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If you happened to be one of the hundreds of thousands of Kruppianer, which is what workers who toiled in the forges of Essen for the Krupp family in the nineteenth and twentieth centuries called themselves, you had it pretty good. In return for a hard day’s labor, you were paid respectably, given housing, medical care, and, yes, a pension. Marxist historians later liked to argue that this was a Faustian bargain: In return for these benefits, workers eschewed unions and voted the way Alfred, Bertha, Gustav, and finally Alfried told them to vote (which, alarmingly, included voting for the National Socialists in the 1930s). But Faust had nothing to do with this bargain, which was cheap at the price: Most Europeans were living a nasty, brutish and short life, and Kruppianer might as well have been living in an alternate, if admittedly middle-class, universe.
The Krupps were an extraordinarily gifted dynasty, which explains their longevity. They took risks with their business, which legend has it was munitions and then more munitions, but in fact was as diversified as their geographic footprint. But when it came to their investing, they were the very essence of caution. In the shattering aftermath of the Great War, when inflation ran wild, Krupp retirees were still paid their pensions, but in a debased and near-worthless currency: It was the one and exceedingly short period when the Krupp family effectively failed to honor their pension promises. Even in 1946, when there was a pensioner for every worker (Krupp was down at that stage to only 16,000 workers), the Krupp pension fund was fully funded—only the very safest assets were considered—and not a day of pension payouts was missed. As William Manchester wrote in his classic Arms of Krupp, “pensions were the firm’s best investment.”
The Krupps might have understood the worth of pensions better than most, but when it came to funding pension liabilities, caution, across the centuries, was the watchword. This was in part because the “equity” culture, so much a part of the present-day American phenomenon, is a novel intruder, particularly in the institutional marketplace. Corporations in Europe and the United States in the early twentieth century may not have understood the term LDI, but, almost without exception, they practiced it.
And then, almost in a blink of an eye, that all changed. Like all big shifts, there were multiple drivers—legislation and regulation, primarily, but also the marketplace. The passage of ERISA in 1974, itself a kneejerk reaction to the bankruptcy of Studebaker and the consequent scuttling of that company’s pension plan, ushered in a brave new world for corporate pension plans. Among the changes was the establishment of an institution, the Pension Benefit Guaranty Corporation, which some would come to argue brought with it the sort of moral hazard that bank bailouts were later to illustrate. More importantly, corporate plans—and public plans soon followed in their wake—were given the leeway, through smoothing and the ability to transfer excess earnings from their pension funds into their earnings streams, to move away from the cautious, bond-heavy allocations of their past into a dynamic equity market. Suddenly, relative performance became the key: Out went the giant, multi-asset class managers (anyone remember the National Bank of Detroit?) and languid insurance companies, and new boutique asset managers emerged with massive institutional mandates. Investment consultants moved their clients into 60/40, 70/30, and even 80/20 equity/bond allocations.
Importantly, the equity markets behaved well during this period—it was to be the great bull run of the twentieth century. If Jack Welch’s General Electric (and, more importantly, its investors) felt comfortable that in some years the conglomerate made more money from its pension fund than from its operations, how could there be a problem?
The problem, of course, was that the equity market was unlikely to cooperate forever. And long before it ceased cooperating, voices were being raised, though not listened to overmuch, pointing out the fallacy of asset-focused pension investing. In 1989, this correspondent found himself in his cramped Manhattan apartment vainly trying to make some sense of his handwritten notes from a series of unfathomable interviews just conducted with a handful of pointy heads at Wall Street firms, many of which entities have since been consigned to the ash-heap: Salomon Brothers, PaineWebber, and DLJ, among others. The firms may have gone, but the pointy-heads endure, including Martin Leibowitz at Morgan Stanley and Jess Yawitz at NISA in St Louis. So too has endured the topic of those interviews: immunization, or, as we have come to call it in an imperfect world, liability-driven investing.
As has been noted, nothing was particularly novel about immunization: certainly, the Herr Doktor Professor responsible for the Kruppianer pension fund a century earlier wouldn’t have thought so. By 1990, however, it had found its way through business schools and was the domain of rocket scientists: Even the language was impenetrable. To this financial journalist, Yawitz might as well have been a witchdoctor, sprouting incomprehensible theorems with serenity: No matter that anyone who was anyone in the institutional investment world knew that equities outperformed in the medium-term, and that the only real question was whether you picked Brinson Partners or Wellington, these bond savants laid out their case with the calmness of academics—which, of course, they were. And, like most academics, they were ignored. It took almost two decades and serious shifts in the regulatory and accounting landscape to make their theories respectable.
The changes that the Pension Protection Act of 2006 ushered in are still rippling towards us: in retrospect, it was a remarkable piece of legislation, and its strictures on funded status, combined with accounting changes that funded status be reported on balance sheets, was the first signal that the age of adventurism in American corporate defined benefit plans was at an end. A blizzard of pension closing and freezings has since made the headlines: as a society, we have entered the defined contribution age.
Of course, there are still liabilities left to manage: somewhere, a retired IBM widower is eyeing the waitress who will become his next wife, ensuring that, frozen or not, IBM will still be writing pension checks for 50 years. Moreover, asset managers will strongly make the case not for LDI but for “risky” assets and “riskless” assets—the pursuit of alpha will remain part of the landscape. But all that said, for all the right reasons, we have a winner, and the winner is LDI.
There is no little irony in this, as, to a neutral observer, the present day interest-rate environment is a highly inhospitable one indeed. The parallel is to a gold bug, with the price of gold soaring above all-time highs: One can always make the case for gold, but how about some historical perspective? The truth is that the shift we have embarked on is a secular one. In a recent, and it should be said, highly thoughtful piece called Revisiting the Case for Liability-Driven Investing in 2011, by Michael Swell and Scott McDermott at Goldman Sachs Asset Management, there is a telling concluding sentence: “Against this backdrop, we think the strategic case for LDI—in 2011 and always—is clear.” The italics are mine.
-Charlie Ruffel