Defined Benefit Research Articles

Impact of the choice of risk assessment time horizons on defined benefit pension schemes

AbstractWe examine the impact of asset allocation and contribution rates on the risk of defined benefit (DB) pension schemes, using both a run-off and a shorter 3-year time horizon. Using the 3-year horizon, which is typically preferred by regulators, a high bond allocation reduces the spread of the distribution of surplus. However, this result is reversed when examined on a run-off basis. Furthermore, under both the 3-year horizon and the run-off, the higher bond allocation reduces the median level of surplus. Pressure on the affordability of DB schemes has led to widespread implementation of the so-called de-risking strategies, such as moving away from predominantly equity investments to greater bond investments. If the incentives produced by shorter term risk assessments are contributing to this shift, they might be harming the long-term financial health of the schemes. Contribution rates have relatively lower impact on the risk.

Golden Handcuffs and Corporate Innovation: Evidence from Defined Benefit Pension Plans

Abstract This study examines the relation between employee incentives and corporate innovation. We find that firms with a higher defined benefit (DB) pension value secure more patents and patent citations. We further show that pension freezes, which stop the accumulation of pension obligations, negatively affect innovation outcomes. The value of a DB plan enhances innovation by motivating employees to produce higher output and through loyalty. However, pension deficits impede innovation because of the nature of inside debt. Overall, our findings call for a fresh look at pensions by policy makers and practitioners, given the historic shift away from DB plans. (JEL G31, G32, O31, O32).

Benefit Adequacy in Funded Pension Systems: Micro-Simulation of the Israeli Pension Scheme

Purpose: This paper aims to empirically examine the adequacy of the future benefits of the funded pension scheme. Design/methodology/approach: This study investigates a large real data sample from the largest pension fund in Israel and simulates expected benefits using a pension simulator. Findings: We found that even with relatively high market returns, the shift of pension provision from defined benefit (DB) to DC entails a significant shift of risk from capital to labor and might lead elderly participants to poverty during their retirement phase. We find Israel’s pension system to be a unique playground for exploring an almost pure defined contribution (DC) pension system with a continuous trend toward capitalization and liberalization. Practical implications: This paper details the need to implement risk-sharing mechanisms in funded schemes, which provide a risk cushion against market fluctuations and alleviate income inequality and poverty. Originality value: Due to the pandemic crisis in 2020, we also showed that the expected pension benefits were vulnerable to financial, career, and systemic shocks.

Hybrid Cash Balance and Pension Equity Plans: Origins and Development

It is widely recognized that there has been a massive shift from defined-benefit (DB) to defined-contribution pension plans. However, the full extent of that shift from fully functioning DB plans is generally understated. This article measures and relates the extent of that understatement and its importance for retirement income. It then discusses the increasing importance of cash balance and pension equity plans and their legality. It then conducts an in-depth discussion of large (Fortune 500) employers, small- and medium-sized employers, and then very small employers (25 or fewer active participants). It concludes that retirement income plans in the United States are far from static. Indeed, they have evolved throughout the era and will continue to do so in the future.

Impact of Board Composition on Pension De‐risking Strategies

AbstractPension de‐risking strategies have been widely adopted by firms with defined‐benefit (DB) pension plans to reduce pension risk. This paper investigates the influence of board composition on pension de‐risking strategies within the UK, focusing particularly on three strategies: changes to pension asset allocations, switches from DB to defined‐contribution (DC) pension plans and pension buy‐ins and buy‐outs. Our findings suggest that firms with larger boards and more independent directors are less likely to invest their pension assets in equities. Survival analysis shows that firms with larger boards are slower to switch from DB to DC pension plans. This is consistent with stakeholder theory, in that firms with large boards or more independent directors are more likely to protect employees’ benefits when de‐risking their DB pension plans. However, firms with more female directors are faster to switch fully from DB to DC pension plans and slower to engage in pension buy‐in and buy‐out transactions. This suggests that female directors encourage fully switching DB pension plans, while they are concerned with the significant costs of pension buy‐in or buy‐out. This research provides clear evidence that pension de‐risking strategies are influenced by board composition. UK pension trustees play a key role in determining switches from DB to DC pension plans, mitigating the impact of independent directors.

The Tax Cut and Jobs Act (2017) as a Driver of Pension Derisking: A Comprehensive Examination

Corporate defined-benefit (DB) pension sponsors in the US are increasingly on a path of “derisking” – by moving pension assets away from equities and towards fixed-income securities that better match the obligations, or by transferring obligations off their balance sheets entirely, via settlements with insurance companies or lump-sum payouts to beneficiaries. In this study, we examine whether the Tax Cut and Jobs Act of 2017 (“TCJA”) served as a driver of pension derisking. Examining behavior in the window between the TCJA’s announcement and its lower tax rate going into effect, we document that sponsors with stronger incentives to derisk their pensions tend to contribute more into their plans in that window, while deductions can still be taken at the higher tax rate – specifically, sponsors expecting large and uncertain contribution requirements for pensions in the future, facing high regulatory costs to maintaining plans, and with competing demands on cash flows. Examining behavior after the TCJA goes into effect, we document that the firms with the largest TCJA-triggered contributions also engage in more derisking subsequently, both by shifting asset allocations and by transferring obligations to other parties. In sum, our findings point to the TCJA having acted as a trigger for what could be a fundamental reorganization of the DB pension landscape in the US.

Defined benefit pension de‐risking and corporate risk‐taking

AbstractU.S. corporate sponsors of defined benefit (DB) pension plans in recent years have been de‐risking by paying premiums to transfer their pension plan assets and liabilities to the balance sheets of third‐party insurers. The passage of the Moving Ahead for Progress in the 21st Century Act (MAP‐21) in 2012 provided the pension funding relief necessary to make de‐risking a mainstream corporate activity. This study provides the first empirical analysis of plan and firm factors that cause a firm to de‐risk its DB pension plans. We find a positive association between de‐risking and aggregate corporate risk‐taking. The results also show that de‐risking, on average, has a stronger effect on corporate financing policy than investment policy, leading to an increase in credit risk reflected in a firm's credit rating and cost of debt. Also, we present suggestive evidence that the reallocation of pension risk increases firm idiosyncratic risk and excess returns.

Determinants of defined-contribution corporate pension adoptions in Japan

Traditional Japanese corporate pension plans with defined benefits (DB) have been saddled with serious underfunding difficulties since the major stock market crash of the early 1990s. An alternative defined-contribution (DC) plan circumvents the underfunding problem by linking the benefit payout to the market valuation of pension obligations. This paper examines a comprehensive set of Japanese corporations listed on the Tokyo Stock Exchange as to the factors that led to their decision to adopt a DC plan during the period 2001–2015. Our findings point to the relevance of several unique aspects and features of Japanese regulations as well as business practices, in stark contrast to some of the findings reported in the literature focusing on U.S. corporations.

The pensions dashboard: an actuarial perspective

Abstract The pensions dashboard has been talked about across the industry for a long time. With the proposed implementation date of 2019 (although it has been questioned by some whether this is achievable or not), it is time to consider the actuarial aspects behind providing individuals with details of their pension benefits. This paper outlines the perspective of the IFoA’s Future Pensions Landscape working party. The paper considers the objectives of the dashboard and the functionality that may be required to deliver on those. It also highlights the difficulties of the necessary consistency between different types of benefits and the need for alignment with other pensions communications. Lastly, it considers what is needed to enhance the dashboard to enable members to understand what their benefits might look like at retirement and the opportunities the dashboard delivers for further modelling and financial planning. Objectives and functionality Much has been made about the difficulty (or otherwise) of delivering on the promise of a pensions dashboard, but ultimately that will depend on what it aims to provide for the individual. The working party has considered the short and longer-term opportunities with a dashboard and what functionality these may require. It is clear that a balance between functionality and deliverability must be struck to ensure that something meaningful is delivered within a reasonable timeframe (2). Different types of benefits The working party has considered the features of occupational and personal pensions, defined benefit (DB) schemes (5.21), defined contribution (DC) schemes (5.25) and the state pension (3). We believe that it is essential to deliver key information around each of them in a way that is consistent but takes account of the differences between them, including the need to: use scheme/benefit-specific pension commencement dates (4); display accrued and prospective benefits at retirement in real terms (5.6, 5.20); display dependants’ benefits when a part of the scheme rules (5.12); display details of benefits in payment or already in drawdown (5.4); ensure that deferred DBs are revalued to a recent date (5.22); be clear about the level of pension increases payable using inflation linking as a default (5.17); and outline any options on a benefit such as tax-free pension commencement lump sum (5.8). Having included the above, the dashboard must then consider how to allow for consistency of projection of benefits to the scheme/benefit-specific pension commencement dates. For DBs, this can be achieved relatively easily in real terms by allowing merely for future accrual based on the current position and benefit structure. For DC benefits, this needs a standardised approach. After consideration of multiple options (5.25), we have recommended a simplified projection approach using a risk-based allowance for real investment growth depending on the assets held (or a risk categorisation) (5.50). This would enable the dashboard to carry out consistent projections across DC pots. In an ideal world, we recommend that benefit statements use projections aligned to this approach, too. In order to build confidence in any dashboard (and in pensions in general), consistency between benefit statements and scheme provision of information is key (8). This includes the need for dates and speed of information provision, the type of information provided and assumptions and projection approaches to be standardised. We have also considered other hybrid benefit structures that exist. Many or all of these can revert to using the approach outlined for DB, DC, or a combination of the two along with the expertise of a provider to achieve the aims of consistent dashboard provision (6). We have also tried to allow for some of the legacy or complex issues within the UK pensions landscape that we consider relevant to the provision of a usable dashboard, such as the need to include Guaranteed Annuity Rates, and the need to explain the various risks and uncertainties with both DB and DC provision (7). Future opportunities for supporting financial planning The working party has considered the longer-term opportunities to use the dashboard to assist individuals with planning for their retirement. We recommend that the dashboard infrastructure be set up with this in mind from the beginning, even if the deployment of this type of support is a long way away (9) or even provided through third parties (10). The working party looks forward to the Department for Work and Pensions feasibility study on the dashboard (which is due for publication) and welcomes the chance to influence the shape of what has the potential to be a huge engagement opportunity for the pensions industry.

Retirees in Profile: Evaluating Five Distinct Lifestyles in Retirement

Retirees in Profile: Evaluating Five Distinct Lifestyles in Retirement

From ‘Table 29’ to the Actuarial Balance Sheet: Is It Really That Big a Leap?

EU regulations since 2017 have required all Member States to disclose their accrued-to-date pension liabilities (ADL) using a standard actuarial cost method and some common assumptions. This applies to both Social Security (SS) schemes and unfunded defined benefit (DB) schemes covering civil servants. These pension liabilities have to be disclosed in a supplementary table referred to as Table 29. An actuarial balance sheet (ABS) can be defined as a financial statement that lists a pension system's obligations to contributors and pensioners at a particular date, together with the amounts of the assets (financial and in particular those from contributions) that underwrite those commitments. The ABS can be used to assess the solvency of SS schemes, whereas Table 29 cannot. This paper develops a methodology to (easily) transform Table 29 into an ABS and compile its associated income statement (IS). To enable policymakers to better understand how the model would function, the paper also contains a country case study based on data from the most recently published Table 29 for Spain. According to our best estimate assumptions, it can be said that the Spanish pension system is partially insolvent because only part of the pension entitlements is backed up by assets, and that the system's sustainability has markedly deteriorated over the period 2015-2018.

What Determines the Freezing of Defined-Benefit Pension Schemes: Evidence from the UK

Given the shifting corporate policy from defined benefit (DB) to defined contribution (DC) schemes, we investigate the determinants of so-called ‘freezing’ of DB schemes. We test the reasons of pension freezing and its influence on firm performance, for all FTSE350 companies from 2009 to 2017. We find that pension plan asset is the key factor for determining the freezing of the DB plans and companies tend to close their DB scheme under a good economic state.

Соціальне страхування у країнах світу та перспективи для України

The article is aimed at denfining the perspective approaches and evaluating the feasibility of using the world experience of social, in particular pension, insurance in Ukraine. On the basis of the analytical approach, the essence and content of social insurance are considered. In particular, social insurance schemes were studied, among which are distiguished the following: social security that covers all workers and is controlled and funded by the State authorities; scheme for the employed population – includes the relationship between the employer and the employee, which are provided as part of the conditions of employment; individual insurance scheme – concluded solely on the initiative of the insurer. It is determined that common schemes against the background of the COVID-19 crisis among the countries of the world (including Ukraine) are assistance in case of illness, unemployment benefits, pensions and disability payments, health insurance provision, social insurance contributions. It is proved that social insurance performs a protective function for society against external risks. In particular, in the context of the spread of coronavirus infection, thanks to the social insurance system, the degree of impact of the COVID-19 crisis on the income of vulnerable groups at the expense of public policy programs has been reduced. The experience of countries around the world as to social insurance programs, including pension schemes is researched along with their further consideration, namely: schemes with defined contributions (DC); schemes managed by non-governmental institutions; notional defined contributions (NDC) schemes; schemes managed by the public administration sector; schemes of defined benefits (DB); hybrid schemes that combine the characteristics of DC and DB pension schemes; schemes administered by an autonomous pension fund. It is determined that pension schemes are being implemented within terms of three systems: solidarity, accumulation and hybrid. In general, the results of the research indicate that the management of the social insurance system in the countries of the world in general and in Ukraine in particular is carried out under regulatory and legal control by the State, which acts as a guarantor of protection of the population in the conditions of national peculiarities of the economy.

Transition to a New Pension Contract in the Netherlands: Lessons From Abroad

This report presents lessons and observations from abroad that can help in the successful completion of the current pension reforms in the Netherlands. These lessons are based on discussions with and texts from a large number of international experts from nine countries that have gone through a similar reform process. The lessons are organized into two categories, namely lessons and observations regarding (1) the reform process and (2) pension design. An important observation is that it was difficult to define what we are doing in the Netherlands, not only in the eyes of foreign experts, but also of Dutch participants during a Netspar debate. Confusion around the terminology Defined Benefit (DB) and Defined Contribution (DC) played a central role in this. It is clear that we are taking a unique step in the Netherlands, particularly because of the transformation of accrued rights into accrued capital. This has not been done before. It is important to create a crystal-clear and honest storyline and to communicate it well. The road to the new contract does not only involve technical implementation, but a long and winding path to build and maintain trust. A new contract also raises entirely new questions and creates new dynamics.

Defined Contribution Plans: Challenges and Opportunities for Plan Sponsors

American workers rely on their employers to provide a way to generate retirement income beyond their Social Security earnings. Many employers still offer traditional defined benefit (DB) pension plans. A growing majority, however, have replaced DB plans with account-based defined contribution (DC) plans. Virtually everyone acknowledges that the basic DC plan design is flawed. Yet as a society with low private savings and a fraying Social Security system, we count on this imperfect structure to serve as a retirement security bulwark. Workers and society both need the employer-sponsored retirement system to function well. Enhancing DC plan design therefore becomes critical. Defined Contribution Plans: Challenges and Opportunities for Plan Sponsors offers guidance to plan sponsors interested in better understanding the primary issues confronting DC plans. We wrote this book from the viewpoint of the plan sponsor seeking to improve the DC system, and it follows five major themes: the plan participant, the plan sponsor, plan design, investments and investment managers, and asset decumulation in retirement. We present the material conversationally from a high-level perspective. We have not sought to write an encyclopedia on DC plans but rather focus on the basic features of well-run plans. We address key challenges facing DC plans and offer associated design and policy recommendations for plan sponsors and other interested parties to consider. Plan design improvements almost certainly will be incremental, rather than sweeping top-down changes mandated by regulators. Plan sponsors individually will make the important decisions that have lasting consequences for participants and for society. Our objective is to spark interest among sponsors, encouraging them to carry out additional research and take action. We believe the DC system will be strengthened by informed sponsors advocating for and implementing thoughtful strategic changes to their plans.

Location, location, location! Real effects from the mandated removal of pension expected return from operating income

The accounting for defined-benefit (DB) pension expense in U.S. GAAP involves offsetting pension costs against an expected (rather than actual) return on pension assets. Pensions commentators argue that this expensing model tilts pension portfolios towards riskier assets – as sponsoring firms can benefit from assuming higher expected rates of return on riskier assets (which reduce pension expense and boost reported income), without bearing the cost of higher volatility in reported income. We examine a recent regulatory change in U.S. GAAP, which mandates the relocation of the expected return on pension assets from “above the line” of to “below the line” of operating income. Consistent with this change reducing the financial reporting incentives for risk-taking, we predict and find that a sample of U.S. firms subject to this mandate reduces risk-taking in pension assets following the change, relative to a control sample of Canadian firms not subject to the change. In cross-sectional tests, we find that the reduction in risk-taking is more pronounced in (1) firms where the financial reporting incentives for risk-taking were stronger in the pre-period, and in (2) firms where the regulatory change particularly reduced those benefits. Our findings imply that managers are willing to undertake real actions (i.e., invest in riskier assets) to report favorable operating income, and that these incentives are incremental to the incentives to report favorable net income. They also provide evidence that financial reporting incentives serve as a driver of pension asset allocation decisions.

Cenland Corporation: The CIO and the Freezing of the DB Plan

It is the afternoon of 15 October 2020 and Dan Woodbridge, 50, CIO of Cenland’s in-house management organization for the Defined Benefit (DB) plan, just finished a Zoom call with Denise Liu, Cenland’s CFO. During this regular update meeting, Dan and Denise reviewed the recently released Q3 reports. Despite a volatile year, Cenland’s well-diversified DB portfolio is again performing well, and better than peers. However, Denise’s big news was that given the “lower-for-longer” market environment, the Board decided to accelerate the de-risking of the DB plan by freezing the plan at the end of 2020. In recent years, Cenland’s CEO has been zealous about reducing pension cost and enhancing the company’s competitiveness. Cenland is a legacy telecommunications company facing intense price pressure from start-up companies that do not sponsor any DB plans. Last year’s decision to close the DB plan was the first step to address this issue. In addition, Dan recalled the CEO recently expressed his annoyance about the volatility in funding DB obligations due to fluctuating equity markets and increasingly lower interest rates, which, in turn, affect the company’s earnings volatility. After the decision to close the DB plan, Dan knew Cenland would at some point take further actions to align the company’s benefits with current industry standards. But, freezing the plan just a year later came as a bit of a shock as firms typically take a few years after closing to make this next step. Denise also asked Dan to start putting together an agenda for the yearly asset allocation review which will be a one-day virtual conference in early December. For this year’s meeting, given the large allocations to illiquid private assets in the DB portfolio, Denise asked Dan to discuss their DB plan’s risk from a cash flow risk perspective (i.e., always having enough cash from pre-defined liquidity sources to meet liquidity demands such as pension benefit payments, GP capital calls, etc.) instead of the traditional volatility risk angle. This is important as a liquid asset and an illiquid asset could have the same volatility, but the cash flow properties of these two assets might be very different.1 In addition, Denise expects Dan to show the tradeoff between liquidity and performance of the DB portfolio under possible alternative asset allocations that are currently under consideration. After rushing into the living room to help his youngest son log in to his algebra class, Dan sat outside with his laptop and home-made coffee. Surveying his backyard, Dan took a moment to enjoy this precious quiet moment and began to reflect on this past year. Dan thought turning 50 would be the year’s biggest event, but he always knew that life is never with a lack of surprises. Since the pandemic in early March, his team switched to remote working mode. He’s been juggling between managing a newly-closed DB plan and helping his three sons keep up with their remote class schedules, especially the little one. Fortunately, his investment team quickly adjusted to the new normal and has been performing as efficiently as before. Dan sent his investment team a Zoom invite for tomorrow afternoon to break the news about freezing the DB plan and to discuss preparing analyses and recommendations for the yearly asset allocation review meeting. Before meeting with his team, Dan spent some time putting his thoughts together and gathering some plan information to facilitate tomorrow’s conversation.

What Determines the Asset Allocation of UK Defined Benefit Pension Funds?

The asset allocation decision is one of the most important decisions made by defined benefit pension schemes, with a major effect on the scheme contribution rate, funding ratio and financial position of the sponsoring company. We investigate the determinants of the equity allocation of UK pension funds using a panel of 1,304 observations on 125 companies that were members of the FTSE 100 over the 2003-2019 period. We find that seven variables have a significant effect on the allocation between equities and bonds – maturity (as measured by the effective duration of scheme liabilities), default risk, leverage of the sponsor, size of the sponsor (or the scheme), whether the scheme is closed to future contributions, whether the scheme has significant overseas liabilities, and a time trend. Our sensitivity analysis finds that the biggest effects on the asset allocation come from scheme maturity, the scheme’s funding ratio and a time trend.

The role of CEOs in the sustainability of defined benefit pension plans

ABSTRACTThe future of defined benefit (DB) pensions is a hotly debated topic in reward management. Drawing on agency and managerial power theories, the conditions under which CEOs can affect their sustainability have been examined. We show that when the CEO is a member of the same DB plan as their employees or when the CEO is both a member and a trustee of the plan, this affects the agency and power dynamics increasing the likelihood of these plans being retained. To address endogeneity concerns, we mimic randomisation using propensity score matching and the results continue to hold. Using the introduction of pension tax penalties as an exogenous shock on CEO self‐interest, we find that it affects the propensity of DB plan closures. The study highlights the key role that CEO incentives play on pension–provision decisions and indicates how HR practitioners/regulators can harness CEO self‐interest to safeguard the sustainability of DB pension plans.

The role of discretionary pension accruals in earnings management

PurposeManagers of defined-benefit (DB) firms have considerable discretion in deriving pension costs and flexibility in cash contributions to pension plans. Pension accruals occur when cash contributions differ from pension costs. The manipulable nature of pension costs and cash contributions allows managers of DB firms to manipulate pension accruals to achieve their desired earnings. We study whether DB firms with earnings management attributes (referred to as suspect DB firms) used more discretionary pension accruals (DPA) than non-suspect DB firms, especially after the passage of Sarbanes-Oxley (SOX).Design/methodology/approachThe authors develop an aggregate measure of DPA to capture overall earnings management in pension accounting. They then employ a multivariate regression model to study whether the suspect DB firms engage in more DPA than non-suspect firms and to assess the impact of SOX on DPA for all DB firms and for suspect DB firms.FindingsThe authors find evidence that suspect firms inflate DPA to achieve their earnings goals and also that all DB firms and the suspect firms use more DPA in the post-SOX era compared to the pre-SOX period. In contrast, they observe no significant difference in real activities earnings management (REM) between suspect and non-suspect firms. In addition, neither the entire sample of DB firms nor the suspect firms display a significant change in REM after SOX.Research limitations/implicationsThe samples in the study are limited to firms with defined pension plans; thus, the findings cannot be generalized to all firms. In addition, as in other empirical studies relying on models to estimate earnings management proxies, this study inherits estimation errors from Jones and Roychowdhury's models. Consequently, the impact of these estimation errors cannot be ruled out.Practical implicationsThe empirical findings of the study appear that instead of deterring DB firms from engaging in pension accruals earnings management, enacting the stringent anti-fraud SOX prompts these firms to rely more on accrual-based discretionary pension rather than switch to real activities manipulation to manage earnings.Originality/valueWhile many prior studies focus on the impact of managing individual pension assumptions on earnings, the authors study overall earnings management in pension accounting by developing a model to derive an aggregate measure of pension earnings management.