Pension Asset Allocation Research Articles

Corporate pension funds’ search for yield with private equity investment: Its determinants and consequences

AbstractThis study examines corporate pension funds’ search for yield through investments in private equity (PE). Using pension asset allocation data from 10‐K filings, we find that corporate pension funds significantly increase the PE share within their risky assets following underperformance relative to their expected return. This risk‐taking behavior is more pronounced for sponsoring firms that were more financially constrained with poorly funded plans in the previous year. Furthermore, we discover that pension asset allocation to PE does not significantly increase pension returns but does lower pension return volatility and tracking error relative to the expected return.

What affects the financial asset allocation of the elderly? From the perspective of financial literacy and risk attitude

Using data from the 2019 China Household Finance Survey, this study investigates the impact of financial literacy and risk attitude on pension asset allocation in the context of population aging. It can not only provide new research perspectives, but also provide support for the government to promote the improvement of the pension security system. We find that population ageing can inhibit residents’ pension financial asset allocation, with residents’ risk attitudes and financial literacy playing a significant mediating effect. Heterogeneity analysis shows that the inhibiting effect of population ageing on pension financial asset allocation is stronger in the eastern and rural areas.

A Novel Black-Litterman Model with Time-Varying Covariance for Optimal Asset Allocation of Pension Funds

The allocation of pension funds has important theoretical value and practical significance, which improves the level of pension investment income, achieves the maintenance and appreciation of pension funds, and resolves the pension payment risk caused by population aging. The asset allocation of pension funds is a long-term asset allocation problem. Thus, the long-term risk and return of the assets need to be estimated. The covariance matrix is usually adopted to measure the risk of the assets, while calculating the long-term covariance matrix is extremely difficult. Direct calculations suffer from the insufficiency of historical data, and indirect calculations accumulate short-term covariance, which suffers from the dynamic changes of the covariance matrix. Since the returns of main assets are highly autocorrelated, the covariance matrix of main asset returns is time-varying with dramatic dynamic changes, and the errors of indirect calculation cannot be ignored. In this paper, we propose a novel Black–Litterman model with time-varying covariance (TVC-BL) for the optimal asset allocation of pension funds to address the time-varying nature of asset returns and risks. Firstly, the return on assets (ROA) and the covariance of ROA are modeled by VARMA and GARCH, respectively. Secondly, the time-varying covariance estimation of ROA is obtained by introducing an effective transformation of the covariance matrix from short-term to long-term. Finally, the asset allocation decision of pension funds is achieved by the TVC-BL model. The results indicate that the proposed TVC-BL pension asset allocation model outperforms the traditional BL model. When the risk aversion coefficient is 1, 1.5, and 3, the Sharp ratio of pension asset allocation through the TVC-BL pension asset allocation model is 13.0%, 10.5%, and 12.8% higher than that of the traditional BL model. It helps to improve the long-term investment returns of pension funds, realize the preservation and appreciation of pension funds, and resolve the pension payment risks caused by the aging of the population.

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.

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.

Labor Unemployment Insurance and Pension Asset Allocations

This paper examines the effect of unemployment risk on pension investment decisions of defined benefit (DB) pension plans. In particular, we examine whether unemployment insurance (UI) benefits result in increases in pension investment risk. Using fixed-effects and difference-in-difference analysis, we find evidence that firms take higher pension investment risk by investing more heavily in equities after unemployment insurance benefits increase. These results, which are robust to a number of sensitivity tests, are consistent with the notion that firms undertake more risk when the costs of unemployment decrease. In additional analyses, we find that changes in unemployment risk also affect other pension-related decisions such as earnings management using the expected rate of return on pension plan assets (ERR) and DB plan freezes.

So Similar, yet So Different: Comparing the US GAAP and IFRS Experience at Eliciting Greater Transparency on Pension Asset Disclosures

We examine whether (and to what extent) accounting regulation intended to improve disclosure can lead to higher disclosure quality in the absence of a change in preparer incentives. We exploit a sequence of two similar regulatory changes, one under US GAAP and the other under IFRS, which have one key difference — while both changes mandate improvements to the disclosure of pension asset allocation, only the latter removes preparer incentives to disclose opaquely (by eliminating a key reporting assumption–the expected rate of return on pension assets or ERR, which can be more effectively manipulated if asset allocation remains opaque). We construct two difference-in-difference research designs to examine the difference in disclosure outcomes between these two changes. We find that the IFRS disclosure standard is effective at improving pension asset transparency as intended, whereas the US standard — which only mandates better disclosure while leaving unchanged preparers’ incentives to disclose or obfuscate — is not as effective at improving pension asset transparency. Our findings suggest that accounting standards are more effective at improving financial reporting quality when standards are designed so as to minimize the incentives built in to report favorable accounting numbers.

Bridging Financial Reporting Research and Policy: A Discussion of ‘The Impact of Accounting Standards on Pension Investment Decisions’

Barthelme, Kiosse, and Sellhorn (2018. The impact of accounting standards on pension investment decisions. European Accounting Review. doi:10.1080/09638180.2018.1461670) examine the real effects of pension accounting regulation and provide evidence consistent with the claim that recent changes in financial reporting rules affect pension asset allocation decisions. Their study offers an interesting opportunity to highlight the importance of evidence-based policymaking in the field of financial reporting. I discuss some empirical challenges that the authors face to causally identify the effects they examine to show how a closer cooperation between academia and regulators can enable researchers to overcome identification challenges and help produce even more policy-relevant research.

Disclosure of pension asset allocation and expected rate of return management

PurposeThe purpose of this paper is to examine whether the expected rate of return (ERR) management is related to disclosure of pension asset allocation. FAS 132R(1), which requires firms to disaggregate the detailed categories of pension asset allocation, provides a natural experiment setting for investigating the effect of enhanced transparency on firm behavior.Design/methodology/approachThe authors focus on the variation of voluntary disclosure and its effect on ERR management under the two different reporting regimes. The authors measure the variation of voluntary disclosure of the pension asset allocations in the pre-period of FAS 132R(1), by using the self-constructed disclosure score.FindingsFirst, firms create flexibility in their choice of ERR through opaque disclosure of pension asset allocation. Next, firms with poor disclosures are more likely to adjust ERR downward when accounting standards require greater transparency, implying that, for firms with poor disclosures, mandated transparency in pension asset allocation plays a vital role in reducing the ERR management.Research limitations/implicationsThe authors directly illustrate the impact of FAS 132R(1) on ERR management. The authors find that the impact of mandated transparency is not uniform across firms. Next, this study highlights the importance of disclosure in restricting managers’ earnings management motivation.Originality/valueThe authors hand collect the asset allocations under pre-FAS 132R(1) period from the 10-K pension footnotes for all S&P 500 firms, which allows the authors to identify the disclosure variation amongst the firms. Based on the variation of disclosure, the authors construct the ordinal measure of disclosure scores on which the testing indicator variables are built.

Expected Benefit Payments and Asset Allocation in Defined Benefit Plans Post-SFAS 132(R)

SYNOPSIS We contribute to the literature examining defined benefit pension plan asset allocation in the post-SFAS 132(R) reporting environment. SFAS 132(R) requires firms to disclose the expected annual pension benefit payments, thus providing a direct way to measure pension plan payout horizon. Controlling for previously documented determinants of pension asset allocation, we find evidence that a payout horizon measure constructed from SFAS 132(R) disclosures is associated with the firm's pension investment decisions. Specifically, we document that firms with a greater proportion of pension obligations due in the short horizon allocate a smaller portion of their plan assets to equity investments. Additionally, we provide evidence that our proposed measure explains asset allocation over and above previously used proxies representing plan horizon, confirming the usefulness of the 132(R) mandated disclosures.

Employees' risk attitude and corporate risk taking: Evidence from pension asset allocations

Do labor characteristics matter to corporate decisions? We answer this question by examining whether firms consider the risk attitude of rank-and-file employees in investing the pension assets of defined benefit plans. We construct a direct measure of employees' risk attitude from their defined contribution pension portfolio allocations. We find that firms with more risk-averse employees exhibit higher sensitivity to their own default risk in their defined benefit pension investment. The reduction in pension risk taking induced by sponsor risk is more pronounced for low R&D firms, and in the period with stringent pension regulation. We further show that sponsors consider employees' risk aversion in making pension investment decisions regardless of the power of labor union. Overall, our findings suggest that firms incorporate employees' risk attitude into corporate policies.

Standards or Incentives: What Determines Financial Reporting Transparency for Defined Benefit Pension Assets?

We examine whether regulation intended to improve disclosure can itself lead to higher disclosure quality in the absence of a change in preparer incentives. We exploit a setting involving a sequence of two similar regulatory changes, which have one key difference – while both regulatory changes mandate improvements to disclosure (specifically, on pension asset allocation), only one removes preparer incentives to disclose opaquely (by eliminating a key reporting assumption – the expected rate of return on pension assets or ERR, which can be more effectively manipulated if asset allocation remains opaque). We construct two difference-in-difference (DD) research designs to examine the disclosure consequences of each of these changes mandating more transparent disclosures on pension assets ((i) a 2008 rule change under US GAAP and (ii) a 2011 rule change under IFRS), and examine the difference in disclosure outcomes between these two changes. We find that the IFRS disclosure standard, which also removes preparer incentives to obfuscate asset allocation, is effective at improving pension asset transparency as intended by the standard, whereas the US standard, which solely mandates better disclosure while leaving unchanged preparer incentives to disclose or obfuscate, is not as effective at improving pension asset transparency. Using a setting in which firms have a well-documented incentive for lower financial reporting quality (i.e., incentives to manipulate the ERR so as to lower pension expense and boost reported income), our findings reinforce the view in the “standards versus incentives” literature that accounting quality cannot be improved effectively with higher-quality standards alone; preparers’ incentives must work in concert with higher-quality standards to pull firms towards more transparent reporting.

Disclosure of Pension Asset Allocation and Expected Rate of Return Management

This study examines whether expected rate of return (ERR) manipulation is related to disclosure of pension asset allocation. FAS 132R(1), which requires firms to disaggregate the detailed categories of pension asset allocation, provides a natural experiment for studying the effect of enhanced transparency on firm behavior. We posit that firms discretionarily assume higher ERR by using the opaque disclosure under the old standard, and adjust biased ERR downward under the greater reporting transparency. The hand-collected data allow us to identify the extent of disclosure variation under the two different reporting regimes. We find that opaque disclosure of plan asset allocation is associated with ERR management. Specifically, for firms with poor disclosure, mandated transparency in pension asset allocation plays a vital role in reducing the ERR management. We also find that ERR management is facilitated by the opaque disclosure even under the new reporting regime. Particularly, we find that firms tend to assume higher ERR through the opaque disclosure when they disaggregate the indirectly invested funds with no description of underlying asset classes.

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

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.

Does Regulation Matter? Riskiness and Procyclicality in Pension Asset Allocation

In this paper, we investigate the relative importance of drivers to pension funds’ asset allocation choices. We specifically test if the contrast between regulatory approaches of public and private Defined Benefits (DB) pension funds in the US, Canada and the Netherlands have an impact on the riskiness and procyclicality of their asset allocation. Derived from panel data analysis of a unique database comprising of more than 800 pension funds’ detailed asset allocations, our results underscore the economic importance of regulation in the funds’ asset allocation choices, relative to institutional and individual funds’ characteristics. In particular, quantitative risk-based capital requirements, and to a lesser extent valuation and funding requirements (i.e., the choice of the liability discount rate) or the presence of quantitative investment restrictions, induce pension funds to significantly decrease their asset allocation to risky assets, especially to equities. Allocation to alternatives, which are comparatively treated quite favorably by solvency standards, is higher in the presence of risk-based capital requirements. Contrary to popular conviction that regulatory mechanisms encourage procyclical asset allocation, we find that funds subject to risk-based capital requirements were likely to be less procyclical during the last crisis – an outcome possibly tempered by temporary regulatory slackening in response to the crisis.

Does Regulation Matter? Riskiness and Procyclicality in Pension Asset Allocation

We investigate the extent to which regulations governing investment, valuation and funding affect the riskiness of defined benefit pension funds' asset allocations. We compare the regulatory frameworks of public, corporate and industry pension funds in the United States, Canada and the Netherlands over 1992-2011. Derived from panel data analysis of a unique set of asset allocation details for close to 600 funds, our results highlight that regulatory factors are more economically significant than funds' characteristics in shaping their asset allocation. In particular, risk-based capital requirements and mark-to-market valuation are associated with a 7% lower risky asset exposure, regardless of market conditions. Most of the decline in investment risk-taking concerns equities. The exposure of a fund subject to a 100% funding requirement does not differ significantly from that of an unconstrained fund during normal times, but the constrained fund invests 2% less in risky assets during a financial crisis. In line with theoretical predictions, we find that risk-based capital requirements and minimum funding limits have different consequences for pension funds’ risk-taking during periods of financial market stress.

Managerial risk taking incentives and corporate pension policy

We examine whether the compensation incentives of top management affect the extent of risk shifting versus risk management behavior in pension plans. We find that risk shifting through pension underfunding (and, to a lesser extent, through pension asset allocation to risky securities) is stronger with compensation structures that create high wealth-risk sensitivity (vega) and weaker with high wealth-price sensitivity (delta). These findings are stronger for chief financial officers (CFOs) than for chief executive officers (CEOs), suggesting that pension policy falls within the CFO’s domain. Risk shifting through pension underfunding is also lower when the CFO’s personal stake in the pension plan is larger. Overall, these findings show that top managers’ compensation structure is an important driver of corporate pension policy. They also highlight firms within which the moral hazard concerns fueled by Pension Benefit Guaranty Corporation insurance are most relevant.

Optimal Portfolio Allocation for Corporate Pension Funds

AbstractWe model the asset allocation decision of a stylised corporate defined benefit pension plan in the presence of hedgeable and unhedgeable risks. We assume that plan fiduciaries – who make the asset allocation decision – face non–linear payoffs linked to the plan's funding status because of the presence of pension insurance and a sponsoring employer who may share any shortfall or pension surplus. We find that even simple asymmetries in payoffs have large and highly persistent effects on asset allocation, while unhedgeable risks exert only a small effect. We conclude that institutional details are crucial in understanding DB pension asset allocation.

Financial reporting and economic implications of statements of financial standards No. 132(R) and No. 158

Purpose – The purpose of this paper is to address two questions: did adoption of Statements of Financial Accounting Standards No. 132(R) and No. 158 affect neutrality of the financial reporting with regard to the disclosed expected rate of return (ERR) on pension assets assumptions, and did pension asset allocations change in response to the new recognition and disclosure requirements? Design/methodology/approach – The author uses several measures of association between reported expected return and pension assets allocations to assess neutrality of the reported ERR. The series of tests explores changes in correlations between asset allocations and expected rates of return and changes in the implied risk premiums following adoption of Statements No. 132(R) and No. 158. Granger causality analysis is used to explore the second research question: did pension asset allocations change in response to the new recognition and disclosure requirements? Findings – The empirical results are consistent with improved neutrality of financial reporting following adoption of Standard No. 132(R). There were no detectable changes in neutrality following adoption of Standard No. 158. While the data are consistent with portfolio allocations changing to a greater degree than did expected rates of return following Statement No. 132(R) adoption, the effect appears short-lived. Originality/value – The overall results are consistent with Standard 132(R) having a positive effect on the neutrality of the reported ERR. Also, there is no evidence of persistent and systematic structuring of transactions around preferred financial reporting outcomes.

Financial Reporting and Economic Implications of Statements of Financial Standards No. 132(R) and No. 158

Purpose – The purpose of this paper is to address two questions: (1) Did adoption of Statements of Financial Accounting Standards No. 132(R) and No. 158 affect neutrality of the financial reporting with regard to the disclosed expected rate of return on pension assets assumptions, and (2) Did pension asset allocations change in response to the new recognition and disclosure requirements?Design/methodology/approach – The author uses several measures of association between reported expected return and pension assets allocations to assess neutrality of the reported expected rate of return. The series of tests explores changes in correlations between asset allocations and expected rates of return and changes in the implied risk premiums following adoption of Statements No. 132 (R) and No. 158. Granger causality analysis is used to explore the second research question: did pension asset allocations change in response to the new recognition and disclosure requirements?Findings – The empirical results are consistent with improved correspondence between actual portfolio allocations and reported expected rates of return following adoption of Standard No. 132 (R). There were no incremental changes to this correspondence following adoption of Standard No. 158. While the data are consistent with equity allocations changing to a greater extent than expected rates of return following Statement No. 132 (R) adoption, the effect appears short-lived.Originality/value – The overall results suggest that adopting Standard 132(R) may have improved neutrality of the reported expected rate of return. Also, there is no evidence of persistent and systematic structuring of transactions around preferred financial reporting outcomes.