US Corporate Pension Plans Dropped Another 9% In Q4 2002, Says Mercer

The investment performance of US retirement plans and foundation endowment funds managed to rebound in Q4 last year, but not by enough to recover the losses in the rest of the year and things got worse for corporate pension plans.

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The investment performance of US retirement plans and foundation/endowment funds managed to rebound in Q4 last year, but not by enough to recover the losses in the rest of the year – and things got worse for corporate pension plans. Or so says a survey of US institutional performance by Mercer Investment Consulting.

The median corporate, public, and foundation/endowment plan experienced positive fund returns for the fourth quarter of 2002. According to Mercer’s Summary Performance of US Institutional Portfolios survey, the median corporate plan had a fourth-quarter gain of 4.7%, while public plans and foundation/endowment funds had gains of 4.8% and 4.6%, respectively.

For the 12-month period ending December 31, corporate plans had a loss of 9.2%, under-performing both public plans and foundation/endowment funds by 20 and 30 basis points, respectively. Over a 10-year time frame, foundation/endowment funds continue to outperform both corporate and public plans by 55 to 95 basis points. Foundation/endowment funds have been able to outperform their counterparts primarily through a lower equity exposure (both domestic and international) and a higher percentage of alternative investments.

“With a third consecutive year of equity losses behind them, plan sponsors look forward to better times in the markets, although there does not appear to be much in the short term to provide cause for optimism,” says Ravi Venkataraman, who leads Mercer Investment Consulting’s northeast unit. “For a defined benefit plan, which has a long-term investment horizon, a three-year market decline can be considered short-term. Yet the severity and depth of the decline and its impact on the financial health of the pension plan has many sponsors revisiting their asset allocation policies to test whether changes are warranted.”

“Plans typically review asset allocation policies when three major scenarios occur. First, the plan experiences a significant structural event, for example, a change in plan design, a merger, or a spin-off. Second, capital markets’ expectations change. Third, the risk profile of the plan or the corporation changes. Many plans have experienced at least two of these three events within a short period of time,” Mr. Venkataraman says.

The main decision to be made in terms of asset allocation still remains the stock/bond split. Although expectations for equity returns have dampened over the past couple of years, there has been an increase in the equity risk premium as well. Consequently, there has not been a widespread reduction in equity weightings in most plans, beyond some drift due to rapid market decline.

Both value and growth managers produced positive fourth-quarter results, with value managers outperforming their growth-oriented counterparts by 360 basis points. However, the yearly results for all equity managers were poor, regardless of their investment style. In comparing large-cap equity managers, both value and growth styles posted double-digit losses for the year, 17.5% for large-cap value and 26.9% for large-cap growth.

“Although active managers of both large-cap and small-cap funds underperformed their respective benchmarks for the quarter, active management has generally proven to be an effective strategy in declining markets and over longer-term periods,” says Mr. Venkataraman. “The benefit from active management has been more pronounced within the small-cap asset class rather than large-cap equities, with the median small-cap manager outperforming the Russell 2000 index by 400 basis points over a 10-year time-frame. The median large-cap manager outperformed the index by 70 basis points over the same period.”

The median large-cap manager significantly underperformed the S&P 500 Index for the fourth quarter of 2002 by 120 basis points, but outperformed the index by 70 basis points on an annualized basis over the last 10 years. In a reversal of market capitalization performance, large-cap managers outperformed their small-cap counterparts by 250 basis points over the previous quarter, as the median large-cap manager returned 7.2% and the median small-cap manager returned 4.7%.

The international asset class, with a return of 6.5%, underperformed its US large-cap counterpart for the quarter by a margin of 190 basis points, but outperformed US large-cap equities over the recent 12-month period by 6.4%. Within the international asset class, the growth style outperformed value by 2.0% for the quarter but underperformed for the 12-month period by 6.3%.

“Although international investments recently have not produced the type of diversification benefits anticipated by plan sponsors, the asset class nevertheless outperformed US markets on a relative basis for the year,” says Mr. Venkataraman. “Historically, the relative outperformance of international equities has been cyclical in nature, with the true benefits of diversification borne out over longer periods.”

Within the fixed income asset class, the median core fixed income manager equaled the index for the fourth quarter but trailed the index over a 12-month horizon by 50 basis points. Over a 10-year basis the median manager has outperformed the index by 30 basis points.

The fixed income asset class has produced a yearly return of 10.3%, far exceeding Mercer’s 2002 Fearless Forecast prediction of 5.0%. Core opportunistic managers had a strong quarter as they outperformed the index by 70 basis points, as corporate securities and lower quality credits rebounded from their lows in anticipation of a stronger economy. The median high-yield manager had a positive gain of 5.6% for the quarter, but underperformed the benchmark by 110 basis points.

In assessing international fixed income performance, a weak US dollar positively impacted non-US mandates, a reversal from last quarter’s performance. For the recent quarter, the median manager had returns of 6.2% and 4.9% for non-US and global mandates, respectively. Both mandates produced solid 10-year results, 6.4% and 6.6%, respectively.

“Within the fixed income asset class, defined benefit plan sponsors continue to trend towards longer duration fixed income mandates, to better match liability streams and provide greater risk management from a corporate financial perspective,” according to Mr. Venkataraman. “However, the challenge in implementing this type of strategy in a potentially upward-trending interest rate environment depends upon the plan sponsor’s perspective. In situations where this type of strategy is appropriate, our counsel is that the performance of a long-duration strategy should not be viewed in a total return context, but rather in conjunction with the movement of the liabilities.”

Summary Performance of US Institutional Portfolios is published quarterly by Mercer Investment Consulting. The survey is intended to provide marketplace participants with summarized performance data for the most recent quarter and historical periods. Summarized information is shown for plan sponsors at the total plan level while manager performance data are provided at the asset class and sub-asset class level. Fund universes are courtesy of Russell/Mellon Analytical Services. Manager universes are courtesy of Mercer’s proprietary manager database.