December 2003

Feature:After the Perfect Storm

The Perfect Storm is behind us, common wisdom has it—certainly, a more benign equity market seems to have calmed the turmoil. However, the aftereffects promise to be with us for many years to come.

Analysis of data collected in the 2003 Fidelity Investments/PLANSPONSOR report on optimizing plan funding suggests the state of the pension industry has been affected structurally by the events that came together in 2001 and 2002 to vex the nation's pension funds—and, regardless of the future direction of the market and of interest rates, it is unlikely to be "business as usual" going forward. "Despite the improved performance of the equity markets in 2003, defined benefit plan sponsors continue to face significant challenges," says Drew Lawton, CEO and president of Fidelity Management Trust Company. "The widespread underfunded status of pension plans has caused many plan sponsors to question whether or not their long-term asset allocation and investment strategies continue to be appropriate. By partnering with PLANSPONSOR, Fidelity has been able to provide valuable benchmarking information, and a forum for dialogue, to assist sponsors and their consultants in addressing this important question."

The first—perhaps surprising—result of the Fidelity/PLANSPONSOR   study is that, as of August 2003, both public and private pension funds are significantly less well-funded than in mid-2002. In mid-2002, the study found that 55% of respondents were overfunded; this year three out of four plans were underfunded (see table 4). Moreover, 53% of plans surveyed changed their rate of return assumptions in the last 12 months, and the average rate of return change was -72 basis points.

However, it is the structural changes that plan sponsors are contemplating to their plans—changes that seem likely to be implemented regardless of whether funding ratios once more dip into the black—that leap out of the data. Corporate plans in particular are considering changes in plan design that were not on the table a year or two ago. At least half of all plans have considered cash balance or hybrid plans, changing to a defined contribution plan, and reducing pension, health, or other benefits (see table 1). That said, only 12% have considered or implemented a termination of the defined benefit plan. However, the willingness to put radical plan design options on the table (for instance, a third of the respondents said they would consider total retirement outsourcing if cost benefits could be demonstrated—see table 9) suggests that the shock of the rapid about-face from overfunded to underfunded status has deeply affected the institutional investment community.

Asset allocation also is undergoing a rethinking but, there, the change is more incremental. That said, the status of liabilities and funding is now the most important driver of asset allocation policy㬣% of respondents identify it as the single most important driver, compared to return targets (30%), and investment consultant recommendation (20%). In terms of specific asset classes, plan sponsors anticipate decreasing allocations to domestic equity and fixed income, and increasing allocations to non-US equity, real estate, and alternatives (see table 3). However, change is on the margin—the majority of respondents (86%) believe that the expected risk premium justifies a majority allocation to equities. On the fixed- income side, the anecdotal evidence that a more favorable attitude to longer-duration bonds has emerged is confirmed—while only 33% of respondents say that they have considered using long duration bonds as a hedge to liabilities, fully 35% of those considering this say they are very or somewhat likely to implement that strategy. Overall, nearly 90% of plans are considering new strategies to help their funding situation and more than half have implemented at least one.

With regard to alternatives, 23% of respondents say they are increasing their exposure; this is a far cry from the common wisdom that all and sundry are climbing into alternatives. Interestingly, 70% of respondents believe they cannot measure the risk of alternative investments—this is up from 55% in 2002. This translates into an alarming statistic from a fiduciary standpoint—fully 56% of plans with allocations to alternatives acknowledge that they cannot measure the risk of these investments.

Finally, an insight into the institutional mindset that can be interpreted as either an indication of wishful thinking or the intractability of the funding: Nearly all funds agree that the most promising solution to the funding crisis is market recovery. There is no widespread agreement that any strategy that lies within the powers of plans—whether it be asset- or liability-related—can lift pensions out of the present hole in which they find themselves.

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