2 The area where professional asset managers and private investors meet
2.6 Challenges faced by pension funds
nothing wrong about putting many of one’s eggs in the same basket – provided one is willing, able and knowledgeable enough to closely watch that basket.
Several decades prior to Giannini, something similar was stated by Andrew Carnegie, the king of the steel industry, author, and philanthropist, who has also been in his early career a bonds salesman. However, Peter Krass, Carnegie’s biographer who quotes him on this statement of putting all of one’s eggs in the same basket, notes that Carnegie himself was well diversified in his holdings. He had equity in twenty different companies – and major ones for that matter.
Moreover, Andrew Carnegie closely followed the Darwinian principle of business survival advising, who would hear, that when you go by survival of the fittest rules ‘you have no reason to fear the future’. Another one of Carnegie’s principles in choosing people with great business futures was: ‘Look out for the boy who has to plunge into work direct from the common school, and who begins by sweeping out the office. He is the probable dark horse that you better watch.’6Carnegie knew a great deal about dark horses. He had been one of them.
between a fifth and a quarter of American employees hold more than 20 percent of their pension assets in their own companies and if their company goes bust, as with Enron, WorldCom, Global Crossing and so many others, they lose both their job and their nest egg.
More to the point, even without the mass of bankruptcies, stock holdings are good as long as the market goes well. But then comes a bear market and the value of funds drops dramatically. Beyond this, as we have seen, investing in the stock of one’s own company is not a brilliant idea, because it maximizes the saver’s exposure. Is it then better to believe the storytellers of funds of funds?
The answer is not positive. One of the misleading slogans of hedge funds and funds of funds is that ‘your money is actively managed around the world’. Actively in what?
And how much is this costing the investor in terms of fees and assumed risk? Heavy charges, the merchandisers of risk say, are largely to reward investment skills. In the 2000 to 2002 time frame, however, investors have lost heavily.
The average UK equity retail fund has been down some 40 percent over that period, and
The typical UK company pension fund has suffered a cumulative negative return of about 25 percent.7
For their part, corporate pension funds are subject to the ups and downs of the firm itself and of the industry sector to which it belongs. Mid-January 2003 Fitch Ratings warned that US domestic airlines had a funding gap for pension obligations of $18 billion, a steep change from 1999 when they were overfunded by about $1 billion.
Shortly thereafter American Airlines, the largest US carrier, underlined the sorry state of the sector’s underfunded pensions when it said it would take a $1.1 billion charge to equity to cover its pension liabilities.
American’s pension problems came alongside its worst annual loss of $3.5 billion, with losses of $529 million in the fourth quarter of 2002 alone. Don Carty, its chief executive, admitted it remained a treacherous time for the company and emphasized the need for a quick reduction in labor costs to put the airline on a sustainable footing aimed at its continued survival. The call for deep cuts, of 20 percent or more in wages and other benefits, came a couple of weeks later, on 4 February 2003.
For its part, to cut its huge pension fund deficit, estimated at $18 billion, in the last week of June 2003 General Motors (GM) sold $10 billion of debt in the unsecured and convertible debt markets. Its fully owned auto financing subsidiary, General Motors Acceptance Corporation (GMAC), planned to sell an additional $3 billion.
In London, several investment experts were surprised that GM’s bond issue has been oversubscribed, raising more than $16.5 billion in the bond market. While GM’s bond sales seemed to satisfy yield-hungry investors, others remained worried about the financial outlook for auto manufacturers. ‘Do we in our heart of hearts, want to lend to GM for 15 years? I don’t think so. Pricing may affect that, but there are a lot of risks’, said Dennis Gould, head of UK fixed-income at Axa Investment Managers in the UK.8
The bonds issued by GM to plug the huge hole in the treasury of its pension plan had also the distinction of being the biggest corporate debt-raising exercise up to that date. To attract investors GM had priced the issue at an attractive level. Contrary to
offered about 100 basis points above the yield on similar bonds, in multiple tranches of debt denominated in dollars, euros and pounds sterling.
For instance, in the sterling market GM raised £350 million ($630 million) through a twelve-year bond that yielded almost 4 percentage points above benchmark gilts. With this and other offerings, the value of auto debt, which fell sharply in 2002 because of the problems of the motor vehicle industry, rose in 2003 as investors sought higher- yielding securities. Pricing several hundred basis points above government securities has been helped by the fact that interest rates for dollar-denominated instruments have dropped to forty-five year lows.
Given that in America the largest part of pensions is covered by company pension plans, what happens when these firms go bust? The answer is that the retirees are taken care of by the Pension Benefit Guaranty Corporation (PBGC), albeit at cut rates. This is a quasi-governmental agency that insures America’s private, defined-benefit company pension plans, but PBGC, too, faces financial problems. As 2003 came to a close, massive costs saw to it that the pension plans insurer fell $7.6 billion deeper into the red, to a new record low.
The PBGC reckons that another $85 billion in pension deficits can be found in the books of the country’s most shaky companies, while Corporate America, as a whole, has a pensions deficit of some $350 billion. This is worrisome because, technically, the US government does not stand behind PBGC with ironclad guarantees. Yet, nobody believes that the PBGC, which insures the pensions of 44 million voting Americans, would be allowed to collapse.
According to some experts, particularly worrisome is the fact that because pension accounting is complex, it is very difficult to determine whether or not a firm’s pension fund is solvent. ‘Creative accounting’ practices, too, enter the picture, with incentives for firms to invest in assets that make their bottom lines look good at the expense of longer term stability.
Perhaps the most damaging and urgent problem, is a mismatch between corporate pension plans’ heavy investment in equities versus risk-free sovereign debt of Group of Ten countries, to the tune of almost 60 percent of pension plan assets in 2002. During the 1990s, bond investments by pension funds were minor. To right the balances, on 29 January 2004, the PBGC announced that it would shift more of its assets from equities to bonds9– a very much delayed measure.
Can the problems facing public and private pension plans be fixed? On 30 March 2004, a group of leading pensions experts were summoned to 11 Downing Street and asked to improve the standards for governing the £800 billion ($1.5 trillion) held in UK pension funds. At the core of this meeting was the Myners review carried out by the former Gartmore chairman, Paul Myners. In 2000, this was set up principally to examine why pension funds were not investing in small businesses.
Myners reported his findings in 2001 and said the knowledge and expertise of the trustees that were appointed to look after company pension funds and make decisions on how funds were invested needed to increase. Behind this suggestion has been the facts that:
Most pension funds are invested heavily in equities, and
As stock markets have collapsed in recent years, this policy has left them with deficits
At the aforementioned meeting, the British government spelled out which areas the industry must work on. Its main concern seems to have been that not enough progress is being made in educating trustees on where to invest the assets which they supervise and for which they are responsible.
Trustees have a hefty responsibility as every penny counts in the pension fund.
Wherepension funds invest their assets is the biggest decision they will make, and it has to take appropriate account of the liabilities of the pension management industry.
This is the problem faced by every saver and investor. Another concern is that many pension fund trustees are highly reliant on consulting actuaries and employee benefits companies, which earn huge fees from advising trustees on how to run their schemes.
Still another concern has been that:
Trustees assess investment performance on a short-term basis, which can lead to wrong longer-term decisions.
As we will see in Chapter 9, the investment horizon is one of the challenging problems faced by all managers of assets – from retail investors to professionals. The retirees’
and potential retirees’ time horizon defines the pension fund’s cash outflow, and its trustees should appreciate that the sure way to kill any business is for it to run out of cash.
One of the themes which seems to have concerned the participants of the Downing Street meeting is that many companies today are battling against the rising costs of their pension funds. They are closing down pension schemes and cutting back on the retirement promises they have made to staff. In the UK alone, up to 60 000 workers, some having contributed to their company pension plans for decades, are already facing penury in retirement:
After their companies became insolvent, and
The pension plans were unable to meet pension commitments.
This is, indeed, a universal problem and, as such, it underlines the need for a personal investment plan, or at least one which is closely supervised by the interested person.
Governments, companies and the working population should appreciate that the years of complacency about pensions – classically seen as part of entitlements – are gone.
As the Geneva Association aptly suggests, the burden an increasing old-age dependency places upon societies is heavy. A smaller and smaller proportion of the working-age population has not only to generate the goods and services to be consumed by retirees but also to pay for them, and the weight of this task is all too real.
One only needs to look at the widely available tables on forecasts of old-age depend- ency ratios in the most developed countries to get some idea of the magnitude of this issue. The situation is likely to become even worse since, according to the experts, sev- eral of the less developed countries may be underestimating the fiscal and economic consequences of population ageing, given that their official population projections assume that current trends in longevity and fertility will substantially reverse.
It is not that the world is running out of money. To use an allegory, the Stone Age did not end because of a lack of stone, but because there was a phase shift in society. In the same way, there is a phase shift in the financing of retirements, of which individual investors, institutional investors and governments must be fully aware.