The Economic Consequences of Accounting Standards: Evidence from Risk-Taking in Pension Plans

Abstract

Pension experts have long conjectured that pension accounting rules encourage firms to invest pension assets in risky asset classes (Zion and Carcache 2003, Gold 2005). The recent passage of IAS 19 Employee Benefits (Revised) (“IAS 19R”) marks a fundamental shift in pension accounting on the income statement, by removing the use of the expected rate of return (ERR) on plan assets to determine a “smoothed” pension expense. We exploit the quasi-experimental setting created by this shift in a difference-in-differences research design. We demonstrate that a sample of Canadian firms affected by IAS 19R reduces risk-taking in pension investments post-IAS 19R, both over time, and compared to a control sample of U.S. firms unaffected by IAS 19R. Within Canadian firms, we also find that firms expected to be relatively more impacted – namely those with economically substantial plans, for which ERR assumptions have a larger impact on the income statement – engage in more risk-reduction post-IAS 19R. Accounting regimes relying on expected returns to calculate pension expense allow sponsors to recognize in income the benefits of higher risk (via a higher ERR, which reduces pension expense) while not recognizing the costs (of higher volatility in actual returns). We provide evidence that such accounting regimes could tilt plan sponsors towards more risk-taking in pension investment. Our results also suggest that an ERR-based expense smoothing regime – the norm under current U.S. GAAP – could be a driver of pension asset allocation.