In the Classroom
 The Perils of Pensions

In 1999, the pension plans of S&P 500 companies were collectively overfunded by about $250 billion. By the end of 2003, they were underfunded to the tune of $200 billion. While many companies had seen their pension plans primarily as an employee benefit, or as an investment pool, pensions have become a huge strategic concern, pulling down earnings and affecting business strategy. "This is $450 billion that needs to be contributed by corporate America," said James Morris, Vice President of SEI Investments, one of the faculty members of Wharton's new Pension Strategy: Designing Resilient Retirement Systems executive education program.

Pensions have become the tail that wags the dog, shaping financial and strategic decisions. When SEI Investments conducted a study last year of 151 mid-sized companies in the U.S., U.K., Canada, and Holland, with average pension assets of $181 million, it found that one-third of companies with underfunded pensions were changing their business plans as a result. Nearly a quarter of all the companies were cutting back on capital expenditures, and another 11 percent expected to do so in the future. Overall, 68 percent of respondents said pension funding obligations are having a negative impact on corporate financial statements.

"Pension issues are driving business strategy," said Morris, whose company manages about $18 billion in pension assets for some 250 clients. Given its large pension liabilities, General Motors is actually "an investment company that happens to product automobiles," Morris said. An estimated $2,000 of the price of every car goes toward pension obligations.

What went wrong? Pensions were hit by a "perfect storm" of declining asset levels and lower interest rates. But many companies also took too many risks with their pension funds, viewing them as an attractive investment pool without paying enough attention to the downside risks.

Pension Investment Strategies

How can companies and individuals better manage their pension funds? Among the perspectives offered by Morris and Assistant Professor of Finance Christopher Geczy, who also serves on the faculty of the new program:

  • Treat the pension plan as a subsidiary: Morris said companies should think about their pensions as a subsidiary of the company — more precisely, a subsidiary in an emerging market. "You have to be careful about the impact that this pension subsidiary has on the company," he said. "If it requires a cash infusion, it is first in line. If you want to do a stock buyback or pay down high-coupon debt, you may be unable to do that because of the pension plan. If companies view the assets and liabilities together, they take more calculated risks."

  • Recognize the impact of constraints on the portfolio: While socially responsible investments funds perform well on average, research by Geczy and a colleague found that investors, depending on style, give up an estimated 30 basis points or more by limiting their investments in this way. "There is not as much diversity in socially responsible funds so you don't have the diversity to form the optimal portfolio," said Geczy. "The optimal portfolio might want some amount of real estate, for example, but you don't find real estate in SRI funds. On average, SRI funds don't look any worse than other funds, but that is not the physics that the investor faces. No one invests in the average portfolio."

  • Be cautious of complexity: Investments in instruments such as hedge funds are very complex while hedge funds "can play a very positive and appropriate role in the portfolios of DB plans," Geczy notes that "the strategies are often esoteric. Even for some professionals it is not an easy task to understand them."

  • Ensure sufficient management attention: As companies have cut back staffing, Treasury departments are often hit hardest, Morris said. This means that the investment decisions for the pension fund might be managed primarily by a committee that meets once or twice a year. An alternative to increasing internal staff is to outsource the function to companies that can take fiduciary responsibility for the plan and deliver necessary services.

  • Monitor fund managers and consultants: "You have to spend a lot of time and thought monitoring the managers to understand their biases and think about what they are doing, especially if you go into areas such as hedge funds," Geczy said. "You have to understand what the risks are."

  • Stay educated: By staying educated, investors can avoid being hooked by current fads. "You need to stay educated and in touch with current trends," Geczy said. "A lot of funds had very heavy exposure to private equity, for example, which led to negative performance and a severe lock up of their money. You need to avoid getting hooked on the latest hot fad."

  • Beware of a backlash against defined contributions: Defined contributions (DC) plans are gaining in popularity because they place more of the decision making and risk on the employee as compared to defined benefit (DB) plans. But employees are not managing their pension assets well. "It remains to be seen if there is not an enormous outcry when the baby boomers retire and find out they have not been managing their 401k plans as they should be," Morris said. Individuals need to employ the same discipline as corporations, looking carefully at their future needs and then working backwards to ensure they are saving sufficient funds for retirement.

   

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