Many believe that the stock market's rally over the past nine months has brought valuations to far too expensive levels. Now, some institutional investors are putting their money where their mouths are and making some dramatic moves involving their huge pension accounts -- and the results could have a big impact on millions of workers.
Moving pension money
Bloomberg recently reported that a number of companies, including J.C. Penney
Pension funds are still reeling from their losses during last year's bear market. The financial crisis left pensions with a $400 billion shortfall as of the end of 2008, according to a Mercer Consulting study. Many companies, including DuPont
Now, of course, the stock market has recovered significantly, rewarding those pension funds that didn't panic, and instead stuck with their stock allocations throughout the crisis and ensuing rally. Yet it's only natural that companies that narrowly dodged the pension bullet might want to take steps to reduce risk in their pension fund portfolios.
In many ways, pension plans face the same challenges that individual investors do. They have to make decisions about how much money to set aside in their pensions and predict when and how much money they'll need to generate from their portfolio to pay benefits. Even if stocks may have a better long-term return, the constant cash-flow needs that active pension plans have makes a mixed investment approach far more prudent in order to avoid the problems that a sustained downturn like last year's bear market can produce.
Out of the frying pan, into the fire
Yet the question that pension funds have to ask themselves is whether trading stocks for corporate bonds really makes sense right now. Although stocks have definitely risen sharply from their lows, corporate bonds have also put in a stellar performance recently. Although junk bonds have experienced perhaps the greatest returns, even high-quality corporate bond funds like the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) have jumped by double-digit percentages so far in 2009. That's a far cry from the huge losses that long-term Treasury bonds have seen this year.
High-quality bonds have the advantage of giving companies more certainty about returns and cash-flow timing. Pensions often invest in dividend-paying stocks, but recent cuts in payouts have exposed the uncertainty of dividends in comparison to the steadier payouts from a bond. Incorporating more bonds in pension funds will likely smooth returns, reducing volatility and likely making it easier to predict what impact required pension contributions will have on a company's financials from year to year.
The trade-off, though, is that if bonds have lower returns than stocks, then companies have to set aside more money to fund their pension obligations. That will divert profits from a company's bottom line, potentially hurting shareholders that might otherwise see stronger growth in earnings -- albeit with some attendant volatility.
From an investing standpoint, these recent moves highlight just how important it is for you to understand how significant pension obligations are to the companies whose stocks you own. Obviously, a company like Ford Motor
Just because pension plans are jumping out of the stock market doesn't mean you should, though. Companies typically have the financial resources to cover pension liabilities without a high-risk investment portfolio, but the same isn't true for you trying to save for long-term goals like retirement. Despite the risk, the higher returns that stocks offer will do a better job of helping you reach your goals over the long run.
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Fool contributor Dan Caplinger thinks stocks and bonds go together like gin and tonic. He doesn't own shares of the companies mentioned in this article. Sears Holdings is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never runs away from a fight.