Pension Plan Assets Research Articles

Pay‐to‐play: SEC staff provides new guidance on Advisers Act Rule 206(4)‐5

PurposeThe purpose of this paper is to explain the SEC staff's web site responses to a series of frequently asked questions concerning SEC Advisers Act Rule 206(4)‐5.Design/methodology/approachThe paper explains the SEC staff responses to FAQs on the ability to rely on prior Municipal Securities Rulemaking Board interpretations regarding MSRB Rules G‐37 and G‐38, determining who is an “official of a government entity,” determining who is a “covered associate,” payments of commissions or other compensation to brokers or others, the Rules' application to political action committees (PACs), and “effective dates” and “compliance dates” under the related recordkeeping rule.FindingsPay‐to‐play is the practice of making campaign contributions and related payments to elected officials in order to influence the awarding of lucrative contracts for the management of public pension plan assets and similar government investment accounts. The staff's answers to the FAQs announce cautious positions, do not address some of the more difficult issues advisers may face on a day‐to‐day basis, and are subject to change.Originality/valueThe paper provides practical guidance from experienced financial services lawyers.

Have pension plans changed after the introduction of IFRS?

In this article, we provide empirical evidence of an important economic consequence after major changes in accounting standards. More precisely, we document that several companies have switched their pension scheme from a traditional defined benefit (db) scheme to a defined contribution (dc) scheme. In many cases, the annual reports of the pension funds and their sponsoring companies state that the introduction of IFRS is the main reason for switching from a db to dc scheme. We also analyse which company or pension fund characteristics might be related to the decision to switch. Even though many companies seem to consider switching to dc schemes, already 12 out of the 44 largest company pension schemes have converted their pension scheme. This is an important economic consequence attributed to the introduction of new accounting standards. Our results do not indicate a clear pattern of company characteristics that predict which companies are more likely to switch, although the relative size of the pension plan assets compared with the company's equity seems weakly positively related to switching.

Pension Accounting: Funding Costs And Liabilities Of Corporate Pension Plans

Overall, pension plan assets analyzed in this study appear strong. They have excellent overall funding and unfunded vested liabilities would require less time to fund currently than in 1978. Pension expense per employee have been increasing, but at very nominal rates. And although the companies with the highest profits may not be the companies with the highest pension expenses, average pension expenses for most categories decreased. Currently unfunded vested liabilities are low relative to both pre-tax profits and net worth. Again, a number of points should be kept in mind when looking at these analysis and trends. Industry categories had small sample sizes. The sample sizes increase when companies are lumped into ranking categories making the data more representative. The overall trends include sample sizes of approximately 90, an acceptable number for statistical analysis. Also, some of the trends could be clouded by definitions of assets, liabilities, and income which differ from the 1978 study. However, after examining basic similarities between the studies and noting the strength of certain trends, the above mentioned conclusions appear warranted.

The Potential for Inflating Earnings through the Expected Rate of Return on Defined Benefit Pension Plan Assets

SYNOPSIS Using a sample of firms over the period of 1991 through 2005, we examine the opportunity that exists for firms to inflate earnings through the expected rate of return (ERR) assumption associated with defined benefit pension plans. The evidence suggests that, on average, the ERR is not overstated relative to several benchmarks, including contemporaneous actual returns, historical cumulative actual returns, and expected future returns based on asset allocation within the pension. We also find that actual changes in the ERR are infrequent and typically have less than a 1 percent impact on annual operating income. We also estimate that a 0.5 percent change (50 bps) in the ERR will result in a cumulative effect on operating income over a five-year period of approximately 0.5 percent or less for the majority of firms. When we examine firms with the highest ERRs or with the greatest opportunity to inflate earnings, again, we find that the ERR is not overstated relative to several benchmarks. Although we do not observe pervasive inflating of reported income through the ERR during our sample period, we do find that for some firms, small increases in ERR can have a material impact on reported earnings. Our results provide evidence related to the pervasiveness, materiality, and impact of overstated earnings through the ERR, which helps regulators assess the costs and benefits of eliminating this discretion in financial reporting.

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.

Goodwill And Goodwill Write-Downs: Their Effects On Earnings Quality For 2008 And 2009

This paper examines goodwill on corporate balance sheets. Specifically, the paper measures the extent to which goodwill exists on corporate balance sheets and the degree of goodwill write-downs that have occurred recently. We report on our study and a study by Intangible Business, which show that many firms carry substantial amounts of goodwill on their 2008 balance sheets. Thus, because of the recent downturn in the economy and the markets, the potential for big bath earnings management for 2008 and 2009 exists. In addition, because of reductions in expected returns on pension plan assets, many firms are likely to record much higher pension expenses. We expect that the combination of goodwill impairments and increased pension expense will have significant effects on both the amount and the quality of earnings for 2008 and, possibly, 2009.

The Many Challenges of Pension Accounting

ABSTRACTAccounting for defined benefit pension plans has long been a major issue in accounting. Standard‐setters are grappling with revisions to pension accounting standards, and much change has already occurred in the United Kingdom. This paper identifies and discusses most of the major issues that standard‐setters must confront in developing new approaches to financial reporting for pensions. Key issues concern how to report the impact of changes in assumptions, how to recognize pension costs on the balance sheet and income statement, and how to reconcile the differences between accountants' and actuaries' approaches to pensions. Current standards assume that accounting estimates are independent of actuarial assumptions, and yet require a direct comparison of the accounting liability with the pension plan assets, when in fact they are incompatible measures based on differing assumptions and differing methodologies. As well, accounting has been complicit in managers' wishes to hide the volatility inherent in a pension plan investment strategy that focuses on higher‐risk equities to fund estimated monetary liabilities that have been discounted at low‐risk interest rates. Drawing on studies and research done largely in Europe, this paper attempts to consolidate some of the current thinking on the topic and to propose some preferred approaches to dealing with the problems of pension accounting.

How Should Public Pension Plans Invest?

How public pension plan assets should be invested is an important but unsettled question. Alicia H. Munnell and Mauricio Soto (2007) find that the share of state and local (S&L) plan assets held in equities has grown over time, largely in parallel with private sector practices, from an average of about 40 percent in the late 1980s to about 70 percent in 2007. This exposure led to a loss of an estimated $1 trillion dollars following the decline of the stock market from October 2007 to October 2008 (Munnell, Kelly Haverstick, and Jean-Pierre Aubry 2008). Nevertheless, some observers endorse the standard practice of investing heavily in higher yielding but riskier equities, reasoning that the higher average returns will reduce future required tax receipts and also help to reduce underfunding over time. Others advocate a more conservative approach that reduces the volatility of funding levels and the likelihood of severe shortfalls during economic downturns when government resources are already constrained (e.g., Lawrence N. Bader and Jeremy Gold 2007). The accounting rules for public pensions create a perverse incentive to invest in stocks: since projected liabilities are discounted at the expected return on assets rather than at a rate that reflects the generally lower risk of liabilities, investing the assets in the stock market leads to

Actuaries and Accountants: The Tower of Babel

Defined benefit (DB) pension accounting standards have changed substantially over the past thirty years and still vary substantially across countries today. In spite of the inter-jurisdictional differences, many observers criticize pension accounting standards for being confusing and even misleading. Our paper considers the difficulties that arise from differences between the legislative requirements regarding funding and administration of DB pension plans and the accounting requirements regarding financial statement reporting of those plans. Specifically, we investigate the effects of: (1) accounting treatment vs. funding of actuarial gains and losses and (2) differences between the accounting and actuarial discount rates that are applied to the pension projected benefit obligation (PBO) and service cost. To analyze these issues, we simulate economic and accounting outcomes for a stable hypothetical DB pension plan over a twenty-year period. We demonstrate that current GAAP for pension plans is problematic in that, in many circumstances: (1) pension expense diverges significantly from funding cash flows; (2) pension deficits reported in the financial statements grow over time even when the pension plan is fully funded; and (3) the divergence between GAAP-reported and actuarially determined pension results is dependent, at least in part, on the allocation of pension plan assets between debt and equity investments.

The Geography of Pension Liabilities and Fund Governance in the United States

If finance is the engine driving economic and geographic change, then pensions are its primary vehicle. On the one hand, pension-plan assets, which approached US$18 trillion in 2005 for OECD countries, are having global impacts on financial markets. On the other hand, pension-plan liabilities, larger than the assets in nominal terms, are also having dramatic impacts on plan sponsors. If assets are not properly managed, pension liabilities can threaten the financial solvency of plan sponsors. Consequently, owing to the enormous and growing financial and political importance of pension plans, I contend that the procedures governing these institutions are of increasing importance for economic geographers. In this paper the effectiveness of the current governance system is tested through a widely subscribed ‘expert survey’. Then, the relationship between pension-fund governance and economic geography is demonstrated through case study. I conclude that the current governance model remains inadequate. Moreover, poor pension-fund governance, in addition to having an economic cost, is shown to have tangible geographic impacts.

Testing Moral Hazard and Tax Benefit Hypotheses: Evidence from Corporate Pension Plan Contributions and Asset Allocation

Testing Moral Hazard and Tax Benefit Hypotheses: Evidence from Corporate Pension Plan Contributions and Asset Allocation

Asymmetric Timeliness in Pension Asset Accounting

We investigate whether revisions in the expected rate of return on pension plan assets are more sensitive to the difference between realized returns and expected returns when realized returns fall short of expectations than when they exceed expectations. We find that the correlation between expectation errors and revisions in the expected rate of return on plan assets is significantly more positive when realized returns in year t are below the expected rate of return in year t-1 than when realized returns are above the expected rate of return in year t-1. Further exploration indicates that this asymmetric-revision sensitivity is accentuated when firm leverage and the volatility of realized returns are high and when CEO stock ownership is low. These conditions are consistent with an increased demand for asymmetrically timely earnings.

Mountain or Molehill? The Pervasiveness of Overstated Earnings Through the Expected Rate of Return on Defined Benefit Pension Plan Assets

Using a sample of firms over the period of 1991 through 2005, we examine the expected rate of return (ERR) assumption associated with defined benefit pension plans. The evidence suggests that contrary to suggestions in the business press, the ERR is not overstated relative to several benchmarks including contemporaneous actual returns, historical cumulative actual returns and expected future returns based on asset allocation within the pension. We also find that changes in the ERR are infrequent, typically have less than a 1% impact on operating income and are positively related to differences between estimated and actual ERRs. When we examine firms with the highest ERRs or with the most opportunity to inflate earnings, we find they are no more likely to boost earnings through the ERR than other firms. We conclude that the evidence suggests overstated earnings through the ERR is not pervasive or material, which helps regulators assess the costs and benefits of eliminating this discretion in financial reporting.

The Geography of Pension Liabilities and Fund Governance in the United States

If finance is the engine driving economic and geographic change, then pensions are its primary vehicle. On the one hand, pension plan assets, which approached $18 trillion dollars in 2005 for OECD countries, are having global impacts on financial markets. On the other hand, pension plan liabilities, larger than the assets in nominal terms, are also having dramatic impacts on plan sponsors. If assets are not properly managed, pension liabilities can threaten the financial solvency of plan sponsors. Consequently, as institutions with enormous and growing financial and political importance, this paper contends that the procedures governing pension plans are of increasing importance for economic geographers. In this paper, the effectiveness of the current governance system is tested through a widely subscribed 'expert survey'. Then, the relationship between pension fund governance and economic geography is demonstrated through case study. The paper concludes that the current governance model remains inadequate. Moreover, poor pension fund governance, in addition to having an economic cost, is shown to have tangible geographic impacts.

Eppur si muove — Risk and alternative asset classes for pension funds

The author draws attention to different investment practices between pension funds in North America and those in Europe. In particular, he points out the very different ways in which so-called ‘alternative’ asset classes are viewed; for example, in the UK, private equity and hedge funds combined make up only about 1 per cent of pension plan assets, whereas in North America some pension plans have allocations just to private equity of anything up to about 25 per cent. The paper examines the example of the Yale Model in North America and suggests that it could and should be adopted by pension funds in Europe, as it is being progressively by their counterparts across the Atlantic. The author deals in turn with risk, correlation and liquidity, suggesting that the traditional risk model is no longer appropriate for modern investment approaches, and perhaps was never really valid at all. He also contends that the existing view of liquidity and solvency is mistaken, and that pension funds actually require far less liquidity than they imagine.

Corporate Governance of Pension Plans: The U.K. Evidence

For this study of the governance of defined-benefit pension plans in the UnitedKingdom, the governance measure was equal to the proportion of trustees of thepension plan in 2002 who were also executive directors of the sponsoringcompany. The findings indicate that pension plans of indebted companies with ahigher proportion of insider than independent trustees invest a higherproportion of pension plan assets in equities and that the sponsors contributeless to the plan and have a larger dividend payout ratio. This evidence supportsthe agency view that insider trustees act in the interests of shareholders ofthe sponsor, not necessarily in the interests of pension plan members.

Winners and Losers: 401(K) Trading and Portfolio Performance

Few previous studies have explored how individuals manage their defined contribution (DC) pension plan assets, though these plans constitute an increasingly important component of retirement wealth. Using a valuable new dataset on over one million active 401(k) plan participants in a wide range of plans, we assess the impact of trading on investment performance in DC plans. We find that, in aggregate, the risk-adjusted returns of traders are no different than those of nontraders. Yet certain types of trading such as periodic rebalancing are beneficial, while high-turnover trading is costly. Interestingly, those who hold only balanced or lifecycle funds, whom we call passive rebalancers, earn the highest risk-adjusted returns. These findings should interest participants in such plans, fiduciaries responsible for designing DC pensions, and regulators of the retirement saving environment.

How Workers Use 401(K) Plans: The Participation, Contribution, and Withdrawal Decisions

This paper examines how workers use 401(k) plans by examining their participation, contribution, and withdrawal decisions. Sixty-five percent of eligible workers participate in 401(k) plans. Employee participation rises with income, age, job tenure, and education. While participation also rises if the employer matches contributions, 401(k) participation does not grow with the rate of matching. When pension plan assets are withdrawn in lump-sum distributions before retirement, just 28 percent of distribution recipients (representing 56 percent of distribution assets) roll over the withdrawn funds into tax-qualified savings plans. Our findings suggest that many workers, particularly those with low incomes, do not use 401(k) plans to save for retirement.

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.

Earnings Manipulation, Pension Assumptions, and Managerial Investment Decisions

Managers appear to manipulate firm earnings through their characterizations of pension assets to capital markets and alter investment decisions to justify, and capitalize on, these manipulations. Managers are more aggressive with assumed long-term rates of return when their assumptions have a greater impact on reported earnings. Firms use higher assumed rates of return when they prepare to acquire other firms, when they are near critical earnings thresholds, and when their managers exercise stock options. Changes in assumed returns, in turn, influence pension plan asset allocations. Instrumental variables analysis indicates that 25 basis point increases in assumed rates are associated with 5 percent increases in equity allocations.