would be very unwise public policy to react to these inequities by suggesting the wholesale abolition of private pensions. Let me give an example of one important contribution which I think private pensions can make. Representatives of the UAW union recently appeared before the Special Senate Committee on Aging and were asked about their programs which encourage early retirement of workers and whether this was in general a very good policy-given that average life expectancy would mean that early retiring workers have about two decades of retirement at benefits which two decades hence might seem very low compared to what they appeared to be at the time of retirement. A very interesting and thoughtful answer came back. They said that within the UAW the foundry workers have a special life expectancy, much lower that the average life expectancy. Therefore, they felt it was important that these workers be allowed to retire at an earlier age with substantial pensions. Now, it would be very difficult to devise, I think, a public pension system for the whole country which could take accounts of the special problems of small groups such as the foundry workers. I think here is where the private pension system can perform quite admirably, taking care of these very special circumstances. So, I would say that private pensions do have their function, and we should not abolish them entirely. Chairman GRIFFITHS. Of course, the trouble with the private pension system is that only the big and the powerful can get the pension. Each of you has pointed out the smaller industries do not have these pensions. One of the saddest things, I think, and I heard it remarked on twice, is the Keogh bill. I think somebody said yesterday the Treasury opposed the Keogh bill. True, they did, but so did 23 other members of the committee oppose it. Thev just did not believe in the Keogh bill in spite of the fact that millions of professional people had absolutely no opportunity to set up a pension for themselves at all. Why should they be denied a tax-free saving? It was absolutely nonsense. The Keogh bill is not adequate now for a professional. He is not being permitted to replace anything like the part of his income that a person in government gets, and yet he would have to earn it all himself. So, in fact, the professionals were not organized. They did not do anything. And the places where the big pensions are being given are in the highly organized industries where they have power but if you are in a small concern where there is no employee power, then you do not get the pension. Mr. SCHOTLAND. Madam Chairman, may I suggest that perhaps rather than diminishing the protections which people in more organized industry are fortunate enough to have as a result of their own fight for collective-bargaining representation, we might integrate in some way the social security system with pension benefits so that, for example, those without any private pension coverage would get more social security coverage. Chairman GRIFFITHS. That would be a good idea but you have to be terribly careful even on this. A. T. & T. integrated itself for years. It has only been recently that every time you lifted the social security, A. T. & T. did not reduce their pensions. I am not for that type of integration. I do not think that really would work properly. I would like to express my deep appreciation to each one of you for being here today and I would like to ask that if the other members of the subcommittee would like to send you some questions, if you would answer, would you please answer them then for them? Thank you very much. This subcommittee will adjourn until 10 o'clock in the morning at this place. (Whereupon, at 12:05 p.m., the hearing was recessed, to reconvene at 10 a.m., Wednesday, April 29, 1970.) INVESTMENT POLICIES OF PENSION FUNDS WEDNESDAY, APRIL 29, 1970 CONGRESS OF THE UNITED STATES, The Subcommittee on Fiscal Policy met, pursuant to recess, at 10 a.m., in room S-407, the Capitol Building, Hon. Martha W. Griffiths (chairman of the subcommittee) presiding. Present: Representative Griffiths. Also present: John R. Stark, executive director; James W. Knowles, director of research; Loughlin F. McHugh, senior economist and Douglas C. Frechtling, economist for the minority. Chairman GRIFFITHS. Today we look at some special but broad aspects of the impact of the growth of pension funds on financial markets and the changing structure of control of the Nation's re sources. Professor Dietz of the University of Oregon has been a longtime student of pension fund problems, particularly in the area of goals and objectives and measurement of the proficiency with which pension funds are managed. His remarks today are addressed to these subjects. Professor Harbrecht, of New York University in Canada, has written extensively about pension funds; his book, "Pension Funds and Economic Power," is one of the most authoritative texts in the field, dealing with the changing economic power structure as institutions grow in size and ownership of corporate stock. Professor Lerner, of the Graduate School of Management at Northwestern University, has researched extensively the workings of financial markets. He will direct his comments to the question of the liquidity of stock markets as the size of transactions increase significantly with institutions becoming a major factor in the stock market. Gentlemen, we appreciate your desire and interest to help us obtain a fuller understanding of these very important subjects. You may proceed, Mr. Dietz. Mr. DIETZ. Thank you. STATEMENT OF PETER 0. DIETZ, PROFESSOR OF FINANCE, GRADUATE SCHOOL OF MANAGEMENT AND BUSINESS ADMINISTRATION, UNIVERSITY OF OREGON Mr. DIETZ. Thank you, Madam Chairman. My name is Peter O. Dietz, and I am associate professor of finance, Graduate School of Management and Business Administration, University of Oregon. PENSION AND INVESTMENT POLICY My own interests in the pension field are primarily twofold: (1) development of investment goals and objectives, and (2) measurement of investment performance. I would like to develop this topic along three broad questions. First, based on an analysis of investment goals and objectives, what are appropriate investments for pension funds? Second, how should investment performance be measured and how good has performance been? Finally, based on goals and an analysis of past performance, what is the future direction that pension fund investment should take? Sound pension fund investment administration requires the establishment of investment goals just as much as any other aspect of business enterprise. These goals become the plan of action under which the investment manager works, the basis for effective communication between trustor and trustee, and the basis for comparison with actual performance. Pension fund managers need to be concerned with earning an adequate return on pension fund assets, since high return reduces the cost of a dollar's worth of pension payments. They also are concerned with the ability of the funded assets to meet pension liabilities. In addition to such goals as high rate of return and protection against loss of principal, there may be other major or subsidiary goals such as liquidity, current income, stable income, stability of market value, et cetera, depending upon particular circumstances. Proper establishment of such goals has an influence on investment policy. For example, a goal of current income would lead to adoption of investment policies emphasizing high-yield bonds without regard to call protection and to high-yielding common stocks without regard to future growth of dividends. But a policy calling for stable income might lead to adoption of investment policies seeking call protection even at the sacrifice of yield and to common stock investments in stable growth industries such as consumer products and public utilities. Again, a goal calling for high return might lead to an investment policy of lower grade bonds and aggressive common stock investments, whereas a goal placing emphasis on risk reduction might lead to higher grade bonds and conservative stock investments. Some writers have implied that the investment goals of all pension funds should be similar. However, discussion with corporate pension fund administrators, pension fund consultants, and invest 1 For a further discussion of this topic, see: Dietz. Peter O.. "Pension Funds: Measuring Investment Performance" (the Free Press. New York: 1966), ch. III: Sieff. John A., "Construction of a Retirement Fund Portfolio." Financial Analysts Journal. JulyAugust 1965: and Dietz. Peter O. "Investment Practices of Trusteed Pension Plans." Financial Executive, June 1969. 2 For example. See Howell. Paul L.. "Common Stocks and Pension Fund Investing." Harvard Business Review, XXXVI (November 1958). ment counselors, indicates that most pension fund experts believe there are factors peculiar to individual corporations which lead to particular goals for individual portfolios. Investment decisions, then, should be made to meet the specific needs of a particular fund. These needs can be stated in terms of the fund's need for high investment return, its liquidity needs, and its ability to accept risk. The major factors which affect a fund's requirement for high investment return as opposed to liquidity needs and ability to withstand risk are (a) the reliability of cash inflow, (b) the predictability of cash outflow, (c) the company's ability to earn returns on its own assets, and (d) the liability structure of the pension plan. To make these points clear, I would like to discuss each of these factors briefly. (a) Reliability of cash inflow Pension fund benefits can be paid out of either the corpus of the fund or out of new monies received by the trustee from company and employee contributions, and from investment income. In those cases where the trustee is, for example, 99.9 percent sure that contributions and income will exceed benefits payments in each of the next 20 years there is, to all intents and purposes, no need to worry about safety of principal and liquidity of the fund's assets in the short run. However, in the situation where there is a probability of say, 50 percent that benefits will exceed contributions and income in three out of the next 20 years, a more conservative investment policy is indicated. Cash inflow to the fund depends primarily on a corporation's earnings, internal cash generation, and work force characteristics. Thus, for example, earnings are more stable in noncyclical than in cyclical industries; growth companies have sufficient earnings to make contributions, but may have pressing cash needs. In addition to the above factors which influence the ability of a corporation to make regular payments to the fund, cognizance should be taken of a company's position within its industry. A strong, successful company can plan its competitive position to meet cash needs; a weaker company may not be so fortunate. Therefore, the trustees of General Motors pension funds would have more assurance of receiving sufficient payment from G.M., than the trustees of the American Motors fund. Work force characteristics also have an important bearing on cash inflow. A company characterized by a young growing work force can expect to make growing contributions each year. Payout from the fund will be small by comparison, and it may be many years before payout becomes influential. An opposite situation exists in a company that has a mature work force where contributions and benefit payments are largely offsetting, and more particularly by a company where the size of the work force is declining. In the latter case, inflow is apt to be less than outflow. Funds characterized by the first attributes can afford to stand investment risks which are not tolerable under the last two conditions. (b) Predictability of cash outflow As indicated above, a major factor to be considered in determining liquidity needs is not only the size of the excess of cash inflow |