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Your pension promise.

Are you making the right promise to your employees for their retirement? One two-letter word makes all the difference. Take a look at the statistics.

What pension promises has your company made to its employees? Most firms promise to provide a given income replacement ratio, usually targeting 65 to 75 percent, on retirement. But is that the right promise to make? Or should the promise be to provide a given standard of living in retirement?

Of course, the difference in these two small words, on and in, is a bigger and more powerful word called inflation. Look at it this way: At age 63, which is the typical actuarial retirement age that companies have adopted for their workers today, the average life expectancy is around 18 years. Over those 18 years, inflation will take place. During that period, a 4-percent inflation rate, for example, will cut a retiree's purchasing power in half to 49 cents on the dollar if you've paid on retirement. A 6-percent inflation rate will cut your promise from $1 to 35 cents. And an 8-percent rate will cut it to 25 cents.

For Corporate America as a whole, the average pension plan participant is 40-1/2 years old. Over the past two years, that average age has been stable. The workforce isn't getting older; it isn't getting younger. And that average participant has worked for his or her company for 11.8 years. That is up very modestly but is essentially stable.

If you assume this average participant will work another 18.8 years until he or she is eligible to retire--the remaining active service life assumption--and you add 18.8 to 40.5, you come up with only 59.3 years. But your retirement age assumption is 63. What happens in those four intervening years?

In the aggregate, 66 percent of the workforce now has a vested benefit. Two years ago, only 59 percent did. So, even though the average working life hasn't extended, you've improved the vesting.

The other characteristic of the workforce is there are both retired and active components. Of the total workforce, 21.6 percent are currently retired. These retirees are already drawing on the pension promise. That's also been relatively stable over the past two years.

But what about investments? A year ago, the average corporation was expecting its investments to earn 9.4 percent long term. And almost one-quarter of companies expected their investments to earn more than 10 percent. But interest rates have fallen dramatically in the last 12 months. Companies will have a hard time earning 9.4 percent if long-term bonds are under 7.5 today and equities are sporting high P/E multiples.

The typical company assumes inflation at 5.7 percent. (That's the 6 percent I mentioned earlier that makes a dollar today worth 35 cents for your participants near the end of their retirement.) Firms discount their liabilities at 8.7 percent and their plans are overfunded--so overfunded, in fact, that the cash flow of defined benefit plans is becoming increasingly negative. In 1990, for instance, there was $20 billion negative net cash flow; in 1991, that grew to $30 billion. That's almost 4.5 percent of assets for the average fund.

Turning to retirees, the benefits that firms pay to all participants average $520 a month. In the past two years, that hasn't changed. However, companies are giving new employees more--as much as $815 dollars a month, up 5 percent over the past two years because employees' incomes are up and firms are trying to provide a replacement ratio on retirement. So new participants get a higher benefit, but still probably not equal to inflation over the past two years.

While these figures represent Corporate America in the aggregate and not individual companies, the kind of question companies are asking is the same: What should an investment policy be for a fund where the average employee is, say, 41 years of age, the pay-in period is 21 years and the pay-out period is 18 years? If you're in your firm's defined contribution plan with these bullet characteristics, you'd go all equities. But since more than 20 percent of the company's workforce is retired and currently drawing benefits, the mix is a little different. So what should be your investment policy?


What progress have we made? The most noteworthy is that the pension industry's professionalism is expanding. Plan sponsors are managing their pension fund portfolios much more efficiently than they did just a few years ago.

We're coming off one of the greatest bull markets in history, both in size and in duration. And, on average, pension plans are now overfunded. So haven't we won the game, with so many plans overfunded? Well, yes and no. Yes, we've won the game if the pension promise is to provide a replacement ratio on retirement. But we've lost the game if the promise is to provide a certain standard of living in retirement.

How many companies have taken seriously the promise of providing a standard of living in retirement? About one-third. In 1991, 14 percent of the corporations surveyed by Greenwich Associates raised benefits for retirees. In 1990, 12 percent raised benefits. In 1989, 10 percent raised benefits. But, in the past five years, more than 50 percent have not raised benefits at all for their retirees. And 25 percent have never raised benefits. So one-fourth of the companies are clearly making their promise on retirement, a third are making the promise in retirement and the rest aren't sure.

The impact of this decision is immense. Take, for example, my 84-year-old mother. My father died when she was 57. He was 62, so he TABULAR DATA OMITTED hadn't retired. He had worked for a progressive company that promised its plan participants a certain standard of living in retirement. So, while my mother started with a pension of $235 a month, she now receives more than $700 a month and can maintain her living standard.

My mother has a friend whose husband worked for a firm that has never raised its benefits. She started out earning $275 a month and still earns that. Of course, her standard of living has declined and she's now separated from many of her friends because she can't afford to participate in all their activities. She'd thought the golden years would be great, but they haven't been and they're getting worse.

One step many companies have taken to help their employees prepare for retirement is to set up defined contribution plans. These plans are another leg to the pension stool, along with social security, which everyone knows is in trouble, and defined benefit plans. But the defined contribution plan isn't a substitute for defined benefits.

So far, the pension industry has pursued three strategies to win the on retirement game. Unfortunately, the strategies probably aren't going to help companies win the in retirement game.

* First, plan sponsors have taken control of the asset mix. The asset mix is the single most important decision in the management of pension finds. The impact of this decision dwarfs all of the trading decisions about which fund managers to hire and which managers to fire.

For example, a 5-percent shift in the equity ratio can raise a fund's returns by 25 basis points. So, by raising the equity ratio by 8 percent, you can pay all the management fees you now pay to your investment managers. That's not an insignificant amount when capitalized and multiplied over an 18-year expectancy.

Indeed, plan sponsors have been raising the equity ratio in the typical corporate fund. In 1988, the average fund we surveyed was 54 percent in equities. In 1991, it was 58 percent. And research shows that, by 1994, it will be 61 percent in equities, up 7 percent in six years. Six percent of the fund has been invested abroad in foreign securities. That's good, because it increases the efficiency of the assets managed. But, given a 21-year pay-in period and an 18-year pay-out period, is a 60/40 mix right?

Look at this example. In the U.K., the average pension fund is 80 percent in equities. But U.K. companies more often make an in retirement pension promise than an on retirement promise. Their funds benefited enormously from gains in equities in the 1980s, but U.K. plan sponsors look at the process very differently. Inflation is a part of their mentality, unlike the mindset of U.S. sponsors.

It's true that, if all pension funds move to a 75/25 mix, companies could be raising benefits for their retirees to meet the in retirement standard--probably without a cost to the company. But does that make sense?

* Second, plan sponsors have diversified their investments to create more efficient portfolios. Not every approach they've tried has worked, but many have.

Today, 51 percent of pension funds invest in small-cap stocks, and the percentage is rising. Forty-one percent invest in international securities, and that percentage is rising. Forty-three percent invest in real estate, and that's expected to decrease. Twenty-three percent invest in venture capital, and that's steady. Seven percent invest in LBOs, and that's steady. And 7 percent invest in junk bonds, and that's steady.

Because of this diversification, pension plan sponsors could do one of two things: raise the equity ratio and hold the risk the same, or reduce the risk of the portfolio at the given equity ratio. Either option was good, but not without cost.

* Third, plan sponsors implemented structural changes, via specialists, to identify the "best-of-breed" manager in each investment area--small cap, international and the like. Of course, this strategy was costly in fees. Over the past three years, for example, assets of the typical pension fund are up 25 percent but the total fees are down only 2 basis points, from 43 to 41. Normally, when assets are up 25 percent, they come at the low end of the decremental fee schedule. But because sponsors pursued diversified investment initiatives and looked for the best of breed, total fees aren't coming down much.

The results of these three changes? Companies are overweight in the diversification of their fund managers. They're overweight in the fees they pay their managers. And they're undernourished in equities overall.


Sure, it's been fun over the last few years. Most managers have grown professionally. Most companies have improved their asset management. But pension promises still focus primarily on the on, not the in, retirement standard. Now firms have the resources to move to a higher promise if they choose. How can you help your company do it?

* First, get senior management more deeply involved in two issues they probably don't understand as fully as they should. One is to clarify the promise: Is the promise the on-retirement promise, or should it be the in-retirement promise? The other is to consider raising the equity ratio as a way to pay for the promise. These issues are inextricably linked.

The problem is they're such central, deep-rooted issues that senior management can't address them in the classic, American style of decision-making, in which someone makes a half-hour presentation, management discusses the issue for 15 minutes, then they're forced to make a decision so they can move on to another agenda item. These pension issues won't change with that kind of decision-making.

Try, instead, to take your management off site for two days, to immerse them in enough detail about your company's pension promise and asset mix, to make them really think about what your company is doing. You have the body of knowledge, and they need to learn from you. Convince them of the value in thinking more critically about their employees and about Corporate America.

* Second, restructure tactically and strategically the nature of the relationships you have with your fund managers. Tactically, shift your managers' role from one of a supplier to one of a partner. A fund manager should be your partner in knowledge, working with you on managing the asset mix and diversifying investments, on making shifts in your asset allocation at propitious times. Your managers know a lot about these issues, not only from a historical point of a view but from a futures point of view.

Strategically, begin forging partnerships with those managers who pass the best-of-breed test in multiple investment disciplines, not with those who pass the test in only one discipline. Ask these firms to manage a strategic portion of your fund. And, as part of the firms' responsibilities, insist that they counsel you on shifting assets from overvalued areas to undervalued areas, both within the strategic portfolio and possibly outside it--and that they do so at a fee that reflects the value of the work done, the contribution they make, and the scale of the assets they're managing.

* Third, adopt a global perspective for your foreign pension funds. Research shows that 31 percent of the largest corporations have a foreign-funded plan. But most of these plans aren't managed efficiently by U.S. standards and could benefit from your introducing American technology, which is far superior to technology in other markets, to the management of these assets.

Mr. Smith is a partner with Greenwich Associates in Greenwich, Connecticut.


If you think we've got a problem in defined benefits, look at defined contributions. In defined benefits, funds are 60 percent in equities; in defined contributions, funds are 40 percent in equities. Of the latter 40 percent, the vast majority isn't diversified. It's invested in company stock. That's great if you've worked for Merck for the past 15 years, but it's not so great if you've worked for one of the basic industrial companies whose stocks haven't done much more than provide a dividend for ten years.

The real problem is most of the people with investments, who are young, are very heavily invested in fixed-income plans. These plans aren't for retirement but for savings, to buy a car or buy a house. They're tactical, short-term assets. In that context, they need to be fixed income. But plan sponsors are shifting them over to become retirement plans without shifting the asset mix.

From the asset mix point of view, companies aren't providing nearly enough in retirement income. They're not diversifying enough, and they're enabling an employee to shoot himself in the foot from an investment point of view. For instance, who's less able to make investment decisions about the timing of investments from equities to bonds to cash than the employee who works on the shop floor or in the office? If our best investment professionals in America can't make these kinds of decisions, why do we think employees can?

We need much more communication. We need more education. Just think of what companies could do for their employees, not to tell them what to do with their money, but to help them understand their investment choices.

So is giving employees asset classes from which to choose the right way to structure investment options? Why not redesign the communications so you say to employees, "Your first decision is what replacement ration you'd like on retirement"? Most will pick 65, 70, or 75 percent. Then say, "Your next decision is how much money you want to save. If you invest in bonds, you can save 15 percent of your pay. If you invest 50/50 in bonds and equities, you can save 10 percent of your pay. If you invest all in equities at age 25 (which is where the entry-level person is), you can probably save 6 percent of your pay. How much would you like to save?" Instead, we now ask, "How much would you like to see the value of your account go up and down?"

We've got the business all backwards, because nobody has really focused on it. It's shifted from a savings business to a retirement business, and we haven't thought about how to deal with the issue. But we better decide soon, because we're starting to create a very cruel hoax on the young.
COPYRIGHT 1992 Financial Executives International
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Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Pension Fund Management; includes related article
Author:Smith, Rodger F.
Publication:Financial Executive
Date:Nov 1, 1992
Previous Article:Europe after Maastricht.
Next Article:Build a framework for risk management.

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