Pension Fund Losses Spell Lower-Profit Era

By James Flanigan

June 16, 2002 12 AM PT

The nation’s pension funds have lost money in the last two years, and that spells big changes ahead for corporate earnings growth, the stock market and the personal retirement plans of millions of Americans.

Corporate pension plans have lost $630 billion since 1999, a 14% decline, according to a new study by Cerulli Associates Inc., a Boston-based research firm.

That may not sound too threatening considering that private pension funds assets--the money set aside to fund the retirements of more than tens of millions of working Americans--still total $4 trillion after rising dramatically in the bull market years of the ‘90s.

Public employee pension funds also have declined in value--to a little more than $2 trillion--as have individual retirement accounts--to $2.6 trillion.

But the two-year decline does more than break a pattern. It will alter expectations of stock market gains and force companies to contribute fresh money to their defined-benefit pension plans. That will tend to reduce potential growth of earnings and arguably the potential rise in stock prices.

Individuals with 401(k) and other defined-contribution pension plans also will have to lower expectations of big gains in their retirement accounts.

The returns on investment that companies and individuals should expect in the coming years are about 3% to 4% a year, rather than the 9% returns they count on today, says Robert Arnott of First Quadrant, an investment management firm in Pasadena.

Arnott is not alone in saying investment expectations are in for a reality check. Corporations

will have to lower their “assumption about long-term rate of return on assets,” says Stephen Nesbitt, senior managing director of Wilshire Associates Inc., a Santa Monica financial research firm.

The effect of lower assumptions about investment returns will be that companies will have to generate higher earnings from their business operations, says Jeremy Gold, head of New York-based consulting firm Jeremy Gold Pensions.

Change is coming to the vast complex of corporations, public agencies and management firms that invest Americans’ retirement nest eggs. The last time two consecutive years of losses occurred in pension funds

was in the 1970s. And that

decline launched wide-ranging reforms in pension regulation, including the development of

the 401(k) plan.

The need of higher returns for pension funds also contributed to the wrenching restructuring of U.S. industry in the 1980s, when investment managers demanded that companies produce higher earnings. The California Public Employees’ Retirement System, or CalPERS, the largest pension fund with more than $150 billion in assets, was one of the first funds to demand that company managements do a better job of producing profits.

Pension funds and retirement assets in the 1970s were only a shadow of the giant they have become. At that time, almost all pension assets were held in corporate funds that had grown since the post-World War II era.

To fund pension benefits for their employees, the pension funds of General Motors Corp. or U.S. Steel Corp., for example, were invested in stocks of other companies and in government and corporate bonds.

State and local government employees had pension funds that also had grown large.

But in the last quarter of a century, new varieties of retirement accounts such as IRAs and defined-contribution plans, in which employees make investment choices, have pushed the total to more than $8 trillion, the largest single block of investment capital in the world.

And in the stock market boom of the ‘90s, all such funds made gains large enough to cause illusions and distortions. Individuals grew accustomed to rapid gains in their portfolios. Companies got a free ride on their pension plans.

Because investment gains swelled pension assets, companies did not have to make annual contributions to the funds. The money instead became part of earnings, making reported profits higher than they would have

been otherwise. The bull market was so strong that profits of the large companies that make up the Standard & Poor’s 500 index may have been overstated by more than 30%, investment experts say.

Also, many companies regarded pension assets in excess of future obligations as “surpluses” and took them into reported profits as well. The total of such surpluses in more than 300 companies at the peak in 2000 amounted to $238 billion, Wilshire Associates said.

But now that the boom is over, corporate earnings have been declining and so have the stock markets. The surplus is gone, and whether the stock market will soon regain its ‘90s peaks has become a frequent topic of debate.

Without rising pension assets to boost them, profit growth will be harder to achieve for companies-- and so will investment gains. If pension fund managers want higher-than-average gains, they will have to put more of their money into alternative investments such as venture capital, developing-nation markets and high-yield bonds, says Arnott of First Quadrant, which manages $28 billion in pension assets.

Pension funds now invest 5% to 10% of their assets in such alternative vehicles. The funds are expected to invest a higher percentage but realistically, prudent funds cannot afford to put too many billions of dollars into high-risk investments.

For individuals managing their own defined-contribution plans such as IRAs or 401(k)s, a new tax law allows larger contributions by individuals older than 50, so such accounts will grow. But investment gains may be another matter, says Peter Starr, managing director of Cerulli Associates. Last year, average investments in 401(k) accounts dropped by 11%, or $4,528 per account.

So what can individuals do about their investments? Lower their expectations and look realistically at some conservative investments, advise the pros. Treasury bonds that have protection from inflation are returning 3% to 4% a year. That may not sound like much, but in a tax-deferred IRA account, it can add up impressively.

Most investment professionals are not forecasting a disastrous decline in the stock market, but rather the kind of market that has characterized practically every decade--one of modest gains and many fluctuations.

Finally, an important point to keep in mind is that a chastened outlook for the stock market does not mean a gloomy one for the U.S. economy. Most economic growth comes from new ideas and new companies--a truth that has been evident in every period of U.S. history, including the high-tech 1990s.

In this decade, with increased venture capital available, continued developments in information technology and medical and biological science will bring forth new companies and new divisions of old companies-- and new investment opportunities.

After a boom that inevitably frayed into illusions and distortions, realism can be bracing.

James Flanigan can be reached at jim.flanigan@latimes.com

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Largest U.S. Pension Funds

In little more than 50 years, pension funds have grown into unique repositories of retirement income for American workers and, at about $8 trillion in aggregate, the largest block of investment capital in the U.S. economy.

Pension funds provide a necessary adjunct to Social Security in an aging society. Countries in Europe and Asia are now studying U.S.-style pension management as a solution to the problems of financially strained government retirement programs.

Here is a list of the largest U.S. pension funds, with asset totals as of the end of 2000, the latest figures available.

Public Funds

California Public Employees’ Retirement System, $144 billion

New York State Common Fund, $106 billion

Corporate Funds

General Motors, $ 82.5 billion

General Electric, $68.8 billion

Union Funds

Western Conference of Teamsters, $ 22.6 billion

Teamsters, Central States, $17.4 billion

Miscellaneous

Federal Retirement Thrift, $93.3 billion