firm Venture Economics, versus 17 percent for the S&P 500, according to research group Ibbotson Associates.

Pension asset rebalancing will cut both ways this year for LBO and venture capital funds looking for money. On the one hand, more small plans are adding private equity to their asset mix, broadening the base of potential private equity investors. On the other hand, many of the large funds find that their shrunken asset base leaves them overexposed to private equity, forcing them to either cut back on their holdings or refrain from making additional investments that had been planned. In terms of total assets, observers say, it should be a wash: neither an overall increase or decrease in the amount of pension fund money available for private equity deals.

Says pension fund consultant Kelly DePonte of La Jolla, California-based Pacific Corporate Group, "You are going to get more players involved, but the dollar amounts are going to be less than they have been for the past few years."

These days pension funds keep an average of 2.9 percent of their portfolios in private equity, according to research group Greenwich Associates. Adventurous plans like those of New Hampshire and Virginia, among others, have allocated up to 10 percent of total assets to the class. The most aggressive plans, including the $170 billion California Public Employees' Retirement System, the $59 billion Washington State Investment Board and the $42 billion Oregon Public Employees' Retirement Fund, were the first to jump into the area. They made their moves soon after a 1979 Department of Labor ruling that allowed pension funds to make investments in private equity as long as they were deemed to be "prudent."

Last summer CalPERS upped the ante, hiking its target exposure to 6 percent of assets, from 4 percent. "If you're going to invest in equity, you should invest all along the spectrum, and that includes private equity," says Mark Anson, CalPERS's senior investment officer for global equity.

Still, he adds, "if you're basing your decision to get into private equity on the past two or three years, you should probably revisit that decision. The returns of the past few years are greater than anyone should expect."

Returns don't come cheap. Private equity investment can cost a pension fund between 200 and 300 basis points annually, versus 20 to 30 basis points for an actively managed equity portfolio and 5 to 10 basis points for a passively managed one.

The Los Angeles Fire & Police Pension System represents the new breed of small plans that are bolstering their presence in private equity. "We are looking for returns," says Thomas Lopez, who runs the $12 billion investment portfolio. At the end of 1998, the fund upped its private equity target from 3 percent to 5 percent. Says Lopez: "Private equity is becoming more of an accepted asset class. Traditionally, the biggest funds were in it. Now it is trickling down to small- and midsize funds."

Hedge fund investment is an even more recent phenomenon for pension funds. Until the past few years, these unregulated investment partnerships were mostly the domain of high-net-worth individuals. But in recent years institutionalization has become the most important theme in the business. Last year's decision by CalPERS to invest $1 billion in these funds was seen as a watershed event that will eventually bring many more pension plans into the market.

Still, problems abound for big pension plans trying to find a comfortable place in hedge funds. Not least is the enormous across-the-board interest in this class. The funds with great track records are almost all closed or returning money, and promising managers coming out of the mutual fund industry or Wall Street can raise big funds almost overnight. The imbalance of supply and demand leaves large institutional investors without the influence they traditionally can exert on other markets. Major hedge funds are unlikely to cut special deals, on price or investment lockups, for pension funds.

For all the steadfastness of pension plans, it's worth remembering that despite last year's market problems, most funds are still sitting on outsize returns over the past decade. It remains to be seen whether they will get antsy if markets continue to perform poorly for any extended period of time.

Consider the Virginia Retirement System, which ranks as a midsize fund. The VRS made its first private equity investment in 1989. Then, in 1994, its officers decided to expand the fund's private equity allocation as part of a dramatic overhaul of the plan, which was just 40 percent funded at the end of 1993. It boosted its allocation to public and private equity from 50 percent to 70 percent, mostly at the expense of fixed income, just in time to catch the best years of the bull market.

"We jacked up our equity exposure and we got lucky," says Burton, who advocated the increased equity allocation at the time. Adds Nancy Everett, "We didn't expect 20 percent returns."

By last June, when the fund's staff and board gathered at the Boar's Head Inn on the University of Virginia's Charlottesville campus to discuss whether to alter the asset allocation, a process the plan undertakes every four years, the pension plan was 98 percent funded. Burton argued that the plan should roll back its equity allocation to 50 percent to protect against further market declines. (After total assets peaked at $42 billion over the summer, the fund lost $3 billion of its value by year-end.) But Everett endorsed the status quo, and in the end the VRS board left its strategy in place.

"The fund's managers have been hitting home runs the past seven years," says Burton. "It is hard to make an argument to switch gears."

Another down year, of course, might add a little spice to that argument.