. 5
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Actively managed international portfolios 1,647 5.7
Passive (indexed) international portfolios 201 0.7
Total equities $13,073 45.3%

Fixed income:
Domestic bonds $ 8,448 29.3%
International bonds 90 0.3
Total ¬xed income $ 8,538 29.6%

Real estate:
Ownership $ 1,782 6.2%
Mortgages 412 1.4
Total real estate $ 2,194 7.6%

Specialized investments:
Guaranteed investment contracts $ 1,619 5.6%
Options 66 0.2
Venture capital 254 0.9
Private placement 1,387 4.8
Total specialized investments $ 3,326 11.5%
Total assets $28,834 100.0%

Source: Nelson™s Directory of Plan Sponsors and Tax Exempt Funds, updated annually.

table, the fund is diversi¬ed across maturities so that securities more or less
continuously mature, providing cash that can either be paid out to bene¬-
ciaries or reinvested in other securities.

What is a plan™s funding strategy? What is a plan™s investment strategy?
Self-Test Questions
What are asset allocation models?
What types of assets are held in pension funds? Why?

Pension Fund Investment Performance
Three factors have a major in¬‚uence on pension funds™ investments: (1) the
dollar amount of assets, (2) the mix of the funds™ liabilities between
those attributable to active workers and those attributable to retired ben-
eficiaries, and (3) the tax situation facing the corporate sponsor. We now
discuss how these characteristics affect funds™ investment decisions and
Pension Fund Investment Performance 29-21

Active Workers vis-à-vis Retirees
Many pension fund managers view pension fund liabilities as consisting of
(1) benefits due now to plan participants who are already retired and (2)
benefits due in the future to current employees. Thus, they segregate pen-
sion assets into two parts: a “retiree portfolio” that provides income to
current retirees and a “worker portfolio” that builds value for current
The retiree portfolio is usually invested in ¬xed-income securities chosen
to produce a cash stream that matches the required retiree pension payments.
In managing the retiree portfolio, fund managers often use immunization
techniques such as duration to eliminate, or at least signi¬cantly reduce, the
risk associated with changing interest rates.11 Simply put, matching the
duration of the portfolio to the duration of the required payments ensures
that any loss of market value due to rising interest rates is offset by addi-
tional interest income, and vice versa. Matching asset and liability durations
balances interest rate and reinvestment rate risks in such a way that the real-
ized return on the portfolio is very close to the targeted actuarial rate of
return, regardless of how interest rates vary.
The worker portfolio usually consists of some relatively risky assets such
as stocks and real estate, along with some lower-risk assets such as bonds.
To reduce the risk inherent in such a portfolio, pension fund managers often
use a hedging technique called portfolio insurance, which does not appre-
ciably affect upside potential but limits the downside risk. Portfolio insur-
ance involves buying or selling options or futures contracts that would gain
about the same amount of value that the portfolio loses if the market takes
a sudden fall.

Performance Measurement
Pension fund sponsors generally evaluate the performance of portfolio man-
agers on a regular basis and then use this information when allocating the
fund™s assets among managers. Suppose a fund™s common stock portfolio
provided a total return of 16 percent during a recent year”is this good, bad,
or average performance? To answer this question, the portfolio™s market risk
(beta) should be estimated, and then the portfolio™s return should be com-
pared with the Security Market Line (SML). Suppose, for example, that the
“market” portfolio, say, the S&P 500, returned 15 percent, that 20-year
Treasury bonds returned 9 percent, and that our fund™s equity portfolio had
a beta of 0.9 (that is, it was invested in stocks that had below-average mar-
ket risk). An SML analysis would lead to the visual comparison shown in
Figure 29-2. Here we see that the portfolio did better than expected”it is
said to have an alpha ( ) of 1.6 percentage points. Alpha measures the ver-
tical distance of a portfolio™s return above or below the Security Market
Line. Looked at another way, alpha is the portfolio™s extra return (positive
or negative) after adjusting for the portfolio™s market risk.12

Duration is the weighted average time to receipt of cash ¬‚ows from a bond. For a zero coupon bond, duration equals
term to maturity. A coupon bond has a duration that is less than its term to maturity, and the higher the coupon for any
given maturity, the shorter its duration. See the Extension to Chapter 23 for an expanded discussion of duration.
The Jensen alpha, so called because this measure was ¬rst suggested by Professor Michael Jensen, is popular because
of its ease of calculation. Theoretically, its purpose was to measure the performance of a single portfolio versus the mar-
ket portfolio, after adjusting for the portfolio™s beta. However, this measure is not useful in evaluating the performance
of portfolios which include real estate and other infrequently traded assets. This fact has led to the development of a
number of other portfolio performance measures. For a discussion of these measures, see Jack L. Treynor and Fischer
Black, “How to Use Security Analysis to Improve Portfolio Selection,” Journal of Business, January 1973, 66“86.
29-22 Pension Plan Management
Chapter 29

Alpha Analysis
Figure 29-2

and Required
Rate of Return

±p = 1.6%





0 0.5 0.9 1.0 1.5 Risk, b

Alpha analysis adds substantially to a pension manager™s knowledge
about his or her equity portfolio™s results, but several shortcomings must be
recognized. First, alpha is based on the CAPM, which, as we discuss in
Chapters 2 and 3, is an ex ante equilibrium model that in theory requires
that all risky assets be included in the market portfolio (for example, human
capital and residential real estate). Therefore, market proxies such as the
Standard & Poor™s 500 Index result in some degree of measurement error.13
Second, the statistical signi¬cance of alpha is often too low to make strong
statements about the portfolio™s relative performance. And third, all of the
measurements are based on ex post results that contain both expected
returns and unanticipated returns caused by random economic events. Thus,
a large positive alpha may indicate good luck rather than good management,
and vice versa.
Another way to measure portfolio performance is peer comparison. At the
end of each year, managers with similar investment objectives, say, aggres-
sive growth, can be ranked on the basis of total realized return. Managers
who are consistently in the top quartile have done a better job than their
peers. Unfortunately, though, good past performance is no guarantee of
good future performance.
More and more investors, including both pension fund managers and
individuals, have been shifting assets from actively managed funds to index
funds. Today (2002) there is more than $1 trillion tied to the S&P 500
Although managerial performance statistics exhibit about 80 to 90 percent correlation regardless of the index used,
Richard Roll presents some interesting examples which show how easily rankings can be changed by measurement pro-
cedures. See Richard Roll, “Ambiguity When Performance Is Measured by the Securities Market Line,” Journal of
Finance, September 1978, 1051“1069.
“Tapping” Pension Fund Assets

through index funds. The reason for this popularity is simple”during the
past ten years, only 19 percent of equity funds have bettered the return on
the S&P 500 stock index. Equity managers have been quick to point out that
large capitalization stocks have signi¬cantly outperformed smaller stocks in
recent years, and this stacks the performance deck in favor of the index
funds, which are dominated by large companies. However, index funds are
now available for small and mid-cap companies, and early results tend to
con¬rm that such funds also outperform their managed counterparts.
Management fees explain these results.

How is Jensen™s alpha used to judge the performance of common stock fund
Self-Test Questions managers? Can you think of any other measures?
What is the difference between active and passive portfolio management?

“Tapping” Pension Fund Assets
Corporate sponsors administer de¬ned bene¬t plans with assets running into
the hundreds of billions of dollars. To what extent should a corporation be
able to invest its fund™s assets to the corporation™s own advantage? Or, if the
plan is overfunded”perhaps because investment results were better than the
actuaries had assumed”should the company be able to take assets out of the
plan? (Obviously, we are talking about de¬ned bene¬t plans only; compa-
nies are not permitted to touch the assets of de¬ned contribution or pro¬t
sharing plans.) Here are some examples of recent actions which have been
called into question:
1. When Occidental Petroleum acquired Cities Service, their combined
pension plans had assets of $700 million, but the combined vested
funding requirement was only $300 million. Occidental terminated the
two old de¬ned bene¬t plans, replaced them with a new de¬ned con-
tribution plan, and took $400 million out of the fund™s assets.
Similarly, FMC Corporation recently restructured its plan in a way
that allowed it to recoup about $325 million. FMC™s pension invest-
ments had earned an average return of about 16 percent over the past
ten years, placing it near the top in performance ratings. FMC used
outside advisors and investment funds for its plan, and the vast bulk
of the plan™s assets were invested in stocks.14
2. Some cash-short companies have been making required payments to
their funds by using their own stock, bonds, and real property rather
than cash. This is legal under ERISA provided that a fund has no more
than 10 percent of its sponsor™s own securities and assets, and pro-
vided that the Department of Labor agrees that the transaction is made
at a fair price. Thus, Exxon Mobil recently contributed a $5.4 million
of¬ce complex to its plan; Boise Cascade added timberland worth $16
million to its plan; and U.S. Steel, Alcoa, Armco, Reynolds Metals, and
Republic Steel all contributed their own newly issued securities rather
than cash.
3. Grumman Corporation, Bendix, and others have attempted to use
their pension funds to help thwart hostile takeover attempts, or to help

This type of action can be taken only (1) when approved by the plan™s bene¬ciaries, (2) in conjunction with the estab-
lishment of a new pension plan, and (3) after approval by the Labor Department, Internal Revenue Service, and the
PBGC if the new plan is a de¬ned bene¬t plan.
29-24 Pension Plan Management
Chapter 29

the fund™s company take over another ¬rm. For example, Grumman™s
pension fund bought 1.2 million of its shares, paying a 43 percent pre-
mium over the pre-bid price, to help fend off a takeover attempt by
LTV. The takeover failed, but the fund incurred an immediate $16 mil-
lion paper loss on these shares.15 Similarly, Bendix tried (unsuccess-
fully) to stop its fund™s trustee from tendering 4.5 million shares of its
stock to Martin Marietta.
These examples raise some interesting issues: (1) Do the excess assets in a
de¬ned bene¬t plan belong to the sponsoring company or to the employees?
Legally, they belong to the company, which de facto contributed more to the
plan than was required. However, a number of union leaders have argued
that they ought to belong to the workers. (2) Should the PBGC get
involved in revisions such as Occidental™s? Since Occidental switched from
a de¬ned bene¬t to a de¬ned contribution plan, it left the PBGC™s jurisdic-
tion (and also eliminated the $19 annual employee “head tax”), but if it
had simply reduced the funding level of a de¬ned bene¬t plan from over-
funded to fully funded, the plan would have been exposed to more risk after
assets were removed. (3) Should companies be able to use fund assets to help
¬ght off takeovers?
There are no easy answers to these questions. Obviously, actions which
would either violate existing laws or jeopardize the safety of the plan should
not be permitted, but many actions are not clear-cut. Given the importance
of pension plans, it is safe to assume that the debate will continue.

How can companies “tap” excess pension fund assets?
Self-Test Questions
Do pension plan assets belong to the sponsoring company or to the employees?

Retiree Health Benefits
Most companies offer health care bene¬ts as part of their retirement pack-
ages, usually from the time of retirement until the retiree reaches age 65 and
becomes eligible for Medicare. The plans typically cover hospitalization,
some physicians™ fees, and prescription drugs, with employers paying the
entire cost of the coverage. Some ¬rms even pay for supplemental coverage
after age 65, the so-called Medigap insurance. Until recently, not much
attention was paid to such bene¬ts”¬rms merely paid the bene¬ts each year
and, if the cost was material, reported the annual cost as a note to the annual


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( 7 .)