Monday Morning: Did pension funds cause the bubble?

What sparked the 1990s stock market bubble?

U.S. pension funds are obvious suspects because they are large and have a reputation for putting short-term performance pressure on money managers.

Did that pressure contribute to the bubble?

Actually, I think that U.S. pension funds, defined-benefit and defined-contribution, were only part of a complex process that contributed to the bull market that became a bubble.

There was no bubble in the late 1970s and early 1980s, although corporate pension assets grew rapidly, and pension funds and their managers avidly pursued performance during that period. Something more had to be at work in the 1990s.

Among those additional factors was the move into equities by the nation’s public pension funds, many of them very large funds. Most public pension funds had low equity exposures in the early 1980s.

In 1985, public fund equity exposure was only 30.1% on average. By September 2000, it had reached 61.2% (excluding private equity). That represented a large flow of dollars into stocks.

At the same time, corporate defined-benefit pension funds were boosting their average domestic-equity exposures as well, to 63.3% (excluding private equity), from 48.5%. And corporate 401(k) plans, which were relatively small and heavily invested in guaranteed investment contracts in 1985, were large and 69% invested in equities by 2000.

Those three sources of increased demand for stocks certainly helped lift stock prices during the late 1980s and 1990s. That rise in stock prices, in turn, attracted additional demand, first from individual investors outside their employer-sponsored pension plans.

IRA equity exposures began to match those of 401(k) plans. Even assets in the trust accounts of wealthy individuals became more equity oriented.

Foreign Boost

In addition, foreign investors were attracted by the rise in U.S. stock prices and by the strength of the U.S. economy and the U.S. dollar. In 1999 and 2000, they began to pour money into the U.S. stock market. The foreign investors became the marginal buyers who set the price, pushing the market over the top.

But what about performance pressures? Didn’t they play a role?

Money managers have been complaining about pressure from pension executives for above-average quarter-to-quarter returns for almost all of the 29 years I have been reporting on pension funds. Was anything different this time?

Yes. The stock market demanded earnings, and CEOs and chief financial officers were determined to deliver them.

Pension income was a source of earnings. Therefore pension execs at corporate pension funds felt enormous pressure to deliver those returns to maximize corporate pension income – or at least minimize pension expense.

In addition, the number of available defined-benefit domestic-equity mandates for money managers dropped because of the dramatic decline in the number of corporate defined-benefit plans. This occurred at the same time as declines in corporate pension fund cash flows and in the average number of managers used per dollar of fund assets.

Intensified competition

The result was intensified competition among money managers for that smaller number of assignments. Performance became even more critical to being retained or being hired.

Growth-stock managers, in particular, chased the highest-flying stocks and the latest IPOs in the hottest industries to generate that performance.

Individuals in 401(k) plans also sought the hottest funds in their plans’ universes, and they chased the hot funds with their investments outside their retirement plans. Performance became even more critical for success in the mutual fund arena.

All this was piled on top of the hype from Wall Street analysts and investment bankers, and the genuinely strong performance of corporate America and the economy.

So pension funds did contribute to the bubble – but they had a lot of help from Wall Street, mutual fund companies, foreign institutions and individuals.

Mike Clowes is the editorial director of InvestmentNews and its sister publication Pensions & Investments.