pension fund perspective: inflation and the pension fund asset mix

CFA Institute

Pension Fund Perspective: Inflation and the Pension Fund Asset MixAuthor(s): Patrick J. ReganSource: Financial Analysts Journal, Vol. 36, No. 2 (Mar. - Apr., 1980), pp. 16-17+80Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478325 .

Accessed: 16/06/2014 17:49

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 185.2.32.134 on Mon, 16 Jun 2014 17:49:28 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=cfa

http://www.jstor.org/stable/4478325?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


Penulun fund Perupeclime BAs

Inflation and the Pension Fund Asset Mix The 1960s were the growth decade, and pension funds gradually shifted from bonds and blue chip stocks to glamour issues. The 1970s were the income decade, and the emphasis returned to bonds and high yielding stocks. Now, only a couple of months into the 1980s, the new trend seems to be toward natural resource stocks whose underly- ing assets can provide a hedge against inflation.

The first two months of 1980 were characterized by an investment anomaly-a plummeting bond market accompanied by a robust stock market. At the end of February, the yield spread between stocks and bonds was a record 600 basis points in favor of bonds. According to some commen- tators, these trends were accentuated by pension fund managers altering their asset mixes, selling bonds and buying stocks. For example, the administrators of the General Motors pension fund-at $10 billion, one of the largest in the nation-announced that they would increase their equity/debt mix to 70/30 from the current 50/50.

Many reasons underlie this shift in pension fund asset mix, but inflation is the most important. As inflation rates rose through the 1970s, plans steadily boosted their actuarial assumptions for projected salary growth and investment returns. However, as we noted in this column in the September/October issue, plan sponsors tended to increase both key actuarial assumptions by equal increments (e.g., the interest rate assumption might have been raised from six to seven per cent as the salary assumption was increased from five to six per cent).

This procedure benefited the plans with mature work forces, because the increase in the salary growth assumption applied only to the active work force, while the increase in the interest rate or investment return assumption affected all plan members, retired or active. The net effect was to reduce pension costs and liabilities and, the higher the ratio of retired to active members, the greater the reduction.

During the 1970s, the typical interest rate assumption jumped from approximately four per cent to seven per cent.

Over the same 10 years, the Salomon Brothers high grade corporate bond index grew at a 6.2 per cent compound rate, outpacing the Standard & Poor's 500 stock index, which grew at only a 5.9 per cent annual rate. Unfortunately the Consumer Price Index beat them both, rising at 7.4 per cent. Over only the last five years, however, the returns

have been 5.8 per cent for bonds and 14.7 per cent for stocks (with the CPI at 8.1 per cent). In this latter period, the equity-oriented portfolios have been exceeding the average actuarial assumption-and the inflation rate- while the same cannot be said for fixed income accounts.

Two other factors had spurred pen-

The Energy Systems Company. Helping to find and bring in oil and gas.

Upgrading and building refineries and petro- chemical plants. Developing cleaner, more efficient ways electric utilities can use coal. Demonstrating safe, reliable ways of harnessing nuclear power. And leading the way in the development of alternative fuels.

No other company has Combustion Engineering's broad range of capabilities for helping energy-related industries meet the challenges of the 80's and beyond.

COMBUSTION ENGINEERING

The Energy System Company For a copy of our latest report to shareholders, please write

Combustion Engineering, Inc., Dept. 7004-133, 900 Long Ridge Road, Stamford, Connecticut, USA 06902.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1980 [ 16



Table One Assets and Asset Mix of Private Non-Insured Pension Funds

(Dollars in Billions)

1979 1978 1977 1976 1975 1974 1973 1972 1971 1970

Assets (at market value) $201.5 $181.6 $173.9 $145.6 $111.7 $132.2 $154.4 $126.9 $104.7

Asset Mix Stocks 53% 56% 62% 60% 56% 68% 73% 68% 62% Corporate Bonds 24% 24% 22% 24% 28% 21% 17% 21% 24% Other 23% 20% 16% 16% 16% 11 % 10% 11 % 14%

1969 1968 1967 1966 1965 1964 1963 1962 1961 1960

Assets (at market value) $94.6 $96.0 $85.4 $72.8 $72.9 $63.9 $54.6 $46.7 $45.3 $37.1

Asset Mix Stocks 63% 63% 59% 53% 55% 52% 49% 45% 49% 43% Corporate Bonds 22% 23% 26% 31% 30% 32% 34% 37% 35% 39% Other 15% 14% 15% 16% 15% 16% 17% 18% 16% 18%

1959 1958 1957 1956 1955

Assets (at market value) $32.4 $28.2 $22.7 $20.0 $18.1

Asset Mix Stocks 43% 38% 30% 32% 30% Corporate Bonds 39% 42% 47% 43% 43% Other 18% 20% 23% 25% 27%

Source: Securities and Exchange Commission

Table Two Net Financial Acquisitions by Private Pension Funds (Dollars in Billions)

Total Net Net % of Net Cash Available Purchases Cash Flow for Investment of Equities to Equities

1969 $6.3 $5.4 86% 1970 6.9 4.6 67 1971 7.1 8.9 125 1972 6.7 7.3 109 1973 8.3 5.3 64 1974 10.7 2.3 21 1975 11.8 5.8 49 1976 11.2 7.3 65 1977 17.7 4.5 25 1978 19.6 5.3 27 1979 Quarters(a): 1 Qtr 17.5 8.7 50 2 Qtr 24.2 13.4 55 3 Qtr(P) 20.8 12.0 58

(a) Annual rates. (P) Preliminary. Source: Kidder, Peabody, from SEC data.

sion fund interest in fixed income securities in the 1970s. The first was the insurance industry's development of the Guaranteed Investment Contract. This contract fixed the total return for a specified period of time (generally five years), but the holder of the contract did not have to mark it to a market value to reflect fluctuations in interest rates. In addition, some legal experts believed that GICs offered corporate directors better protection than bond portfolios from lawsuits over ERISA's fiduciary responsibility requirements. These two characteristics, along with

guaranteed rates in excess of nine per cent, accounted for the popularity of GICs. The other major factor in the 1970s was the growth of the U.S. government securities market, due partly to the record level of interest rates and government deficits and partly to the proliferation of new agencies and investment vehicles, such as the Gov- ernment National Mortgage Associa- tion's mortgage pass-through certifi- cates.

Past Trends in Fund Asset Mix The shift in pension fund assets

away from equities and toward fixed

income vehicles during the 1970s was a major change following two decades of movement in the opposite direction.

The Securities and Exchange Com- mission has for many years conducted an annual survey of the asset mixes of private non-insured pension funds. The book value or cost figures date back to 1950, when the total assets of private non-insured pension funds in the United States were a mere $6.5 billion. Of this total, only $802 million, or 12 per cent, were invested in common stocks, while $2.8 billion, or 44 per cent, were in corporate bonds and $2.0 billion, or 30 per cent, in U.S. government securities.

By 1955, with the bull market in stocks well under way and the book value of pension assets up to $16.1 billion, 49 per cent of pension assets were invested in corporate bonds, 21 per cent in common stocks, 19 per cent in U.S. government securities and 11 per cent in other assets. That was also the first year that SEC computed the market value of pension assets. Their $18.1 billion market value exceeded their book value by two billion dollars. The entire difference was due to the un- realized gains on common stocks. On a market value basis, corporate bonds accounted for 43 per cent of pension assets, while common stocks com- prised 30 per cent, U.S. government securities 16 per cent and other assets 11 per cent.

As shown by Table One, the market continued on page 80

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1980 ? 17



Pension Fund Perspective conduded from page 17

value of private non-insured pension assets has grown at approximately 10 per cent a year since 1955. In only four years did the market value decline-by negligible amounts in 1966 and 1969 and by 14 and 15 per in 1973 and 1974. But the striking feature of the table is the shift in asset mix over the years. The portion of the total portfolio accounted for by common stocks rose from 30 per cent in 1955 to over 40 per cent in 1959, 50 per cent in 1964, 60 per cent in 1968 and 73 per cent in 1972. During the same period, corporate bonds declined steadily from 47 per cent of the total portfolio in 1957 to a low of 17 per cent in 1972. Meanwhile, other assets dropped from 27 per cent of the portfolio in 1955 to 10 per cent in 1972.

Between 1972 and 1978, these trends reversed themselves. Stocks fell from 73 to 53 per cent of the aggregate portfolio, corporate bonds rose from 17 to 24 per cent, and other assets increased their share from 10 to 23 per cent. The major swing factor in the "other assets" category was U.S. government securities, which dropped from 16.3 per cent of the portfolio in 1955 to a mere 2.4 per cent in 1972, then rose to 11.0 per cent in 1977. The re- bound was due to a narrowing of yield spreads between corporate and government bonds, as well as to the proliferation of securities issued by various governmental agencies.

The figures indicate that the asset mix of pension portfolios changes slowly. The rise and fall of stock prices accounted for some of the shift in asset mix, but most has been due to the allocation of net pension contributions. Table Two lists the net cash available for investment (after payment of pension benefits) by private non-insured pension funds. Between 1969 and 1972, the amount available was relatively constant in the $6.3 to $7.1 billion range. In 1973 there was a sharp increase to $8.3 billion-the reason being that just prior to ERISA, many plans liberalized their eligibility and vesting provisions to comply with the new law. From 1974 to 1976, net cash ranged from $10.7 to $11.8 billion; since 1977, the range has been $17.7 to $20.8 billion. The increases in 1974 and 1977 followed the three-year cycle for major labor contracts.

Pension fund administrators have been criticized for their poor investment timing. Throughout most of the 1950s, they held more corporate bonds than stocks, thereby missing one of the great bull markets in equities. Even during the 1960s their commitment to stocks was generally less than 60 per cent. It wasn't until 1972-73, when the stock market was peaking, that the

pension funds allocated more than two-thirds of their assets to equities.

Table Two indicates that, until 1979, the amount of dollars allocated to equities by the pension funds was relatively constant-from $4.5 to $5.8 billion in each of the years 1969, 1970, 1973, 1975, 1977 and 1978. However, with the increase in net cash available, a constant allocation to equities has re- sulted in lower and lower percentage allocations. The heavy commitments to equities, displaying poor investment timing, occurred in 1971, 1972 (over 100 per cent of net cash available, as bonds were liquidated to buy stocks) and 1976. The unusually low commitment coincided with the market bottom in 1974.

Secular Trends Why have the pension funds had

such a dismal record in the area of investment timing? Part of the answer lies in the secular changes that affected all defined benefit plans in the mid- 1960s.

During the 1950s and the first half of the 1960s, inflation in the United States rose at a modest one to two per cent rate each year, while the stock market advanced at approximately a 15 per cent annual rate. Plan sponsors felt they could afford to liberalize retirement benefits and use stock market profits-rather than company contributions-to pay for the increases.

One of the major changes attendant upon this development was a shift from a "career average" to a "final pay" type of formula. Under a career average method, an individual's retirement benefit is a function of his average earnings level over his entire career with the sponsor. In a final pay plan, it is a function of his earnings over the final years-generally the last five-of service. Since most retirees have 15 to 30 years of service, this shift to the final five years made the retirement benefits much more sensitive to changes in the rate of inflation.

The great miscalculation of the 1960s was the failure to anticipate the high inflation rates of the 1970s. Another negative factor was the attempt to index wages and pensions to the cost of living. By the end of the decade, COLAs, or cost of living adjustment clauses, were common in labor contracts; wages rose with each jump in the Consumer Price Index. Most pension plans are now of the "final pay" type, so inflation-induced increases in wages and salaries will continue to boost pension benefits and unfunded liabilities.

Perhaps the most serious current problem for pension plan sponsors is the trend toward post-retirement increases in benefits. Social Security benefits are indexed to the cost of living, and many government Pension plans

have for years been indexed so that retirement benefits (for retired military personnel, firemen and policemen) increase with the level of starting salaries for new employees in those job categories. In the private sector, a Bankers Trust study of 100 major cor- porations revealed that 81 per cent have granted increases to retirees over the last five years.

Pension planning has heretofore al- ways assumed that the present value of benefits owed to a retiree under a defined benefit plan could be determined on the date the individual retired. If the trend toward indexation continues, ac- tuaries will have to rethink the concept of a defined benefit pension plan.

In sum, pension funds have shifted to equities as an inflation hedge. The increase in final pay plans relative to career average plans, the COLAs won by the unions, and the trend toward post-retirement increases have made pension liabilities much more sensitive to changes in the rate of inflation. To the extent that today's low price- earnings ratios reflect the expectation of double digit inflation and a high dis- count factor, equities should regain a large share of pension fund portfolios in the 1980s. U

NOTE: This column is adapted from a chap- ter for the forthcoming book, The Hand- book of Dynamic Markets: Financial, Options, Futures, published by Dow Jones-Irwin and edited by Frank J. Fabozzi and Frank G. Zarb.

UTILITIES COMPANY

DIVIDEND INCREASED

The Board of Directors has declared a regular quarterly dividend of 44 cents per share on the common stock of the Com- pany, payable April 1, 1980 to shareholders of record at the close of business February 29, 1980.

R. E. FONVILLE Secretary

Dallas, Texas February 15, 1980

Electric Utility Subsidiaries:

Dallas Power & light Company Texas Electric Service Company Texas Power & light Company



pension fund perspective: inflation and the pension fund asset mix

Documents