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Mining Pensions' Silver Lining for Stocks

Underfunded pension funds will bring some money into equity markets, but how much?
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Asking whether a "new bull market" is likely seems sillier now than just

a few days ago, given the stock market's recent backslide. Still, let's delve deeper into one of the optimistic arguments presented in that story -- specifically, Kenneth Fisher's theory about a "silver lining" in underfunded pension plans.

Many experts agree with Fisher's contention that significant amounts of money destined to replenish such plans will ultimately go into equities, but they disagree over how much money and when. A separate but related question is whether the "hit" to earnings from pension liabilities will offset any presumed positive inflows into stocks from pension funds. Finally, some skeptics wonder whether pension funds really will "rebalance" their holdings back toward equities.

Standard & Poor's so-called core earnings forecast includes a $7.25 per share reduction for the

S&P 500

in 2003 due to pension-related costs.

"High pension charges for companies -- meaning lower earnings -- could depress stock prices," Fisher conceded recently wrote in


. But the money manager "believes the supply-and-demand effect will overwhelm the earnings effect."

Fisher, who oversees about $10 billion as CEO of Woodside, Calif.-based Fisher Investments, estimates pension funds will invest $70 billion in U.S. equities in 2003. "So far, there has been scant media mention of the size of global pension underfunding," he wrote. "Hence, it will surprise investors and be all the more bullish."

While not doubting those estimates, some experts question whether all that money will find its way into equities, and when.

Pensions & Investments

, which covers the money management industry, estimated last November that the 21 companies with the largest defined benefit plans will contribute about $32 billion to their funds this year. Other publications have used a contribution target of $100 billion for all public companies. (Defined benefit plans are "traditional" pension plans that promise a specific monthly stipend to retirees. By contrast, defined contribution plans, such as 401Ks, promise nothing and have become increasingly favored by U.S. corporations since the Financial Accounting Standards Board adopted Rule 87 in 1985.)

Whatever the final tally, "we're not seeing an imminent burst of money into the stock market," said Michael Clowes, editorial director of

Pensions & Investments


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have started to replenish their pension funds, and corporations have to pay higher fees to the Pension Benefit Guaranty Corp. if their plans are underfunded, he noted. Also, some plans are subject to an excise tax if funding falls below certain criteria.

Despite those pressures to contribute to pension plans, the bottom line is (well) the bottom line: Both corporations and public entities are facing cash-flow shortages. Therefore, we "won't see the bulk of refunding of plans until corporate earnings and tax receipts improve," Clowes said. Furthermore, most public pension plans aren't legally bound to be 100% funded, so administrators can postpone contributions until the economy improves and tax receipts rebound. (Correctly gauging when that's going to occur remains elusive.)

"I don't think

pension fund money is going to come into the market this week or this month, and it's not coming in one fell swoop," agreed Diane Garnick, recently named head of U.S. portfolio strategy at Dresdner Kleinwort Wasserstein. "But I know it's coming."

Garnick is convinced inflows from pension funds will be a "net positive" this year, noting portfolio trading has risen into the high-30% range as a percent of all

New York Stock Exchange

volume, up from under 20% two years ago. Because of their size, it's more effective for pension plans to use portfolio trading, i.e., a basket of at least 15 stocks worth at least $1 million.

In addition to corporations needing to contribute to underfunded plans, the trend toward defined contribution plans is also bullish because individuals tend to favor higher equity exposure than do professional administrators, she said. Garnick contends that's "absolutely still the case," despite the brutal bear market. Somewhat cryptically, she also noted that rising unemployment means more individuals overseeing their own pension plans.

To Rebalance, or Not to Rebalance

The biggest impact on the stock market could come from the presumed "rebalancing" by pension funds because of recent gains in their fixed-income portfolios and declines in equity investments.

"Regardless of whether a fund is underfunded or not, they are going to be buying U.S. equities when that asset class has underperformed" for an extended period, said Brian Gray, formerly a senior trust analyst at Southern Company's pension fund. "The implication of this concept potentially encompasses a much larger dollar amount than Fisher's $70 billion."

Not every pension plan is underfunded, but nearly all of them will be rebalancing given the extended outperformance of fixed-income, according to Gray, currently managing partner of Gulfstream Capital Management, a Wilmington, N.C.-based hedge fund.

Pensions & Investments

recently reported the largest 200 defined benefit plans had equity allocations of 55% in 2002 vs. slightly above 60% in the late 1990s and 2000. If pension funds were to restore what many consider a standard allocation of 60% equities and 40% bonds, billions of dollars would go into shares, given pension funds' total assets were $3.44 trillion in 2001, according to the publication.

However, this "pension fund rebalancing" story is one the bulls have cited repeatedly in recent years, and some observers believe it's just (more) wishful thinking.

At issue are assumptions about the long-term expected returns from equities. Between 1926 and 2000, equities posted compounded annual returns of 10.7%, according to Ibbotson Associates. Based on these historic returns, most pension funds assume equity returns will be in the range of 9% to 11%. Obviously, that's significantly higher than the performance in the past three years, even if optimists claim stocks' recent struggle is more reason to expect higher returns going forward, i.e., reversion to the mean.

Crucially, however, recent academic studies found a large portion -- approaching 50% -- of that 10.7% historic return came from dividend payouts and, since the 1980s, price-to-earnings expansion. For example,

S&P 500

companies had annualized returns of 8.7% from 1950 to 2000 based solely on capital appreciation, but 12.75% including reinvestment of dividends.

"Why would pension administrators believe that putting the bulk of new money into stocks is a good thing if experts are telling

them that the dividend yield is less than half the historical average and that 50% of stocks' return comes from that dividend?" wondered Frank Bifulco, director of research at Orazio Financial Services, a Suffern, N.Y.-based financial planning firm. "And if P/E levels are still at the high end, why go for the uncertainty of a stock when all

fund administrators are interested in is matching asset and liability durations?"

The S&P's dividend yield fell from 5.15% in 1926 to as low as 1.1% at the end of 2000, according to Ibbotson. Currently, it's around 1.9% and still historically low. Similarly, P/Es are down from bubble-era extremes but still far above their long-term average of around 14 on a trailing 12-month basis. The S&P's P/E is over 18 today, based on 2002 operating earnings of $47.94. (P/Es are higher-still based on S&P's "core" earnings or reported results, but lower based on forward estimates.)

Bifulco noted the updated academic studies on historical returns have been published since 2000 and believes "slow moving" pension funds and endowments are just starting to react to them. He expects pension plans will increase their exposure to high-yield bonds, emerging market and other foreign debt, and other "income-related vehicles," but is "not so sure about stocks."

In sum, there's no quick fix for what ails U.S. pension funds, and rebuilding those plans likely won't provide a panacea for what ails the stock market either.

As originally published, this story contained an error. Please see

Corrections and Clarifications.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.