Pension Assets Research Articles

Double (Accounting) Standards: A Comparison Of Public And Private Sector Defined Benefit Pension Plans

We examine and compare funding status, actuarial assumptions and asset investment allocations of defined benefit pension plans in the public and private sectors across time, using information as reported under GASB and FASB. We find that pension plans in both sectors are underfunded and that inferences about pension funding in the public sector would be different if pension assets' fair values were required in the computation of funding status. Actuarial assumptions of public employee plans appear to be both more optimistic and less variable than those of private sector plans. Finally, we document that public sector plans allocate invested assets somewhat differently than in the private sector, although our findings do not confirm anecdotal reports of riskier pension investment strategies relative to the private sector.

The Crisis in Public Sector Pension Plans: A Blueprint for Reform in New Jersey

Pension plans operated by state governments on behalf of their employees are underfunded by an estimated $452 billion according to official reports,1 with total liabilities of $2.8 trillion and total assets of $2.3 trillion in 2008. However, many economists argue that even these daunting liabilities are understated. Current public sector accounting methods allow plans to assume they can earn highv investment returns without any risk. Using methods that are required for private sector pensions, which value pension liabilities according to likelihood of payment rather than the return expected on pension assets, total liabilities amount to $5.2 trillion and the unfunded liability rises to $3 trillion. The ability of governments to pay for the retirement benefits promised to public sector workers runs up against the reality of limited resources.

The Impact of the Financial Crisis on Funded Pension Saving

The authors describe the various ways in which the financial market crisis might affect workers, pension funds and governments. In 2008 the impact of the stock market decline on global pension assets was substantial (roughly 40 per cent, according to the authors’ estimates for the G20 countries). Some individuals, especially those near to retirement, may have been severely affected. However, the authors note that, in most countries, the richest part of the population was disproportionately affected by the losses. Moreover, they used a simulation to show that the performance of individual accounts over the past 45 years has been quite satisfactory, even if internal rates of return differ markedly across cohorts. DB pension plans were affected by the crisis as well, since their assets/liability ratio declined sharply; therefore they could be obliged to increase contributions and/or cut benefits in order to restore an adequate level of funding. Governments will also be affected by the fall in asset prices: indeed, they often provide guarantee schemes that offer insurance against the loss of assets in private DB plans due to employer insolvency; in addition, some governments also guarantee minimum benefits or minimum rates of return to defined-contribution pension plans. Finally, there is the possibility that governments will be forced by strong political pressures to compensate pension plans for at least a portion of the reductions in asset value they suffered. The authors warn that in no case should government responses compromise fiscal sustainability.

The Sustainability of Pension Schemes

Poor financial market returns and low long-term real interest rates in recent years have created challenges for the sponsors of defined benefit pension schemes. At the same time, lower payroll tax revenues in a period of high unemployment, and rising fiscal deficits in many advanced economies as economic activity has fallen, are also testing the sustainability of pay-as-you-go public pension schemes. Amendments to pension accounting rules that require corporations to regularly report the valuation differences between their defined benefit pension assets and plan liabilities on their balance sheet have made investors more aware of the pension risk exposure for the sponsors of such schemes. This paper sheds light on what effects these developments are having on the design of occupational pension schemes, and also provides some estimates for the post-employment benefits that could be delivered by these schemes under different sets of assumptions. The paper concludes by providing some policy perspectives.

Down the DC Road: Estimates of Future Pension Assets in the United Kingdom

Down the DC Road: Estimates of Future Pension Assets in the United Kingdom

Managerial Risk-Taking Incentives and Corporate Pension Policy

Theory predicts that stockholders of firms with defined-benefit pension plans will engage in risk-shifting by underfunding plans and investing plan assets in risky securities, as their firms approach distress. The empirical evidence so far has, however, been consistent more with risk-management than risk-shifting. We test 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 is stronger with compensation structures that create high wealth-risk sensitivity (vega), and weaker with high wealth-price sensitivity (delta). These relationships hold across firms and within firms and managers over time. We find consistent but weaker results with risk-shifting through pension asset allocation to risky securities. While both CEO and CFO incentives affect pension strategy, CFO incentives dominate, suggesting that pension decisions fall within the CFO’s domain. We find also that risk-shifting through pension underfunding is lower when CFOs’ own pensions are 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.

Inflation, nominal portfolios, and wealth redistribution in Canada

Abstract This paper quantifies the redistributional effects of inflation in Canada that arise through the revaluation of nominal assets and liabilities. We find that the effects are non‐trivial even for low inflation episodes. The main winners are young, middle‐class households with mortgage debt. The government receives a windfall gain from its long‐term debt. The old, the rich or the middle‐aged, middle‐class lose, largely owing to their holdings of bonds and non‐indexed defined benefit pension assets. Finally, our Canada‐U.S. comparison reveals that the extent of redistributions can be quite different even between countries of similar economic and legal environments.

The Enduring Controversy Over Pension Accounting: Are There Current Measures Of Pension Assets And Liabilities Misleading?

The accounting profession has long attempted to improve the disclosure of pension information. However, even the most recent pension disclosure standard is criticized as being deficient. The purpose of this article is to: 1) briefly explain the current reporting standard, 2) note how the standard may tend to understate pension liability and expense, and 3) illustrate one of the most controversial aspects of the standard, which allows certain obligations to be reported as both a liability and an asset.

Pension Accounting: The Changing Landscape Of Corporate Pension Benefits

<span style="font-family: Times New Roman; font-size: small;"> </span><p style="margin: 0in 36.1pt 0pt 0.5in; text-align: justify; mso-pagination: none;" class="MsoTitle"><span style="font-family: Times New Roman;"><span style="color: black; font-size: 10pt; font-weight: normal; mso-themecolor: text1; mso-bidi-font-weight: bold;">This paper</span><span style="color: black; font-size: 10pt; mso-themecolor: text1;"><strong> </strong></span><span style="color: black; font-size: 10pt; font-weight: normal; mso-themecolor: text1; mso-bidi-font-weight: bold;">discusses recent changes in the generally accepted accounting principles related to accounting for defined benefit pension plans. SFAS 158 imposes new rules related to calculating net pension assets or liabilities and increases the likelihood that companies may report net pension liabilities. This paper looks at a sample of Fortune 100 companies to determine the effect of implementing SFAS 158 on the reported funding status for defined benefit plans, and then tracks the reported pension status from 2005 through 2009. Contrary to expected results, the funding status did not deteriorate following implementation of SFAS 158. The ensuing economic meltdown in 2008 and 2009, however, resulted in more companies reporting pension liabilities.</span></span></p><span style="font-family: Times New Roman; font-size: small;"> </span>

Financial investment instruments of pension reserves: New approaches to investment policy

This paper reviews investment policy and new approaches to the allocation of pension reserves based on the principle of the reasonable investor. The offered approaches permit nongovernmental pension funds to more adequately respond to market challenges, at the same time maintaining transparency and reliability of investments, which make it possible to provide stable growth in pension assets in the long term. The application of such approaches is demonstrated in terms of the MDM Nongovernmental Pension Fund.

Should public retirement plans be fully funded?

AbstractMost state and local retirement plans strive for full funding, at least by actuarial standards. Funding measured at market values fluctuates and often falls short. In a model where most taxpayers hold debt and face intermediation costs, returns on pension assets are less than taxpayers’ costs of borrowing. Hence, zero pension funding is optimal. Also, unfunded pension promises are properly discounted at a rate strictly greater than the government's borrowing rate. Funding can still be in taxpayers’ interests if legal enforcement problems make unfunded pensions risky for employees, but except in special cases, the optimal funding ratio is less than 100%.‘Neither a borrower nor a lender be’ (Shakespeare)

An Examination Of The Economic Impact Of Pension Rate Reductions On Future Pension Expense, Earnings, And Cash Flows: A Simulation

In this paper, we develop a two-period analytical model of pension cost, which allows us to simulate pension expense and the associated earnings impact. These estimates are important because they provide information to the market, and because they are useful in estimating future cash flows or for other analytical purposes. This is especially true now, because the economic environment has deteriorated to a point that many investors perceive increased uncertainty with respect to pension plans and the effect they have on future income. Some plan sponsors have not been faced with pension plan losses for over a decade or longer, having enjoyed reduced or eliminated funding holidays as a result of high returns to pension plan assets. Given the current economic climate, however, these results (boosts to earnings due to pension credits and reduced or eliminated funding requirements) may change abruptly. In fact, several authors in the popular financial press have speculated on the impact of such fundamental changes in pension assets, liabilities and estimates. We simulate the potential results for two periods in the future based upon percentiles drawn from a sample of 1,116 firms taken from Compustat. We compute projected pension expense for the 25th percentile firm, the median firm, and the 75th percentile firm by varying the discount rates, expected rates of return, and actual asset return assumptions. Our results indicate that while the pension expense effect is large in both periods across small, mid-sized and large firms, large firms show the greatest increase in pension expense. Interestingly, however, the earnings impact is the smallest for large firms in both periods, and is not material in period one for both large and mid-sized firms. It is material for small firms. Firms with small pension plans appear to have the greatest earnings drag both one and two years into the future. In period two, all firms face significantly greater expense and earnings reductions, although again, smaller firms face the greatest impact. In addition, all firms face significantly increased cash funding requirements in order to prevent funding ratios (plan assets scaled by pension liabilities) from deteriorating. These results suggest not only future earnings reductions form pension rate changes, but also a potential cash flow impact as well.

A Comparative Analysis Of Global Pension Tax Arbitrage

In a company with defined benefit plans, pension assets often represent a sizable portfolio of financial assets. The intention is to examine whether pension tax arbitrage has the potential to add value to the sponsoring corporation with secondary benefits to plan participants, through a less volatile pension fund. To implement the arbitrage, it is recommended that the plans shift all assets to bonds. Replacing stocks with bonds reduces the risk of the firm, and the benefit stems from the creation of an additional tax deduction on the payment of interest with no increase in firm risk.

Optimal Portfolio Allocation for Corporate Pension Funds

We model the asset allocation decision of a defined benefit pension fund using a stochastic dynamic programming approach. Our model recognizes the fact that asset allocation decisions are made by trustees who are mandated to act in the best interests of beneficiaries - not by sponsoring employers - and that trustees face payoffs that are linked in an indirect way to the value of the underlying assets. This is because of the presence of pension insurance - which may cover a portion of deficits in the event of a sponsor default - and a sponsoring employer who may make good any shortfall in assets, and who may reclaim some pension surplus. Our model includes an allowance for uncertainty both of the future value of assets (because of uncertain investment returns) and liabilities (because of uncertainty in future longevity and in future interest rates). We find that we are able to substantially replicate observed DB pension asset allocations in the UK and conclude that institutional details - in particular asymmetries in payoffs to pension trustees - are crucial in understanding pension asset allocation.

The Persistence of Employee 401(K) Contributions Over a Major Stock Market Cycle: Evidence on the Limited Power of Inertia on Savings Behavior

Many middle-income workers save for retirement through 401(k) plans. This study addresses the concern that low account balances of older workers may indicate that these vehicles are not sufficient to insure adequate retirement savings. In particular, the study shows that workers are not persistent (continuing once a worker has started) in contributing, and a weak stock market exacerbates the problem. The study suggests that the concept of inertia, which is in vogue in behavioral economics, does not seem to hold for 401(k) saving behavior. Furthermore, the investment strategy of dollar cost averaging does not seem to hold, either. Using panel data (Panel Study of Income Dynamics) covering a six-year time span from 1999 to 2005, the study presents descriptive and econometric evidence about the persistence behavior of individuals with 401(k) accounts. In particular, the PSID data that were analyzed come from four biannual waves in 1999, 2001, 2003, and 2005. Descriptive data show that of the sample of household heads aged 21-65 in 2005 who were employed in every time period, only about one-third (35 percent) contributed to their plan in all four waves. Job changing had an impact. However, even for individuals in the sample who did not change jobs, less than half (46 percent) contributed in all four years of the survey. An equation modeling 401(k) contribution behavior was estimated using logit regression analysis. When this model was estimated with the sample of individuals who were employed in each panel and with the sample of individuals who were employed in each panel and never changed jobs, the coefficient on the Dow Jones Industrial Average was positive and significant. Workers contributed to their plans when the market was up. This investment error is called herd investing, where individuals get into the market when it is high and not when it is low. The study concludes that the findings have important implications for the pension system and adequacy of retirement income. Projects of future retirement income readiness that assume that workers persistently contribute over their working lives greatly exaggerate the future levels of pension assets workers will have accumulated.

An Empirical Examination Of Pension Rate Estimates: A Benchmark Approach

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt; mso-pagination: none;"><span style="font-size: 10pt;"><span style="font-family: Times New Roman;">In this paper, we analyze pension rate choices for a sample of 495 firms over the thirteen-year period from 1994-2006. In recent years, articles have appeared in business publications alleging abuse of the discretion afforded to management in setting pension rates, particularly the pension discount rate and expected rate of return on plan assets. We find that pension discount rate estimates and expected rate of return estimates generally comply with the authoritative requirements, although there appears to be a smoothing effect in setting pension discount rates as well as a lag in fully reflecting economic conditions. We find evidence consistent with discount rate choice being influenced by deteriorating economic conditions, and possibly passage of the Sarbanes-Oxley Act. We also find that, in general, firms’ expected rate of return assumptions tend to reflect their long-run internal rates of return on pension assets, although the recessionary influences in the early 2000s were not fully reflected in the expected rates of return toward the end of our test period. There is also a sizeable minority of firms (approximately 27%) for which their expected rates of return on plan assets consistently overstate their actual, long-run returns.</span></span></p>

The ‘New Classic’ Equity Allocation

The recent financial crisis led many institutional investors to review their asset allocation policies and explore alternative approaches to implementation. MSCI recently held discussions around the world with major pension plans, asset managers, and investment consultants to understand different approaches to implementing equity allocation. Following these consultations, we provide a framework for the implementation of global equity allocation.Our research suggest that global equity mandates, together with dedicated emerging market mandates and small cap mandates, may be emerging as the “new classic” structure for implementing equity allocation. Investors who need to maintain a home bias can manage the domestic portfolio separately. Such a more top-down mandate structure not only accrues benefits from the potential merits of an integrated global investment process, but it also accommodates segment-specific considerations on manager selection, legacy or mandatory home bias, and different risk and return drivers in various equity market segments.

Relative performance evaluation and pension investment management: A challenge for ESG investing

Abstract The fund management industry is the primary investment arm of the pension funds that control a significant portion of global capital market assets. Pension assets are frequently cited as vehicles for the use of “environmental, social and governance” (ESG) factors in investing for broader, extra-financial aims. Yet, compensation practices in the pension investment management industry remain focused on relative performance. This study examines the use of relative performance evaluation (RPE) as a form of compensation and control, including its historical emergence, using a genealogical history that attempts to provide some critique of its current day usage. In doing so, it follows the call by Norman Macintosh to both examine the social embeddedness of accounting, and to engage in reflexive accounting histories. The study argues that continued focus on relative results may pose challenges to incorporating ESG factors, and that further study of the RPE technique is needed, particularly with the increased focus on ESG at the policy level.

Testing Moral Hazard and Tax Benefit Hypotheses: Evidence from Corporate Pension Contributions and Investment Risk

We jointly test moral hazard and tax benefit hypotheses related to the defined benefit pension plan funding and investment risk-taking decisions by incorporating the pension plan termination probabilities. We hypothesize that sponsors with different plan termination probabilities are dominated by different incentives. In particular, sponsors are dominated by the moral hazard incentive when they face high plan termination probabilities, as the put option derived from the Pension Benefit Guaranty Corporation (PBGC) guarantee has the greatest value. In contrast, the tax benefit incentive dominates if sponsors have low termination probabilities. As the value of the PBGC put option is low, maximizing tax benefits associated with pension contributions and investment earnings becomes a dictating incentive. The findings based on sponsors’ voluntary contributions strongly support our hypotheses after controlling for endogeneity issue. However, in examining sponsors’ investment risk-taking incentives, the results based on pension beta and asset allocation do not support either of the hypotheses.

Liability-driven investment: multiple liabilities and the question of the number of moments

The selection of investments held in dedicated pension or insurance asset portfolios should be liability-driven. Techniques have been developed to hedge or immunize single liabilities from the effects of a variety of yield curve changes. In this paper, we extend these results to a more relevant practical problem, to immunize multiple liabilities occurring at different times in the future. This immunization approach can accommodate a variety of non-parallel yield curve behaviours. In a practical application, we demonstrate that our approach is effective in selecting index tracking portfolios in the UK Gilt (government bond) market.