Time & Attendance
By Timothy Inklebarger
Jul. 14, 2009
Corporate pension executives now more than ever are hunting for ways to cut costs.
Faced with high fees from hedge funds, poor returns from traditional active managers and sharp declines in their defined benefit plans’ funded status, corporate executives are looking to squeeze fees, adopt passive strategies and close or freeze their plans.
In their search to reduce expenses, many are focusing on fees charged by hedge funds. Those fees start at 2 percent of assets and 20 percent of performance and can range up to 5 percent and 44 percent.
David Bauer, a partner with Casey, Quirk & Associates in, Darien, Connecticut, believes fees for many hedge funds will decline over the coming months to 1 percent of assets and 10 percent performance, the levels charged about six years ago.
“[Two-and-20 fees] became the norm and people were willing to swallow them in a bull market, but particularly now given the performance, not only do the levels not work, but the structure doesn’t work,” Bauer says. “I think you’re going to see more alignment around the actual performance over a longer period.” For example, hedge fund fees could be based on a three-year rolling period, he says. “It’s not a blanket ‘one structure fits all’ anymore,” he says.
Charles Gradante, co-founder of the Hennessee Group, a New York-based consultant to institutional investors on hedge fund allocations, says he has not yet seen hedge funds lowering their fees across the board. He says the Hennessee Hedge Fund Index was down 19.2percent in 2008, but he estimates 9 percent of the loss was due to extraordinary events in September and October, such as the temporary ban on short selling financial stocks.
Gradante says hedge funds were up 1.09 percent year to date by the end of March, beating the Dow Jones industrial average, which came in -13.03 percent, and the Standard & Poor’s 500 Index, at -11.67 percent.
“Eventually, the pressure to reduce fees will be offset by the performance of hedge funds. If hedge funds don’t go back to historic performance levels relative to the S&P 500, fees will likely decline rapidly.”
Some pension funds are focusing more on passive strategies.
In a newsletter, Robert Arnott, chairman and founder of Research Affiliates in Newport Beach, California, and John West, director, product specialist at the firm, wrote that in 2008 a passively implemented 60/40 stock/bond portfolio outperformed the same actively managed mix by 3.4 percentage points, before fees.
“In short, we believe investors will favor simplicity over complexity, lower fees over higher fees, liquidity over lockups and transparency over opacity,” Arnott and West wrote in the firm’s March newsletter.
A February survey by Mercer of fee data on 19,000 investment products estimates the median fees for passive equity strategies are 50 to 80 basis points lower than those charged for active strategies. Passive fixed-income managers charged the lowest fees, costing an estimated 10 to 30 basis points less than active fixed income.
Carter Lyons, managing director in the Americas institutional business at Barclays Global Investors, San Francisco, says he is seeing a significant increase in demand for index funds, although he declined to give statistics.
Lyons says he expects more reallocations and rebalancing in the second half of 2009. “Plans will make decisions in the first half, but will likely implement more in the second half,” he wrote in an e-mail.
Some experts believe pension funds are focusing more on revamping their asset allocation and risk structure, rather than cutting fees.
Rich Nuzum, president and global business leader for Mercer Investment Management in New York, says pension executives are focusing most of their time trying to develop a plan to “get them out of the [funding] hole and make sure it never happens again,” rather than trying to figure out how to reduce fees.
“Most plan sponsors wouldn’t mind an extra $100,000 in fees if it eliminates the chance of a loss of $100 million,” he says.
Nuzum says he’s seeing increased interest in fixed-income and U.S. large-cap equity strategies, and plan executives are giving “careful consideration” to indexing because of the underperformance of actively managed strategies. He says some plan sponsors are asking: “Should we pay fees for active management?”
“On fixed income they can see the spreads and the opportunities,” Nuzum says.
In addition, more companies are closing their plans to new employees as they figure out how to deal with unfunded liabilities and new requirements under the 2006 Pension Protection Act.
Judy Schub, managing director of the Committee on Investment of Employee Benefits Assets, an industry organization that represents large defined-benefit plans, says the CIEBA is lobbying Congress to postpone the PPA funding rules that give underfunded pension plans seven years to get their plans fully funded.
That requirement went into effect January 1, but Schub is pushing to move the start date for the new amortization schedule to 2011. Plans would have to pay interest on their losses between now and 2011 under CIEBA’s proposal, she says.
“People will still have funding obligations, they just won’t have the very dramatically increased funding obligations,” Schub says.
“Along with others, we are talking to Congress about urgency of moving forward with some temporary relief,” she says. “We have an emergency situation with the rapid decline in asset values and interest rates. Forcing plan fund sponsors to take money they would use for employment or capital investment and forcing them to put it in the pensions is not a smart thing to do during a recession.”
Mike Archer, chief actuary at Towers Perrin, says a new survey of 480 North American companies has found that 44 percent have closed their plans to new participants, 3 percent intend to close their plans to new employees in 2009 or 2010, 10 percent are considering closing plans to new participants, and 43 percent have no changes in the works. Archer says that in 2002, 76 percent of employers had open DB plans, but that percentage had dropped to 51 percent by 2007.
Archer says he doesn’t expect a lot of terminations over the next couple of years, largely because many plans dropped below 100 percent funded over the last several months, and pension plans must be fully funded to terminate or be in dire straits to get a distressed termination status by the Pension Benefit Guaranty Corp.
The Pension Protection Act also set in motion a change in how minimum lump-sum payments are calculated. Prior to the PPA, the payments were determined using a specific mortality table and 30-year constant maturity Treasury bonds that yield around 3.5 percent. The new interest rate basis under the PPA relies on high-quality corporate bonds that fetch 6.5 to 7 percent.
As such, Archer says that because plan sponsors often offer participants lump-sum distributions when ending plans, pension executives are likely to wait to terminate plans until they move to the new rate.“Over time, the gradual [five-year] move to the corporate bond yield basis increases the interest rate basis for lump sums, and therefore reduces the amount of lump sums payable,” Archer says. “Hence, if a sponsor is going to issue lump sums on plan termination, all other things being equal, the cost of the plan termination will decrease as the corporate bond basis is phased in.”
He notes that the cost of plan termination can increase if interest rates move down, even during the transition period.
“There are also a lot of administrative costs in terminating a plan; it’s a long, arduous process,” Archer says. “That’s another reason employers have frozen plans … and haven’t terminated.”
And so the hunt goes on.
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