Only for the sake of a punch line must it be mentioned that Morgan Stanley has not been as risk-cognizant as the organization would like to project. They, like every other bulge-bracket firm, survived the fall of 2008 by the grace of the United States federal government and its willingness to support faltering financial institutions. While hindsight has allowed some to suggest that TARP injections and the billions of dollars AIG received—and ultimately passed onto the Goldman Sachs’ and Morgan Stanleys of the world—were unnecessary for financial survival, few would maintain even now that these sober institutions had a firm grasp of the risks they faced in recent years.
Which makes Morgan Stanley’s mastery of its defined-benefit pension fund risk all the more interesting.
“May 1997. Dean Witter and Morgan Stanley had merged—and for the next 18 months we worked on merging the defined-benefit (DB) pension plans,” says Ed Puckhaber, Chair of the now-combined Retirement Plan Investment Committee (RPIC) for Morgan Stanley’s $3.1 billion American fund. He sits in Charleston, South Carolina, his residence now that he is no longer active with Morgan Stanley outside of the pension plan. A low-key man, it is easy when speaking with him to forget just how revolutionary were the changes he and his team instituted from that merger through 2008. Today, the Morgan Stanley pension fund, a singular construct in an ocean of underfunded plans, is essentially 100% immunized.
The firm’s pension fund wasn’t always in such robust shape. “In 1999 and 2000, we thought the asset allocation as it stood was good,” Puckhaber says. “It was what you’d expect at the time—30% in debt, 70% in equity.” The market environment of 2000 to 2002, however, was a “perfect storm, where assets fell and liabilities went up.” It was only after the pension deficit increased during that time that the fund’s investment committee, lead by Puckhaber, began to “refocus on the portfolio and risk.” The investment committee members, the team charged with leading the defined-benefit pension plan, the fund’s consultant (since replaced by Mercer), and even those within the bank’s treasury department began to discuss the options. “Were hedge funds, private equity, a larger allocation to risk-seeking assets the answer? Should we start to discuss overlays as hedges?” Puckhaber remembers the group asking. “Or was liability-driven investing something we should focus on? We discussed this over four or five years—there were no snap decisions.”
The end result of this extensive back-and-forth between all interested parties ended with a decision to gradually shift the equity portion of the portfolio into the fixed-income bucket. Somewhat uncomfortably, the fund began reducing its large equity allocation as the asset class rallied in the middle of the last decade, exiting altogether as markets turned from enthusiastic to ecstatic to maniacal. “We really exited equities in a major way in the fall of 2007, right as the markets peaked, and we had entirely vacated the space by the early summer of 2008. We wanted to insulate ourselves from equity volatility—but, to be fair, we had no idea what was about to happen in the market.” Through the use of fixed-income duration extension and swaps (due in part to a lack of long-duration Treasury bonds available), the plan’s average asset duration would soon be over 20 years, almost perfectly matching its liabilities. “Today, we’re entirely in Treasuries and swaps,” he adds.
The timing was impeccable. “We were up 21% in 2008,” Puckhaber says. “I think the average large plan fell 26%—so we had a delta of 47%. It was a lot of luck in the timing,” he avers. “We feel very good about the move—and we feel even better about the luck.” The plan, as of the end of September 2011, was overfunded at 116%.
Skeptics will claim that external factors, namely, the solvency-demanding Pension Protection Act of 2006 and changing accounting standards, plus the closing and freezing of Morgan Stanley’s defined-benefit plan spurred action more than any activism on the part of an investment committee or risk-aware Treasury department. The retort, of course, is that these forces pressed equally on practically every corporate pension plan worldwide, and yet Morgan Stanley, unlike nearly all others, de-risked their plan at exactly the right time. Luck it may be—but Morgan Stanley made its own luck.
They did so by more than just possessing an All-Star investment committee immersed in the world of finance. For every high-profile athlete, of course, there are journeymen who, year in and year out, produce results. One such person at Morgan Stanley is Michael Forgit, executive director and retirement plan manager. Forgit is exactly what one expects from a defined-benefit pension manager. He is a quiet man, an actuary by training who has been with Morgan Stanley since 1997. When queried, he consistently pauses before answering, in thought about how best to express himself. He, like Puckhaber before him, insists that the focus be on team rather than individual when discussing the fund’s transition to LDI. (Almost every character associated with this story insisted that someone else, and not them, be featured on the cover of this magazine.)
“We just have a treasury group that understands pension risk,” he says when asked about the success of the plan. “They, and we, wanted to de-risk the plan—and they were willing to pay for it. In the mid-2000s, they were willing to fund up the plan in exchange for de-risking it, which we liked. The firm was and is willing to take on risk where it has very sophisticated tools to monitor it—and not take on risk for those assets, like the pension plan, which are held outside the firm.” A senior member of the Treasury department—usually Daniel Park, a managing director there —attends nearly all the quarterly defined-benefit pension meetings, Forgit notes, “more to listen and ask questions than to direct.” This cooperation is invaluable, he and the others involved agree with enthusiasm. “It’s a truly collaborative group.”
Forgit also insists that the work done by the firm’s consultant is essential. In his role, he works extensively with Mercer, which acts as a bridge between many of the parties involved. “It’s about being a bridge, yes, but it’s not just between the asset managers and Michael,” says Steve Case, a lead Mercer consultant on the fund. “Involving the actuary,”—in this case, also Mercer—“the investment committee, and even the Treasury department is key, so everyone buys in.” Case and Mercer can be seen to be the quarterback for the Morgan Stanley plan, although Case stresses that Puckhaber is the “team captain. My job is to aid the partnership between all the groups involved,” he says. “I need to provide them with all the necessary information for them to make the right decisions in conjunction with all parties.” While Case and Mercer’s role extends beyond dealing with the firms managing Morgan Stanley’s pension assets, it is this domain that most explicitly reveals how an effective glide path works—and how the debate over active and passive investing demands more nuance than it currently receives.
When the portfolio was fully transitioned to fixed-income and swaps in 2008, the fund employed four asset managers. Two were active managers charged with seeking alpha; two were passive managers charged with mirroring a benchmark. As calculations showed the plan’s funding status approaching 100%, assets were shifted from the active to the passive managers (one manager was fired; the other active manager’s mandate was shifted to a more passive approach). In effect, by doing well, the active managers were performing themselves out of the job. “How do managers deal with losing the mandate after they’ve done well? It’s similar to a shift from active to passive management for equity mandates—it goes with the territory of active management,” Case says. “Passive managers also have far lower fees. Active managers simply wouldn’t be able to manage for the fees that are being paid for the much more risk-controlled mandates.” Besides creating this interesting dynamic between fund and asset manager, the Morgan Stanley experience suggests that for those who do believe consistent alpha can be obtained, the debate over how to find it is no more important than the debate over when to seek it.
Looking at the Morgan Stanley pension experience, it must be asked: Is such a smooth transition from risk-seeking to de-risking—executed in a collaborative manner between investment committee, pension management, Treasury, corporate executives, asset managers, actuary, and consultant—replicable? When the author was surveying the defined-benefit pension field for an appropriate profile for this magazine, he asked asset managers, consultants, and former chief investment officers to recommend potential subjects. Two names emerged as clear forerunners: the pension funds of Morgan Stanley and Prudential. This begs the question of whether effective pension risk management is the result of their sponsor’s business line—in this case, finance.
Mercer’s Case, for one, believes there are lessons for many sponsors in the Morgan Stanley experience. “It is replicable. Clients can outsource implementation to a variety of service providers if they are not comfortable with the details.” With a competent and engaged investment committee in place, Case, Forgit, and Puckhaber all agree, it doesn’t take a financial firm to produce strong financial decisions within its pension fund. “It isn’t just about the board and the fiduciaries and the managers—it’s about reaching out to the companies’ finance division—which every company with a defined-benefit plan will possess. It’s about having the right structures in place to succeed.”
Jeff McLean, CEO of Seattle-based Wurts & Associates, largely agrees with Case’s overarching assertion that success with LDI (and other allocation possibilities) is largely a function of plan governance. “I think it has to do more with governance than the business line of the institution,” he says. “Does the fact that Morgan Stanley and Prudential offer LDI solutions make them more likely to consider this approach for their own plan? Probably. But there are many other non-financial institutions that have already implemented LDI. The questions to ask are ‘How are these funds governed and how did that enable them to switch from a total-return framework to a liability-oriented framework?’”
“To me, this governance story is not told enough, and it deserves front-page treatment,” McLean continues. “The way funds govern themselves, who sits on their Boards, who does what—and how they process all the decisions required—that makes the difference. It doesn’t matter if it’s an endowment, public pension, or corporate plan. What our industry needs is a self-introspection on how we govern.” A lot of boards aren’t thinking strategically about the mission they’ve been handed, McLean believes. “They oftentimes aren’t managing assets towards their liabilities,” he adds. “They want to beat their peers. It’s mindless.”
Governance reforms, McLean believes, will lead to more outsourcing. “Many [board members] will look themselves in the mirror and say ‘What am I doing here? I’m a teacher, a police officer—why am I spending my day picking managers?’” Implementing policies and procedures may not be as exciting as picking individual managers, McLean admits, but “a director at a public company doesn’t get into the weeds on the square footage of a new factory. They approve the capital allocation or bond offering needed to build it.” It should be the same for asset owners, he insists. “It is—I don’t want to say 90% of the ball game—but governance is essential to a success like this.”
All parties involved are adamant that Morgan Stanley’s core businesses and managers led, instead of followed, when it came to its pension plan’s risk management success. To a man, they insist that senior management at the bank was involved in the decision to de-risk, and thus the divide that some may see between the management of the pension’s risk and the management of the bank’s risk is more ditch than canyon. “The story of Morgan Stanley is that this has been a team effort in which Human Resources, Treasury, Finance, Pension Committee, Consultant, and Actuary all signed on and implemented in concert,” Mercer’s Case stresses. “It’s a cultural change. It’s very hard to do, but necessary.”
The problem for Morgan Stanley as a whole—and for financial institutions in general—is that such efforts tend to fail when applied across complex and diverse business lines exposed to unknown risks. (Even Morgan Stanley’s New York office situation suggests complexity: the firm’s employees are scattered around Manhattan like buckshot from an errant shotgun blast.) Add in the ruthlessly unforgiving banking culture—quarterly earnings scrutinized, billions of dollars in bonuses on the line—and one can at least understand why Mister Market has forced the firm’s share value down nearly 50% in 2011. The market, frankly put, does not think Morgan Stanley is very good at managing risk.
Perhaps this is because the market isn’t paying attention to Morgan Stanley’s pension plan. It should. If the bank’s pension plan can be considered a microcosm for the rest of the firm, it manages risk—at least the risk it can define—extremely well. Of course, all risks are not created equal, but that does not negate the idea that Morgan Stanley’s pension fund brought together the required constituencies needed in order to successfully de-risk. For the sake of shareholders (and the safety of the entire financial system), let’s hope that this pension success is being replicated throughout the Other Morgan Stanley.
-Kip McDaniel