fell from 77 percent of all assets to 62 percent in 1958, solely as the result of a deemphasis of Government securities, which outweighed an increase in corporate bond holdings. Simultaneously, pension funds placed rapidly mounting reliance on common stock. From 1951 to 1958, when total assets expanded by $15.2 billion, $5.2 billion of common stock was added to fund portfolios at book value, to raise it from about 12 percent to 27 percent of assets; at market value, it rose to 39 percent. In 1958, 43 percent of net receipts were invested in common stock.

This drastic redistribution was both a defense against inflation and an attempt to take advantage of economic growth and rising yields. It was the key move to preserve the health of pension funds in a rapidly shifting financial environment.

The Foundations of Investing Policy

The history of pension investments highlights two characteristic tendencies: the predominance of debt securities and the extensive use of common stock. These derive from a combination of the purposes of pension funds and the financial structure peculiar to them.

Fixed Liabilities and Bond Investment. The main reason for the use of relatively stable-valued bonds as the mainstay of pension portfolios is that the liabilities of a pension trust are largely fixed. Given this, investment managers on the whole have concluded that asset values should parallel the fixed liability of the fund. Therefore, in general, investment policy has elected the bond as its major instrument.

The fact that corporate bonds normally have constituted the major part of total debt securities held by pension funds is the straightforward result of a customary superiority of their yields over those on the bonds of the other major issuers—the Federal Government and State and local governments.

State and local government bonds are, in effect, ruled out by the tax status of pension funds. Such bonds ordinarily yield less before tax than similar quality corporate and U.S. Government bonds. They attract investors with high tax rates because interest on them is exempt from Federal income tax, and their after-tax yield to these investors is higher than that on fully taxable corporate and U.S. Government bonds. However, pension funds, whose investment income is tax free, have no incentive to accept the lower before-tax yield of State and local government bonds. In consequence, these bonds do not appear in pension portfolios.

Among the fully taxable bonds, mainly corporate bonds and most U.S. Government bonds, pension funds rely mostly on the former because they offer higher yields. Many investors find a place in their portfolios for Governments because their combination of yield and liquidity is satisfactory, but large pension funds have little use for a high degree of liquidity.

Small funds do, however, have a systematic tendency toward a much heavier usage of liquid as

Corporate Pension Funds, 1958, Statistical Series Release No. 1605 (Washington, Securities and Exchange Commission, May 26, 1959), p. 5.

"Pension funds employ the commonplace devices relied upon by all investors; for example, diversification of assets along several lines. Analysis here is focused on distinctive aspects only.

sets-cash and Government securities-than the larger funds. This probably stems both from the small funds' difficulty in trading profitably because of the small sums involved and the consequently prohibitive cost of security analysis, and from their greater need for liquid reserves due to inability to benefit from an averaging of expected cash demands, as funds with large memberships do. Hence, they are subject to less regular and less predictable needs for cash, and keep proportionately larger precautionary reserves.

This observation is an important one because an overwhelming proportion of pension plans are comparatively small, say, under $5 million of assets. At the end of 1954, the assets of nearly 71 percent of all corporate funds fell under this figure." However, these funds controlled only slightly in excess of 7 percent of fund assets at the time.

Assured Liquidity Positions. The keystone of pension funds' rather extensive commitment to common stock is the stability and predictability of their needs for cash. Pension funds have no obligations payable on demand. Benefit payments are the only significant outflow of cash, and they are tied to employee retirements, which are actuarially predictable. Moreover, the inflows of cash from employer and/or employee contributions are semicontractual and reliable. Consequently, there is no danger of having to sell stock at depressed market levels to meet an unexpected demand for cash. Even the small funds, with their relatively great liquidity, have substantial holdings of common stock.

Equally important is the long period of net growth enjoyed by most pension funds. If the work force is relatively young or if employment covered by the plan is expanding, particularly among young workers, payments to the pension fund will more than equal benefit payments to retired workers, for an indefinite period. As a result, for most funds there is almost no threat for the period of a generation that it will be necessary to sell a fund's assets to pay benefits.

• Survey of Corporate Pension Funds, 1951-1954 (Washington, Securities and Exchange Commission, October 1, 1956), table 4, p. 28.

Ibid., table 7, p. 31.

In general, then, a pension fund's investment manager can bide his time in liquidating the trust's stock holdings. This same long-term stability affords him plenty of opportunities to redistribute his portfolio, should changing conditions warrant, by diverting cash inflows in the desired direction rather than by selling one security to buy another, which is more expensive and may be difficult to do without loss.

Legal Circumstances of Pension Trusts. An important permissive element in the use of common stock by pension trusts is the fact that they, unlike most financial institutions (except investment companies), are not subject to regulations which severely limit or prohibit investment in common stock. However, the law of trust investment has been powerful in molding present attitudes toward pension and other trust investment by indirect means. State laws imposing investment limitations, other than those setting forth fiduciary responsibility, etc., apply only to trusts invested at the discretion of the trustee. Nevertheless, the standards imposed on discretionary trusts do establish an informal benchmark for cases where the trustor determines investing policies.

Two schools of thought have run concurrently in fiduciary law. One has argued that safety and defensibility in investment can be achieved by compelling trustees to purchase securities from a prescribed legal list of securities; the other, that defensibility in investment is to be achieved by relying upon the skill of prudent men without giving specific limitations. This "prudent man" rule has prevailed in Massachusetts since 1830. In most States, however, the "legal list" notion prevailed until the 1930's, when many securities on legal lists failed. Now, a great majority of the States employ the prudent man rule.

The most important State fiduciary laws for pension trusts are those of New York because a very large proportion of total pension assets are governed by trustees domiciled there. In 1950, New York adopted a modified prudent man rule which, in effect, permits trustees to invest up to 35 percent of a trust's assets in securities not on the legal list, and this generally is taken to mean that up to 35 percent of a discretionary trust may be allocated to common stock. This liberalization of trust law was but one of several moderate statu

tory changes, all aimed at taking account of a changing disposition toward common stock investment.8

The Threat of Inflation. At first glance, a rapidly rising price level poses no problem for a pension fund because its liabilities are stated usually as fixed monetary sums. For at least two reasons, however, pension fund managers cannot shrug off inflation, and they have hedged against it by investing in common stocks.

First, rises in the cost of living are almost sure to be manifested sooner or later in employee pressure for expanded pension benefits. Increased benefits can be financed partly by devoting some of the pension portfolio to common stock, which will presumably appreciate in value as commodity prices rise. In large measure, this explains the surge of pension funds into common stock starting at about the time of the Korean conflict, when prices were soaring. The trend was strengthened by the acceptance, at about the same time, of a liberalized view of fiduciary law, and by the fact that postwar fears of the widely anticipated relapse of the economy into chronic depression had been dispelled.

Pension trust managers are alert to the possibilities of common stock on a second score. Many arguments have been advanced to the effect that, irrespective of inflation, the combination of price appreciation and dividends on common stock has proved to be superior over long periods to the earnings on other investment media. This logic, carried to its ultimate, means that a pension fund can, and should, invest virtually 100 percent in common stock. Presumably, added risk will be more than offset by increased earnings. But, in fact, few pension trusts are devoted entirely to common stock.

The Distribution of Earnings

The earnings and capital growth of a pension fund are of paramount importance because of the role they play in determining the cost of a pension plan, and/or the level of benefits it pays.10 Contributions to a pension trust, until they are eventually paid out as benefits, are invested as earning assets. Reinvestment of earnings over a long

period has the familiar power of compound interest. Together, the contributions and the earnings must grow to meet the future liabilities for retirement payments. With a given level of benefits promised, contributions can be reduced dollarfor-dollar by added earnings. Alternatively, if contributions remain constant, increased earnings can be used to raise benefit levels. In other words, earnings can be divided between cost reduction and benefit expansion. One illustration of the power of increased earnings is that an increase of 1 percent in the return on a portfolio will, over 40 years, decrease costs by about 20 percent, or raise benefits by approximately 25 percent. In practice, the division of yield between added benefits and cost reduction depends largely upon the particular plan's characteristics.

The Interests of Covered Employees. Employee interest in a pension fund's assets is predominantly conservative, in the sense that with the passage of time the fund should progressively absorb responsibility for retirement benefits. Because the fund is a kind of collateral for pension payments, preservation of its assets should be a prime interest of employees. Employee concern is weak, however, particularly under a fixed-benefit plan, where the employer is ultimately responsible for any deficiency of the fund if contributions and earnings prove insufficient.

The link between employee interests and a fund's investment return depends upon the benefit formula of the plan in question. If the plan specifies fixed benefits, the employer will use increased earnings to achieve cost reduction unless benefit levels are raised. However, the ability of employees to obtain liberalized benefits will depend partly upon the earnings of a fund because, of course, increases from this source substitute for added contributions.

8 For example, since 1950, New York laws governing life insurance company investing have been liberalized twice to allow greater use of common stock and a similar modification of the laws governing savings banks has been enacted.

See Paul L. Howell, A Reexamination of Pension Fund Investment Policies (in Journal of Finance, May 1958, pp. 261274). Also, Common Stocks and Pension Fund Investing (in Harvard Business Review, November-December 1958, pp. 92106).

10 Other factors affecting cost and/or benefits are neglected here to pinpoint the impact of fund earnings alone.

On the other hand, if the pension plan is the money-purchase type, in which the employer merely agrees to contribute a certain sum periodically, benefits are entirely dependent on money available upon the employees' retirement. Anything added through earnings on the fund will directly return to the employees as increased benefits. In such cases, the interest of the trust's beneficiaries is decidedly pointed.

Union Interest. Much as the employees' interest in safety and earnings is heavily qualified by the employer's ultimate responsibility and by the benefit formula of the plan, union concern with investment policy is weakened." In money-purchase plans, the union, like the employees, has a stronger interest.

Unions exercise some investing influence when they participate in the choice of individuals serving as trustees. In plans using individuals as trustees, unions either alone or with the employer appointed trustees in about 28 percent of the pension plans covering 20 or more employees in New York in 1955.12 Unions, however, rarely participate in the choice of trustees in bank-trusteed funds; in New York in 1954, the trustee had been appointed by the union alone in 0.2 percent of the plans and jointly with the employer in 0.8 percent of the cases.1

13

11 In plans covering at least half of the 5.8 million pensioncovered members of the American Federation of Labor and Congress of Industrial Organizations in 1954, the union exercised no significant control. See Final Report Submitted to the Senate Committee on Labor and Welfare by its Subcommittee on Welfare and Pension Funds (84th Cong., 2d sess., Committee print, April 6, 1956).

12 Private Employee Benefit Plans-A Public Trust: A Report on Welfare and Pension Funds in New York State (New York, State Insurance Department, 1956), table 5.

18 Pension and Other Employee Welfare Plans, 1955 (New York State Banking Department, 1955), table 17, p. 17.

14 References to cost here refer directly to employer contributions, but the meaning of cost to the employer can take another turn. One author has pointed out that 100 percent investment in bonds in a prominent fund led to a rate of earnings lower than the employer's cost of debt financing. In effect, pension benefits were financed indirectly through the earnings on higher cost funds derived from the capital market. See Howell, op. cit., pp. 268-270.

15 Pension and Other Employee Welfare Plans, op. cit., table 17,

p. 17.

16 Ibid., table 30, p. 30.

17 Two questions that arise unfailingly concern the investment of a pension fund in securities of the employer, and the voting of stock held in trust. The matter has been thoroughly debated in other publications, and so it is left aside here.

The Employer as Trustor. In fixed-benefit plans, the employer has the clearest and most immediate interest in the investment policy, because increased earnings either directly lower costs 14 or serve as a hedge against future liberalizations of the pension plan's benefits if contributions are not reduced. In money-purchase plans, the employer's stake in earnings is less pointed, because his financial commitment is stated in fixed monetary terms. It is true, however, that the prospects of increasing benefits from fortunate investment might forestall pressure in bargaining for expanded contributions. The immediacy of the employers' interest is reflected in the control they exercise in trust investment policy, either directly or through the appointment of trustees. Employers almost exclusively rule the choice of bank trustees. In over 97 percent of the 1,024 pension trusts held by New York banks in 1954, the trustee had been appointed by the employer alone.15 In over two-thirds of these cases, the trustee alone determined investments and investment policy and in almost 90 percent, the trustee had some responsibility.16 When the employer alone appoints an individual(s) as trustee or administers the plan himself, his influence is direct. Sometimes too, the corporation employs a professional investment manager who also serves as one of the trustees, and this strengthens the corporation's influence.

Impact on the Securities Markets

The rapid financial growth of pension funds has led to widespread concern over the effect of their purchases in the securities markets because of the great magnitude of these purchases and their concentration on high-grade securities. The latter aspect is also significant as a comment upon the quality of their investments.

Government Securities. The volume of Government securities held and traded by corporate pension funds is small compared with the Government debt outstanding and with trading by major investors in this market. Government securities held by pension funds only slightly exceeded $2.5 billion at the peak in 1955, and since have fallen by about $0.6 billion, as already indicated. Moreover, it has been unusual for pension funds' holdings of Government securities to change more than $100 million in a single quarter.18 Thus, in quantitative terms, it is unlikely that pension funds are large enough to affect the Government securities market appreciably.

Corporate Bonds. In terms of current purchases, pension funds are not modest figures in the corporate bond market. As a percentage of corporate bonds outstanding, pension holdings are not large, perhaps about 9 percent.19 The rapid growth of pension funds and their emphasis on corporate bonds, however, has made the rate of their bond acquisitions second only to that of life insurance companies. In the 6 years 1951-56, pension funds accounted for nearly 22 percent of the total increase in holdings of corporate bonds by all investors. 20

The institutional investor's preference for highgrade corporate bonds is shared by pension funds. The best statistical evidence comes from a survey of securities held in pension trusts by New York banks on September 30, 1954, which showed that over 99 percent of securities held, including bonds, were "investment grade" as rated by the investment services or by the New York State Banking Department.21

A certain amount of interest attaches to the direct sale of new issues of corporate bonds to pension funds. No data are available on the extent of the practice, but it is clear that the large funds, especially those trusteed by individuals appointed by the corporate employer, purchase a significant share of their yearly acquisitions this way rather than in the open market.

Stocks. At the end of 1956, pension funds held only about 2 percent of the common and preferred stock outstanding. Again, however, the current rate of their net purchases makes them a sizable figure in the stock market. In the period 1951–56, investors as a whole made $17 billion net purchases of common and preferred stock. Corporate pension funds accounted for one-fifth of the total.

The penchant for high-grade securities applies to common stock too. Financial observers have asked if pension fund buying, together with that of other institutions concentrated in the "bluechip" stratum, will produce price and yield distortions favoring high-grade common stocks. The statistical evidence supports the contention that purchases are closely concentrated. When pension trusts held by New York banks were surveyed in 1954, 10 separate stocks constituted almost 27 percent of all holdings of individual stocks with aggregate holdings of more than $1 million; 20 stocks equaled nearly 40 percent and 30 stocks came to a little less than half of all such holdings.22 Similarly, a study of institutional investors in the common stock market in the period 1953-55 found that roughly one-fourth of total common stock purchases by a sample of pension funds fell within a list of 25 selected stocks.23

18 Treasury Bulletin, March 1954, p. 30, and quarterly issues thereafter.

19 Vito Natrella, Implications of Pension Fund Accumulations, paper delivered at the 117th annual meeting of the American Statistical Association, Atlantic City, N.J., September 10, 1957, table 8, p. 27.

20 Ibid., table 7, p. 26.

1 Pension and Other Employee Welfare Plans, op. cit., table 3, p. 3.

22 Sherwin C. Badger, Thinking Ahead: Funds in the Stock Market (in Harvard Business Review, July-August 1956, p. 34).

23 Institutional Investors and the Stock Market, 1953-1955 (U.S. Senate, 84th Cong., 2d sess.), p. 3.