Pension Portfolios Research Articles

U.S. Fiscal Policy in an Era of Federal Budget Surpluses

Gokhale examines how the US budgetary surpluses can best be managed in view of the long-term expenditure pressures that the Social Security and Medicare programmes will exert on the US federal government budget. He notes that the worsening of the American fiscal outlook in 2002 postpones but does not entirely eliminate the need to think about how to deal with a potential cash accumulation with the federal government. If the surpluses turn out to be so large that debt is eliminated and a sizeable cash reserve accumulates with the government, the funds will have to be invested in private assets. Gokhale considers four policy options, in which the assets are respectively managed by the Federal Reserve, the US Treasury, the Social Security Trust Fund (SSTF) and by private individuals via an individual Social Security account system. The last solution implies that the surpluses of the SSTF are invested in marketable debt which is attributed to individual Social Security accounts. Individuals can then trade the public bonds for private stocks and bonds. The alternative solutions are evaluated on the basis of four objectives: preserving a liquid public debt market, minimising deadweight losses from inefficient resource allocation by the government, allowing diversification of pension portfolios and improving intergenerational risk sharing. According to Gokhale, the use of surpluses to start an individual Social Security account system is the best solution.

Portfolio Restriction to Impose on Defined Benefit Pension Plans

When a firm sponsoring a defined benefit pension plan approaches financial distress, the Pension Benefit Guaranty Corporation (PBGC) insurance effect materializes and the optimal pension portfolio policy becomes aggressive. In this configuration, a regulation restricting the pension investment strategy is needed. We suggest that the restriction imposed should follow asset-liability management principles. A low risk investment policy, as defined by the preference-independent liability hedge only, should be the regulator's benchmark. We recommend that the risky asset proportion maximum limit is fixed at 30%.

Would emerging market pension funds benefit from international diversification: investigating wealth accumulations for pension participants

In recent years, investment portfolio selection is growing in importance for many emerging market pension funds, as pension reforms replace traditional pay-as-you-go systems with advanced funding systems. Various investment regulations are applied to the funded pensions, particularly in the form of portfolio limits for equities and international assets. With a bootstrap simulation approach, this paper attempts to quantify the impacts on retirement benefits of restricting international assets from the investment portfolios of emerging market pension funds. We find that, on average, over half of the pension portfolios of emerging market countries should be in international assets in order to maximize the expected utility of moderate and conservative pension fund participants. More generally, international assets can play a significant role in the investment portfolios for workers with risk aversion varying from aggressive to conservative. With few exceptions, the entire probability distribution of wealth accumulations at retirement could be shifted higher with the inclusion of international assets.

Optimal Corporate Pension Policy: A Unified Framework

This paper develops a general continuous-time framework for defining optimal corporate pension policy. Interactions between the firm's optimal investment and financing policies and the defined benefit pension plan optimal portfolio strategy are studied. We prove that the three decision rules are driven by speculation and hedging motives, the latter concerning in each case both the pension plan and firm variables. We emphasize that in normal times the optimal pension portfolio rule from the equity holders' perspective is acceptable to both the participants and PBGC. Yet it is no longer the case when the firm approaches financial distress. The PBGC should then exert a much stronger control than today exerted on the sponsoring company to prevent the further deterioration of the Corporation's financial status.

Longevity Hedging 101

Basis risk is an important consideration when hedging longevity risk with instruments based on longevity indices, since the longevity experience of the hedged exposure may differ from that of the index. As a result, any decision to execute an index-based hedge requires a framework for (1) developing an informed understanding of the basis risk, (2) appropriately calibrating the hedging instrument, and (3) evaluating hedge effectiveness. We describe such a framework and apply it to a U.K. case study, which compares the population of assured lives from the Continuous Mortality Investigation with the England and Wales national population. The framework is founded on an analysis of historical experience data, together with an appreciation of the contextual relationship between the two related populations in social, economic, and demographic terms. Despite the different demographic profiles, the case study provides evidence of stable long-term relationships between the mortality experiences of the two populations. This suggests the important result that high levels of hedge effectiveness should be achievable with appropriately calibrated, static, index-based longevity hedges. Indeed, this is borne out in detailed calculations of hedge effectiveness for a hypothetical pension portfolio where the basis risk is based on the case study. A robustness check involving populations from the United States yields similar results.

Fiduciary Investment Under Uncertainty: Examining Pension Plan Investment Behavior When Trustees Have Reputational Utility

Pension funds investment behavior have found to be persistent over time. Empirical findings of such persistence support conjectures that belief biases such as overoptimism and reputational concerns affect fiduciary investment behavior. Standard mean-variance analyses do not consider the implications of prudent-man laws on pension fund investment. We suggest an alternative way to derive pension portfolio choice by explicitly allowing pension trustee to make a joint belief-allocation choice in a utility function which takes an entropic form and considers investment objectives in a fiduciary environment. Our results demonstrate that pension trustees are inherently optimistic in forming projections but such optimism increases with the degree of risk-aversion. Further, the higher the level of risk-aversion, the more likely trustees will conform to peer group consensus and the less likely the consensus will change over time. This pattern of investment behavior seems consistent with empirical observations.

On “optimal pension management in a stochastic framework” with exponential utility

This paper reconsiders the optimal asset allocation problem in a stochastic framework for defined-contribution pension plans with exponential utility, which has been investigated by Battocchio and Menoncin [Battocchio, P., Menoncin, F., 2004. Optimal pension management in a stochastic framework. Insurance: Math. Econ. 34, 79–95]. When there are three types of asset, cash, bond and stock, and a non-hedgeable wage risk, the optimal pension portfolio composition is horizon dependent for pension plan members whose terminal utility is an exponential function of real wealth (nominal wealth-to-price index ratio). With market parameters usually assumed, wealth invested in bond and stock increases as retirement approaches, and wealth invested in cash asset decreases. The present study also shows that there are errors in the formulation of the wealth process and control variables in solving the optimization problem in the study of Battocchio and Menoncin, which render their solution erroneous and lead to wrong results in their numerical simulation.

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.

Faces of Ageing and Fundamental Background of Pension Investments - In East Central Europe, Russia and Scandinavia

During the transition in East Central Europe, a number of criteria and schools of thought clashed over the creation of a market economy and the role of the state. The long-term demographic vulnerability of the region is also coupled with a crisis in the labor market tied to the transition. To deal with these problems, a series of pension reforms has attempted to improve the country's demographic situation since the mid-1990s in addition to reducing the financial role of the state. Placing self-provision in the foreground, the state only assumes financial risk for the first pillar, thus, in making a regional comparison of pension systems, the economic background and the status of the country's external equilibrium must be taken into account. This study compares potential Slovenian, Czech, Hungarian and Russian pension portfolios with Swedish, Danish and Finnish data - bearing in mind differences in the real economy.

Factors affecting corporate choices of postretirement benefits in the USA

PurposeThe purpose of this paper is to examine the determinants of US firms' postretirement benefits choices.Design/methodology/approachThe paper uses empirical methodology (univariate and multivariate) to test the research hypotheses.FindingsIndustry norm, average employee age, financial structure, and firm size are significant factors in the determination of the proportion of compensation that is deferred. Industry norm, financial structure, and firm size are significant factors that determine the percentage of deferred compensation that is negotiated as defined benefits. Finally, industry norm, corporate tax rates, and cash flow help explain the percentage of defined benefits that are paid in the form of retiree health benefit plans.Research limitations/implicationsData requirements might bias the sample towards larger sized firms. Data availability limits the number of observations in 2000 and 2001.Practical implicationsThe trends in post‐retirement benefits reported in this paper are important for policy makers.Originality/valueThese findings have implications for the baby boomers. The trend to offer smaller proportion of compensation as deferred benefits reflects the increasing costs of deferral to the employers. This increases the employees' responsibilities to save on their own. This also would shift the retirees' dependence on the public pension system for their retirement income. The trend to favor defined‐contribution plans instead of defined‐benefit plans reflects the employers' attempts to diversify their risks of paying promised post‐retirement benefits by transferring the risk to the employee. On the other hand, the popularity of defined‐contribution pension plans also reflects the increased Government's incentives to encourage savings via 401‐k plans and employee's willingness to manage their own pension portfolios.

Redefining retirement: how will boomers fare?

PART I: PROSPECTS FOR BABY BOOMER RETIREMENT Will Boomers Redefine Retirement? Cross-Cohort Differences in Retirement Expectations and Realizations The Sufficiency of Retirement Savings: Comparing Cohorts at the Time of Retirement Understanding Baby Boomers' Retirement Prospects PART II: CHANGING HEALTH STATUS AND HEALTH INSURANCE Are Boomers Living Well Longer? Baby Boomers vs Their Parents: Economic Well-Being and Health Status Cross-Cohort Differences in Heath on the Verge of Retirement Health Insurance Patterns Nearing Retirement PART III: NEW ROLES FOR RETIREMENT ASSETS The Impact of Pensions on Non-pension Investment Choices Measuring Pension Wealth Trends in Pension Values around Retirement Pension Portfolio Choice and Menu Exposure Saving Between Cohorts: The Role of Planning Retiring on the House? Cross-Cohort Differences in Housing Wealth

Home Bias Makes Sense for U.S. Pension Plans

A home bias of investment means international securities are less represented in a portfolio than domestic securities. In an asset-liability framework, pension portfolio weights are chosen not just by an asset9s return and variance, but also by its correlation with the pension liabilities. This results in higher weights on the assets that are highly correlated with pension liabilities. When managers try to maximize the portfolio surplus, allocations to international equities are lower than would be predicted by typical mean-variance models. Thus there is really no home bias in pension plan investment. <b>TOPICS:</b>Pension funds, portfolio construction, global

Hidden Risks to the Long-Term Goals of Pension Portfolios

The investment policies of defined-benefit plans are designed to maximize the long-term funding ratio (assets/liabilities) while limiting the risk of underfunding. Pension plan sponsors, in contrast, have a much shorter focus and a tendency to use any excess of assets over liabilities to improve benefits or reduce contributions. This practice negates the benefit of long-term investment risk management and increases the odds of having to rely on the sponsor deficiency guarantee at a time when pension plans have become large and risky relative to sponsor business operations. Maintaining a long-term mindset is difficult but necessary to keep defined-benefit plans sustainable.

TIPS, the Dual Duration, and the Pension Plan

By defining “duration” as the sensitivity of an asset's price to changes in some other variable, one may characterize any asset as having an inflation duration, D i , and a real-interest-rate duration, D r . Unlike nominal bonds, for which D i = D r , inflation-linked bonds, such as Treasury Inflation-Indexed Securities (commonly called TIPS), have different values for D i and D r . Defined-benefit pension liabilities also have different values for D i and D r . Such liabilities can be modeled as bonds (or portfolios of bonds and equities or other assets) held short. Thus, by appropriately combining TIPS and nominal bonds, a manager can build a portfolio that has the same inflation duration and real-interest-rate duration as the liability stream. Equities also have different values for D i and D r , so the interaction of equities with TIPS and nominal bonds can be exploited in forming efficient pension portfolios—particularly in defeasing various liability streams.

Protecting underfunded pensions: the role of guarantee funds

Employer-related pensions are a common and extremely important component of the compensation paid to workers in both the public and private sectors of developed economies. Many private pensions are insufficiently funded, exposing workers to the risk of a loss should their employer cease operations and not be available to meet pension obligations.In this paper we study the role of guarantee funds as providers of insurance to workers against the failure of firms with underfunded defined benefit pension plans. Employing a model that predicts pension underfunding, we consider first how private guarantee funds might operate and then explore some potential advantages of public funds.Overall, we do find that both public and private funds provide insurance benefits. However, private guarantee funds requiring ex ante premia payments may be infeasible in the presence of capital market imperfections, and funds which rely upon ex post contributions may suffer from strategic uncertainty. A public fund can overcome this coordination problem. However, a public fund, such as that administered by the US Pension Benefit Guaranty Corporation, may lead to: (i) greater underfunding of pensions, (ii) distortions in the market participation decisions of firms and (iii) the inclusion of excessively risky assets in the pension portfolio. In some cases, a guarantee fund is not welfare improving.

Did Pension Plan Accounting Contribute to a Stock Market Bubble?

DURING THE 1990S THE assets of corporate defined-benefit (DB) pension plans ballooned as a result of the booming stock market. Because of accounting rules for DB plans put in place in 1986, this robust growth provided a substantial, although stealthy, boost to the profits reported by sponsoring corporations. In particular, the extraordinary returns earned on pension assets flowed to the bottom line on corporate income statements through lower net pension cost accruals included in general corporate expenses. These developments may have misled many investors about the value of corporate equities, because pension cost accruals provide a fairly convoluted signal of the underlying value of net pension assets, in two ways. First, the accounting rules allow firms to smooth the effect of volatility in asset returns in calculating net pension expense; this smoothing both hides the variation inherent in the realizations of risky returns and tends to make current accruals of pension cost a stale measure of a pension plan's net asset value. Second, the net costs of financing outstanding pension liabilities are effectively understated when pension sponsors assume a future rate of return on plan assets that far exceeds the discount rate they use to calculate the present value of plan obligations. In effect, the costs associated with providing a pension plan to employees are offset on the sponsoring firm's financial statements by a smoothed and inflated stream of income flowing from the pension portfolio. In this paper we assess the degree to which investors may have been fooled by current pension accounting rules and practices. We do so using two alternative models of pension valuation. The first, known as the standard transparent model, holds that investors gauge the contribution of a pension plan to the sponsoring firm's value by looking at the plan's marked-to-market net asset value, which is reported in footnotes to the firm's financial statements. The second, the "opaque" model proposed by Jeremy Gold, presumes that the market's assessment of net pension value is driven instead by the pension cost accruals reported in the body of the firm's income statement. (1) Our analysis applies a standard framework for equity valuation based on abnormal earnings and shows that, under the current accounting regime, the market appears to pay more attention to the flow of pension-induced accruals reported in the body of the income statement than to the marked-to-market value of pension assets and liabilities reported in the footnotes. These findings strongly support the predictions of the opaque model of pension valuation. We then perform a second battery of tests to determine whether the market prices a firm's pension accruals any differently than it prices the firm's core business earnings. The results suggest that investors do not distinguish between these two sources of earnings, at least not in the way that one would expect in an efficient market. If anything, the earnings associated with pension accruals appear to receive a higher valuation multiple than do core earnings. Finally, we bring this evidence to bear on the question of whether there was a substantial pension-induced bubble in equity prices by simulating firm-level valuation errors using one of the empirical models employed in our hypothesis tests. The simulations suggest that, for the average firm in the Standard & Poor's (S&P) 500 with a DB plan, pension-induced valuation errors added 2 to 3 percent to the stock price during the late 1990s. Although significant in terms of absolute dollars of wealth, this source of error thus explains little of the runup in stock prices over this period. However, the estimated pension-induced distortions rise considerably in 2001, when the plunge in pension net asset values had not yet shown through to pension cost accruals. In particular, we estimate that, as of. early 2002, one-tenth of the firms in our sample that sponsored a DB pension plan were at least 20 percent overvalued, relative to otherwise similar firms, and that the unweighted average level of overvaluation of the stocks of pension-sponsoring firms was 10 percent. …

Did Pension Plan Accounting Contribute to a Stock Market Bubble?

DURING THE 1990S THE assets of corporate defined-benefit (DB) pension plans ballooned as a result of the booming stock market. Because of accounting rules for DB plans put in place in 1986, this robust growth provided a substantial, although stealthy, boost to the profits reported by sponsoring corporations. In particular, the extraordinary returns earned on pension assets flowed to the bottom line on corporate income statements through lower net pension cost accruals included in general corporate expenses. These developments may have misled many investors about the value of corporate equities, because pension cost accruals provide a fairly convoluted signal of the underlying value of net pension assets, in two ways. First, the accounting rules allow firms to smooth the effect of volatility in asset returns in calculating net pension expense; this smoothing both hides the variation inherent in the realizations of risky returns and tends to make current accruals of pension cost a stale measure of a pension plan's net asset value. Second, the net costs of financing outstanding pension liabilities are effectively understated when pension sponsors assume a future rate of return on plan assets that far exceeds the discount rate they use to calculate the present value of plan obligations. In effect, the costs associated with providing a pension plan to employees are offset on the sponsoring firm's financial statements by a smoothed and inflated stream of income flowing from the pension portfolio. In this paper we assess the degree to which investors may have been fooled by current pension accounting rules and practices. We do so using two alternative models of pension valuation. The first, known as the standard transparent model, holds that investors gauge the contribution of a pension plan to the sponsoring firm's value by looking at the plan's marked-to-market net asset value, which is reported in footnotes to the firm's financial statements. The second, the model proposed by Jeremy Gold, presumes that the market's assessment of net pension value is driven instead by the pension cost accruals reported in the body of the firm's income statement. (1) Our analysis applies a standard framework for equity valuation based on abnormal earnings and shows that, under the current accounting regime, the market appears to pay more attention to the flow of pension-induced accruals reported in the body of the income statement than to the marked-to-market value of pension assets and liabilities reported in the footnotes. These findings strongly support the predictions of the opaque model of pension valuation. We then perform a second battery of tests to determine whether the market prices a firm's pension accruals any differently than it prices the firm's core business earnings. The results suggest that investors do not distinguish between these two sources of earnings, at least not in the way that one would expect in an efficient market. If anything, the earnings associated with pension accruals appear to receive a higher valuation multiple than do core earnings. Finally, we bring this evidence to bear on the question of whether there was a substantial pension-induced bubble in equity prices by simulating firm-level valuation errors using one of the empirical models employed in our hypothesis tests. The simulations suggest that, for the average firm in the Standard & Poor's (S&P) 500 with a DB plan, pension-induced valuation errors added 2 to 3 percent to the stock price during the late 1990s. Although significant in terms of absolute dollars of wealth, this source of error thus explains little of the runup in stock prices over this period. However, the estimated pension-induced distortions rise considerably in 2001, when the plunge in pension net asset values had not yet shown through to pension cost accruals. In particular, we estimate that, as of. early 2002, one-tenth of the firms in our sample that sponsored a DB pension plan were at least 20 percent overvalued, relative to otherwise similar firms, and that the unweighted average level of overvaluation of the stocks of pension-sponsoring firms was 10 percent. …

An Asset-Liability Analysis of the Currency Decision for Pension Portfolios

An Asset-Liability Analysis of the Currency Decision for Pension Portfolios

What the Pension Benefit Guaranty Corporation Can Learn from the Federal Savings and Loan Insurance Corporation

This paper attempts to draw attention to some important lessons that the Pension Benefit Guaranty Coroporation (PBGC) can learn from the experience of the Federal Savings and Loan Insurance Corporation (FSLIC). FSLIC was the government agency that insured deposits at savings and loan associations until it was replaced in 1989 leaving a massive deficit to be financed by taxpayers. Like FSLIC, the PBGC is a government agency that guarantees a form of private corporate debt. As guarantor of the pension benefits promised by private plan sponsors, the PBGC bears the risk of a shortfall between the value of insured benefits and the assets securing those benefits. The magnitude of the the PBGC's exposure to shortfall risk depends on three factors: - the financial strength of plan sponsors, - the degree of underfunding of insured benefits, - the mismatch between the market-risk exposure of insured benefits and the assets securing them. Only the first two of these have been addressed by past legistlative reforms. The third factor appears not to be well understood. It is apparently a widespread belief among policymakers that a well-diversified pension portfolio of equity securities provides an effective long-run hedge against liabilities of defined-benefit pension plans, so that there is no mismatch problem. This belief is mistaken. The policy based upon it creates the potential for large shortfall losses to the PBGC. Therein lies an uncomfortable parallel with the S&L debacle of the 1980s.

Why Do Pension and Insurance Portfolios Hold So Few International Assets?

Why Do Pension and Insurance Portfolios Hold So Few International Assets?