No place like home?

These days, plenty of pension plans are stepping up their overseas investments. Gillette's treasurer says, "Don't bother." But two investment advisers claim plan sponsors can't afford to stay away.

CON

GILLETTE'S DOMESTIC BENT

by Lloyd Swaim Vice president and treasurer The Gillette Co. Boston [phone]

While many studies suggest retirement and 401(k) plan sponsors are increasingly interested in international investment, some of us remain unconvinced that overseas markets necessarily bring enhanced returns. The rush to embrace international assets may be partially attributable to pension-management executives who focus only on investing assets without considering the overall business context of the enterprise sponsoring the pension plans. At The Gillette Co., we recently decided against international investments for our U.S. retirement plan. At the same time, however, we did decide to offer international investment options for employees under our 401(k) plan.

Our analyses for our retirement plan showed the return from international investments is significantly affected by currency movement against the U.S. dollar. The liability of our U.S. pension plan is in U.S. dollars, so why mismatch the assets and liabilities? In our business activities, we carefully watch our exposure to currency movement, and we saw no reason not to follow the same strategy in managing our U.S. pension assets.

We also considered the relationship of currency movement to our overall business. With more than 70 percent of our sales and earnings outside the United States, this is an important question for Gillette. Generally, the dollar strengthens when interest-rate differentials between the U.S. and international markets move in favor of the dollar. A strengthening dollar hurts the translation of our international results, but higher U.S. interest rates also suggest higher inflation, so this currency shortfall may be offset by higher pricing in the United States. When the dollar strengthens, the currency component of returns from international investment funds would generally cause a lag vis-a-vis U.S. investment fund returns and so could compound our business problem.

In the converse case, if the dollar is weakening, it means relatively higher interest rates and inflation rates abroad. While the currency component of international investment returns should then be superior to U.S. investment returns, it's not as important in our total profit picture, because our international business should then be strong, due to inflation pricing actions as well as currency conversion. The key point? The international investment option is really two investment strategies: investment in non-U.S.-based companies and investment in international currencies.

Some of our overseas subsidiaries have pension plans, and in this case we do see a matching of assets and liabilities. There may be diversification in some of these plans' funding policies, but this is as much a lack of development of the local markets as it is a diversification decision. In reviewing whether the U.S. plan needs to diversify, we see the company as a whole is already diversifying in that it manufactures products in countries outside the United States, and these employees' pensions are funded with mainly non-U.S.-dollar investments.

The Big Picture on Returns

                   Average annual returns for period ended 12/31/96
Index                  1-Year         5-Year           10-Year

S&P 500                22.9%         15.2%             15.3%

MSCI-EAFE Index(*)      6.1%          8.2%              8.4%

MSCI-EAFE Index        11.8%          5.6%              NA
(hedged)

* Morgan Stanley Capital International - Europe, Australia and the
Far East Index

Source: Mellon Trust

Also, we achieve the goal of investing in international business almost by default, because we invest in many Fortune 500 global companies. Coca-Cola, DuPont, Merck, Johnson & Johnson, Exxon and GM, not to mention Gillette, are all companies with a large portion of their business in international markets.

MEASURE FOR MEASURE

Diversification to reduce asset return volatility is one of the major arguments for international investment. Again, we believe volatility shouldn't be measured on the asset side alone but on the combined asset/liability model. If interest rates rise, investment returns suffer, but at the same time, the present value of liabilities falls because of a higher discount rate. The true volatility, of the pension expense charge is measured in this asset and liability change.

We might be tempted to rationalize away such concerns or hedge out the currency component if history showed superior results from an international investment strategy. But as the table below shows, the statistics don't bear this out.

Note that the hedged strategy, which removes the currency element, still lags the S&P performance. Of course, you can choose to use a narrower investment strategy and concentrate on particular countries or emerging markets, and the result may be different, but the historical comparisons aren't convincing.

Given our philosophy, you might wonder why Gillette chose to expand its menu of 401(k) options to include international alternatives. The answer lies in the nature of a 401(k) plan: The participant - not the company - determines the investment allocations. When we conducted focus groups, our employees said they wanted to be able to invest in international funds.

We've chosen two funds for employees to consider: an international fund and an emerging-markets fund. Because of the inefficiencies in emerging markets, the latter may be the riskiest investment choice, but it may also offer the highest possible returns. It'll be interesting to see how many of our employees eventually choose these international options, and it'll be a challenge for our employee investment education program to present the pros and cons of international investment. So far, after a couple of months, just over 1 percent of our participants are investing in these international funds. Other companies we've talked to haven't seen a large number of employees selecting international funds, but time will tell.

PRO

EXPAND YOUR HORIZONS

by Agustin J. Fleites and Luis E. Ferreira Principal and investment officer (respectively) State Street Global Advisors Boston [phone]

After the lackluster performance of international markets in recent years, coupled with the strong performance of U.S. stocks, pension plan sponsors are becoming increasingly concerned about the role of international equities in their participants' retirement programs. Over the last 10 years, the S&P 500 has produced annualized returns of 15.3 percent (as of year-end 1996), compared to a relatively insignificant 8.4 percent for the Morgan Stanley/Capital International EAFE Index, a popular international equity benchmark that comprises developed equity markets in Europe, Australia and the Far East.

But the old adage about not putting all your eggs in one basket still holds true. Despite poor returns recently, offshore allocations continue to provide the risk-reduction benefits of diversification. With average historical correlations of the EAFE Index to the S&P 500 fairly steady in the 0.40 to 0.45 range, plenty of opportunities still exist to either significantly reduce the risk of an equity portfolio by investing offshore or potentially increase portfolio returns without introducing any incremental risk. A 30-percent to 40-percent exposure to international equity, according to diversification theory, is the optimal allocation to minimize the volatility of the overall equity portfolio. In fact, a U.S. plan could hold up to 70 percent of its equity portfolio in international markets and still achieve the same level of risk as a 100-percent S&P 500 equity portfolio.

But diversification potential isn't the only reason to consider investing in international equities. In the 1970s, U.S. equities represented 60 percent of the world's equities market. That figure is currently 40 percent. It's becoming more difficult to ignore the increasing investment opportunities available offshore. Plus, while U.S. corporate earnings are expected to grow at 18 percent over the next year, projections for Japan are for 40-per-cent growth over the next year, and those for Europe are at over 20 percent. Overall, developing economies are forecast to grow at more than 7 percent annually over the next five years, vs. 2 or 3 percent for developed markets. Clearly, opportunity now favors international markets.

Plus, stocks in the United States are trading at very high multiples. The price/earnings ratio on the S&P 500 is 18 times earnings, a premium to historical levels of about 15 times earnings. Continued strength in corporate earnings prospects continue to support the market. Growth prospects, however, are closely related to economic growth. The possibility of a slowdown in the economy would weight heavily on stock prices at current valuation levels.

Allocations to international markets do introduce an element of currency risk not present in U.S. equities, mainly the risk of an appreciating U.S. dollar, which can result in lower translated values for investments denominated in foreign currencies. While the market for foreign exchange is one of the most efficient in the world, currencies tend to move in long cycles that turn when they've gone significantly beyond fair value.

The fact that currencies can move for protracted periods beyond fair value is partly attributable to the strength of momentum factors in the markets and also to the difficulty of identifying fair-value levels. Academic valuation tools like purchasing-power parity and interest-rate parity require that purchasing power be equivalent, regardless of what currency it's denominated in, and real interest rates, over the long run, should also be consistent across currencies. With capital moving freely across the foreign-exchange markets, exchange rates do achieve interest-rate and purchasing-power parity over the long run. Currency hedging strategies can minimize volatility in the short term, especially in an appreciating dollar environment.

THE MILLION-DOLLAR QUESTION

What's an appropriate allocation to international markets? This is the million-dollar question. Efficient-markets theory argues that international equities should represent upwards of 30 percent of an investor's equity exposure. Institutional investors are nowhere near these levels. Defined-benefit plans have increased their exposure from below 5 percent in the early 1980s to between 10 percent and 15 percent today. If investors are willing to accept short-term currency volatility, such allocations aren't unreasonable. Allocations much below 10 percent will preclude many of the benefits of overseas investing.

Our current outlook on international markets suggests keeping an eye on Japan, which is trading at record low multiples because of continued concern over the banking sector, deregulation and a slow economic recovery. Low interest rates, in addition to attractive valuations and strong earnings growth expectations, make Japan a strong buying opportunity. Equity valuation levels across Europe are also attractive, and Latin American countries, which will continue to benefit from low U.S. interest rates, are good

[INCOMPLETE TEXT FROM ORIGINAL PUBLICATION]