The U.S. pension system is in crisis. According to a recent study by consulting group Mercer, the 1,500 largest companies in the U.S. have an aggregate pension deficit of $380 billion. Corporations are feeling the heat from the Pension Protection Act of 2006, which stipulates that all corporate defined benefit pension plans be fully funded by 2011. Those companies that are seriously underfunded before then — which the PPA defines for this year as being less than 94 percent funded — must make contributions to offset the shortfall. With the largest 100 corporate pension plans just 71 percent funded, according to estimates by actuarial consulting firm Milliman, compliance at current levels could virtually wipe out earnings for some companies.
What’s a plan sponsor to do? Traditionally, corporate defined benefit managers have increased their equity investments to boost returns and, accordingly, meet their liabilities. But managers now view equities as risky — understandably so, given dramatic market declines of upwards of 50 percent since September. And because of their currently underfunded positions, companies now see capital preservation as paramount. They have learned the hard way that it is extremely difficult to recover substantial losses. The Standard & Poor’s 500 index would have to soar 96 percent from its closing price of 798 at the end of March to reach its peak of 1,565, set in October 2007.
What is the answer? Alternative investments. Hedge fund managers have long-term track records of preserving capital on the downside while participating meaningfully in upside action when markets rally. Yet many plan sponsors are reluctant to increase their allocations to hedge funds, viewing them as too risky. That perception is encouraged by Washington lawmakers, who continue to rail against evil hedge fund managers, accusing them of destabilizing markets.
Such thinking is flat-out wrong. Hedge fund managers often reduce volatility by adding liquidity to the market as they attempt to deliver alpha. Although the majority of hedge funds lost money during the financial bloodbath that was 2008, they outperformed the equity market, losing on average 19 percent, about half the 38.5 percent drop in the S&P 500. Hedge funds continued their outperformance this year, even as the sky-high volatility in equities during the first two months moderated this spring. The major hedge fund indexes were up slightly during the first quarter, compared with an 11 percent fall in the S&P 500.
Now is the time for pension fund managers to allocate a portion of their equity exposure to carefully chosen long-short equity funds. And rather than put these long-short equity funds in their “alternative investments” bucket — as plan sponsors typically do — they would do better to use them in the traditional equity bucket. Long-short equity funds can offer significant participation — and even outperformance — on the upside over a market cycle, as well as downside protection.
Consider the following. Over the past ten years, through 2008, the Credit Suisse/Tremont long-short equity index had an average annual return of 7.9 percent, versus an average annual loss of 1.4 percent for the S&P 500. That’s outperformance of more than 9 percentage points. During the market turbulence in January and February of this year, when the S&P 500 plummeted 18.2 percent, the long-short index lost just 1.5 percent.
In the meantime, we see signs of progress toward solving the pension funding crisis. In October 2008 the American Benefits Council, an employee advocacy group, released a ten-point plan to strengthen the retirement system — including lengthening the transition to the new 100 percent funding level mandated by the PPA. Additional negotiations under way in Washington between lawmakers and companies aim to provide some relief from the PPA provisions for corporations, perhaps in exchange for their reopening some defined benefit plans.
Of course, a federal response is necessary, but it is unlikely to be enough. Government cannot legislate attractive risk-adjusted returns. The best way for plan sponsors to make up their shortfalls is by including hedge funds in their investment mix. Washington needs to understand that. Well-formulated long-short equity strategies have been utilized by leading institutional investors for years to enhance and protect their returns. The upside outperformance and downside protection of hedge funds are just what plan sponsors — and the millions of Americans in danger of losing their pensions — need.
Carrie McCabe is chief executive officer and founder of New York–based Lasair Capital, which provides investment solutions for institutional investors.
