Why targeted investing does not make sense!

Financial Management (Financial Management Association), Autumn, 1998 by John R. Nofsinger

Watson (1994) argues that defined benefit pension plans should be allowed to implement targeted investing in order to generate collateral benefits for the plan participants. That is, some investment opportunities available to a pension plan may be capable of not only generating a financial return, but also of spinning off additional economic benefits that can be captured by the plan participants. Both Watson (1994) and the Department of Labor's (DOL) 1992 Employee Retirement Income Security Act (ERISA) Advisory Council report propose that through these economically targeted investments (ETIs), pension plans can improve the overall performance of their portfolios and benefit the local economy.

The DOL Report and Watson (1994) provide a compelling argument for how ETIs can provide high risk-adjusted returns to the pension fund and economic benefits to society. The idea of targeting investments has been controversial from the start. However, both proponents and critics agree that the success of ETIs hinges on the occurrence of the conditions set forth by Watson (1994): 1) capital gaps exist because the market for financing projects is inefficient, 2) funding ETIs will generate collateral economic benefits that can be measured and captured by the plan participants, 3) the project would go unfunded without the pension plan, and 4) the ETIs earn at least the prevailing risk-adjusted rate of return.

ETI proponents argue that these factors not only occur, but they can be identified and exploited by pension fund managers. However, this article argues that the existence of these four conditions can also lead to inferior investment performance and inefficient capital allocation for society. The results of empirical tests are consistent with this hypothesis.

I. The Inefficient Market Hypothesis

The first key implicit assumption of ETIs is that the market to finance these projects is not efficient. ETI proponents argue that this inefficiency leads to capital gaps where "worthy" investment projects are left unfunded. These unfunded projects have the potential to generate desirable economic benefits (i.e., job creation, etc.) in addition to being potentially underpriced.

In our free-market society, capital is a scarce resource that must be used in the most efficient manner in order to optimize the economy. When the free markets work effectively, some projects will go unfunded because they are not an efficient use of scarce resources. If markets are efficient, then unfunded projects are simply overpriced or suboptimal investments. Those pension fund managers who desire to fund ETIs must be able to distinguish between an ETI and an inefficient/overpriced project. If pension plan capital is systematically and mistakenly used to fund inefficient projects, then both the plan participants and our society are adversely affected.

One important question that has not yet been answered is, do these types of capital gaps exist? If these gaps are shown to exist, then financial instruments or securities which are traded in a competitive market can be devised to fill them. However, if these capital gaps do not exist, or cannot be found by the investment manager, then ETIs target inefficient projects instead of exploiting inefficiencies in the market.

II. Collateral Benefits

Part of the definition of ETIs is that they generate economic benefits in addition to financial returns. When these collateral benefits can be identified, measured, and captured by the plan participants, then proponents argue that these benefits should be considered in the investment-decision process. That is, the decision to invest should jointly include both financial risk/return considerations and collateral economic benefits. However, these collateral benefits must be quantifiable (ideally as in cash flows) and not just "benefiting society" or "benefiting a local economy." Although it has not been the center of the ETI debate, the practical aspects of measuring and capturing collateral benefits deserve some discussion. Even ETI proponents have difficulty describing a situation in which the plan participants can capture collateral benefits.

To illustrate this point, consider the three ETI examples described in Watson (1994). One concerns a pension plan providing venture capital and technology development in the same industry as the plan sponsor. Although this could help create jobs in the industry, it is difficult to determine how this adds cash flow to the plan participants other than the traditional investment cash flow. Another example suggests that pension plans invest in low-income and multi-family housing in the inner cities. Although this would benefit society, there is no mention of how plan participants can capture any collateral economic benefits, that is, cash flow.

The third ETI example does seem to generate collateral benefits that can be captured by the plan participants. Consider an underfunded pension plan for a building trades union. Financing new construction projects would create demand for the members' skills. The new work will create new pension liabilities and associated cash flow. If the project can be constructed so that the multi-employer contract is designed to make up past underfunding, the plan participants will be able to capture an economic benefit in addition to the financial return of the investment. This very narrow ETI example does have some merit because an economic benefit is generated that can be captured by plan participants. However, this example still has several problems that make it impractical. First, will employers agree to overfund the pension liabilities that are created by their projects? It is common for union pension plans to be underfunded. They become underfunded because the employers of the union workers do not contribute enough to meet the benefit liabilities.(2) A contract requiring full funding (and even over-funding, as in this example) would increase the employers' costs and affect the profitability and financial characteristics of the investment.