Many on Wall Street are obsessed with the idea that in a market decline, unsophisticated mutual-fund investors will panic, redeem their funds en masse, and turn a correction into a catastrophe. What the Cassandras seem to miss is the potentially destructive behavior by the sophisticated investors who run the nearly $5 trillion in private- and public-sector pension plans.
Federal Reserve statistics indicate--and many pension-fund consultants agree--that pension plans are top-heavy in equities. This suggests that many of the executives and trustees who run these defined-benefit pension plans might dump stocks in a hurry if the market takes an abrupt turn southward.
SKITTISH. Most large plans, either by policy or by statute, in the case of state and local government funds, impose limits on the portion of assets that can be invested in stocks. That allocation usually falls somewhere in the 60% to 65% range. The latest available Fed data show that the pension funds reached the 63% point at yearend and the stock market is up another 6% since (chart). "Most funds are at least five percentage points over their equity allocation targets," says Tom Pipich, a principal at Buck Consultants Inc. who advises pension plans on investment policy.
Those overextended equity allocations could become a huge short-term liability. "I'm worried about the pension executive who wakes up after a few bad days in the stock market and realizes he has too much in stocks," says Roger M. Kubarych, chief investment officer at Kaufman & Kubarych Advisors LLC in New York. "To protect his job, he has to take a lot of stock off the table in a hurry." Such wholesale dumping could create a vicious cycle in which a wave of selling drags down prices so much that even investors who had planned to sit tight might start unloading as well.
Largely ignored by market forecasters, these big investors could have an impact on a market that is becoming increasingly skittish. Long-term interest rates are once again nearly 7%, and many fear the Fed will hike short-term rates at its Mar. 25 meeting. On top of that, the end of the quarter is near, and investors need another strong earnings reporting season to overcome the drag of higher rates. Any hint of bad news on profits is bound to unnerve investors, large and small.
Even in a raging bull market, defined-benefit plans are not supposed to buy every stock in sight. They're supposed to stay within their targets. If market appreciation pushes up the percentage of the plan that's in equities, the plan's managers are supposed to sell the excess and shift the money to an asset class in which the fund is below its allocation, such as bonds. That way, the fund is always taking profits in a fully priced asset and reinvesting in a cheaper one. The purpose of a defined-benefit fund is not to make the most money it can but to make sure that it earns enough to meet present and future obligations.
But in the last year or so, many pension overseers have not been that diligent about taking their profits. "Pension boards don't always stick to the discipline," says Ronald D. Peyton, president of Callan Associates Inc., a pension-fund consultant. "It's hard to get them to sell an asset that's performing well and buy something that isn't." A little excess equity does not necessarily touch off alarms, since most funds' guidelines allow an allocation to fluctuate within a few percentage points of a target. But now that the stock market is running into strong headwinds, pension managers may decide to get back in line. "This is the time of year when fiduciary committees sit down for an annual review," says Pipich.
One reason pension-fund officials may have been slow to sell stocks is that they don't find bonds an attractive alternative. Consider the $85 billion New York Common Retirement Fund, one of the largest such funds in the nation. It has 48% of its assets in U.S. equities, mainly index funds--about three percentage points higher than its target. Fund managers want to get that back to 45%, but they want the proceeds of those sales to go into foreign stocks and other nontraditional investments. To do that, they have asked for enabling legislation.
Some pension-fund executives contacted by BUSINESS WEEK say they are within their equity limits. "We expected a downturn some time ago and positioned ourselves to be lighter in stocks," says James Francis, chief economist for the Florida State Board of Administration, which runs the state's $61.7 billion pension fund. Robert J. Scott, executive director of the $20 billion Colorado Public Employee Retirement Assn., say his fund is staying put. "We're not going to run for the door," says Scott. "We're looking at the market over the long term." The Colorado fund, which has a 65% statutory limit on equity holdings, is now at 63.5%.
Some private pension funds have even higher allocations to equities. The $33.7 billion General Electric Co. pension plan, for instance, has about 70% of its assets in equities, which is permissible under its guidelines. Half of the total assets are in U.S. stocks and the remaining equities are international stocks and "private equity" investments such as venture capital and merchant banking. The fund is not interested in adding to its U.S. stock portfolio. "We would probably put more into the emerging markets and other international equities," says John H. Myers, president of GE Investments. Eric T. Miller, chief investment officer at Donaldson, Lufkin & Jenrette Securities Corp., says the GE fund's investment preferences are fairly typical. "We're also hearing a lot more about real estate these days," says Miller, "and there's certainly no trouble raising money for private equity deals."
The funds don't have to dump stocks en masse to cause trouble. These funds are so huge that unloading just 1% of their equities could generate more than $30 billion in sales. In a declining market, that sell order would be a tough one to fill.