US Pension Fund Underfunding and Hedge Funds

According to a new survey by Greenwich Associates, US pension funds and
endowments registered the sharpest declines in 2002 of the last three years, a
period that has cost them over a trillion dollars in lost assets under management.

Between August to October 2002, Greenwich Associates interviewed fund
professionals at 574 corporate funds, 246 public funds, and 212 endowments
and foundations in the United States. Interview participants were asked about
their investment-service providers, their business practices and philosophy, and
their future expectations.

Consultant Dev Clifford of Greenwich Associates calls the 2000-2002 period
"probably the most destructive in the whole history of the US fund business".

That was particularly so for corporate pension funds, where year-on-year losses
have been severe and became even more so in 2002. According to a matched
sample of 380 large corporate funds who have interviewed with Greenwich
Associates for each of the past three years, the average decline in 2002 was
14.6 per cent, sharper even than the 10.1 per cent loss sustained by corporate
pension funds last year.

Among public funds, the diminishment was less substantial but hardly minor. A
matched sample of 199 public pension funds revealed average asset losses of
9.3 per cent from 2001 to 2002, slightly worse than the 8.9 per cent reduction
seen from 2000 to 2001.

Endowments and foundations lost 6.3 per cent of their value in 2001-2002, as
opposed to 5.9 per cent of their value in 2000-2001, according to a matched
sampling of 125 non-profit funds. Consultant Rodger Smith said: "Anyway you
look at it, it was a rugged year for pension fund and endowment managers."

Investing less in domestic equity

From representing more than half the total asset mix just two years ago,
domestic equity fell sharply in terms of proportionate investment, from 49.4 per
cent in 2001 to 46.8 per cent in 2002. Fixed income investment rose nearly as
much, from 26.4 per cent to 27.8 per cent.

Consultant John Webster said: "Looking at the asset mix differences between
fund types gives you a sense why they performed differently in the current
markets. Corporate funds are the most heavily invested in domestic equity,
including in the case of many defined contribution plans, in a corporation’s own
stock. Public funds, meanwhile, hold the largest proportion of fixed-income
investment, mitigating the pain of poor market performance".

Growth in alternative asset classes

Endowments are the most heavily invested in alternative asset classes, namely
private equity and hedge funds. These two, along with the less novel alternative
category of equity real estate, picked up many new institutional investors in 2002,
pension funds as well as endowments, and more of this is expected in years to
come. Yet these classes still represent a miniscule part of the total picture, just
7.5 per cent of total institutional assets.

Actuarial assumptions: Still reaching too high

Overall, for more than 1,000 corporate and public funds, the actuarial earnings
rate of return assumptions were marginally lower in 2002 than in 2001, 8.8 per
cent in 2001, 8.6 per cent in 2002, according to data gathered by Greenwich
Associates in the fall of 2002. On average, public funds reduced their
assumptions from 8.3 per cent to 8.0 per cent. Yet corporate funds stayed level
at 8.9 per cent in both years.

Less than a quarter (24 per cent) of corporate funds changed their rates last
year. Consultant William Wechsler notes: "While it may not be right to adjust
actuarial assumptions as they cover 20 or more years, the average rate of return
expectations of both corporate and public funds are so much lower that overall
they don’t have a prayer of reaching their actuarial assumptions in the
foreseeable future."

It should be noted that more corporate funds have been reported of late to be in
the process of significant downward revision in their actuarial assumptions, with
most reducing them below 9.0 per cent John Webster called this  "a welcome
return to reality".

Drastic drops in funding ratios

Just two years ago, fewer than 10 per cent of corporate funds were underfunded.
By the start of 2002, nearly 30 per cent were. This has only worsened in the past
year.

The balance of existing funds against the projected benefits obligations among
corporate funds fell from 121 per cent to 103 per cent in just two years. Among
corporate funds with over US$5 billion in assets, the drop was more severe yet,
from 125 per cent to 99 per cent.

Consultant Chris McNickle warned: "Falling below 100 per cent is just about the
worst thing a pension fund can do, and will require serious review".

The news was bad at public funds, too, where the percentage of underfunded
funds rose from 46 per cent to 52 per cent overall, and from 48 per cent to 58 per
cent among those funds with over US$5 billion in assets.

The challenge facing hedge funds is that of continuing education and persistence
in tackling the US pension plans market. The growth figures may be slow, but in
absolute terms they represent perhaps the most significant potential source of
growth for the industry.