The impact of duration on management's discount rate choice

Previous research finds that firms increase their assumed discount rates to minimize their reported pension benefit obligation. This paper demonstrates that firms whose pension plans have short durations lower their discount rates (rather than increase them), since a lower discount rate decreases their pension expense. These results are especially relevant in the present climate of low interest rates and more firms freezing their defined benefit pension plans, thereby shortening the duration of their obligations. Given its importance in shaping management motivation we believe that firms should be required to disclose the duration of their future obligations.     

Do Managers of U.S. Defined Benefit Pension Plan Sponsors Use Regulatory Freedom Strategically?

We use historical particularities of pension funding law to investigate whether managers of U.S. corporate defined benefit pension plan sponsors strategically use regulatory freedom to lower the reported value of pension liabilities, and hence required cash contributions. For some years, pension plans were required to estimate two liabilities—one with mandated discount rates and mortality assumptions, and another where these could be chosen freely. Using a sample of 11,963 plans, we find that the regulated liability exceeds the unregulated measure by 10% and the difference further increases for underfunded pension plans. Underfunded plans tend to assume substantially higher discount rates and lower life expectancy. The effect persists both in the cross‐section of plans and over time and it serves to reduce cash contributions. We further show that plan sponsor managers use the freed‐up cash for corporate investment and that credit risk is unlikely to explain the finding.     

Pension plan solvency and extreme market movements: a regime switching approach

We develop and test a new approach to assess defined benefit (DB) pension plan solvency risk in the presence of extreme market movements. Our method captures both the ‘fat-tailed’ nature of asset returns and their correlation with discount rate changes. We show that the standard assumption of constant discount rates leads to dramatic underestimation of future projections of pension plan solvency risk. Failing to incorporate leptokurtosis into asset returns also leads to downward biased estimates of risk, but this is less pronounced than the time-varying discount rate effect. Further modifying the model to capture the correlation between asset returns and the discount rate provides additional improvements in the projection of future pension plan solvency. This reduces the perceived future risk of underfunding because of the negative correlation between interest rate changes and asset returns. These results have important implications for those with responsibility for balancing risk against expected return when seeking to improve the current poor funding positions of DB pension schemes.     

Pay me now (and later): Pension benefit manipulation before plan freezes and executive retirement

Large US firms modify top executives’ compensation before pension-related events. Top executives receive one-time increases in pensionable earnings through higher annual bonuses one year before a plan freeze and one year before retirement. Firms also boost pension payouts by lowering plan discount rates when top executives are eligible to retire with lump-sum benefit distributions. Increases in executive pensions do not appear to be an attempt to improve managerial effort or retention and are more likely to occur at firms with poor corporate governance. These findings suggest that in some circumstances managers are able to extract rents through their pension plans.     

Economic consequences of mandatory GAAP changes: The case of SFAS No. 158

This study examines management's reaction to the SFAS No. 158 requirement to recognize previously disclosed post-retirement benefit obligations on the balance sheet. The results indicate that managers attempted to mitigate the impact of the standard by increasing the assumed pension discount rate in subsequent periods. Further, the discount rate choice was related to the magnitude of the SFAS No. 158 balance sheet adjustment. Specifically, firms with larger required liability adjustments and more volatile pension assets and obligations were more likely to increase their discount rates. The findings have important implications for research regarding the economic consequences of accounting regulations and in particular the debate surrounding recognition versus disclosure since they indicate that managers react to the relocation of information from the financial statement footnotes to the balance sheet.     

How does the Funding Status of Defined Benefit Pension Plans Affect Investment Decisions of Firms in the United States?

We investigate whether the flexibility in making contributions towards defined benefit pension plans sponsored by firms in the United States allows managers to save cash and increase investments. Firms invest more at higher levels of pension deficit, defined as pension benefit obligations less pension assets, and scaled by total assets. At the median level (90^th percentile) of pension deficit, investments increase by 6.7 cents (9.4 cents) for every dollar increase in cash. As the pension deficit increases, firms deviate more from the predicted level of investment. These findings suggest that the incremental investments are more likely to represent overinvestment by managers. Our results are robust to alternative model specifications and endogeneity concerns that may arise if investments are jointly determined with the funding policy of pension plans and the firm's target cash level. We repeat our main analysis for the United Kingdom and also find for that country that, at a fixed cash level, total investment increases as pension deficit increases.     

Determinants of Actuarial Valuation Method Changes for Pension Funding and Reporting: Evidence from the UK

This study examines various factors that potentially explain cross‐sectional variations in UK corporate managerial discretion to switch towards a market‐based actuarial pension valuation method for pension funding and reporting purposes. Evidence is based on accounting, actuarial and share market data for an industry‐matched pair sample of 90 UK firms. Consistent with our hypotheses we find that companies have a greater propensity to switch actuarial methods if they use lower discount rates, lower flow funding ratios and sponsor larger pension plans in the pre‐switch valuation year. These findings are consistent with the traditional perspective, which implies that UK corporate switching decisions are explained by characteristics of their defined benefit pension funds. The results run contrary to the findings of earlier US based studies that find that such choices can be explained from an alternative corporate financial perspective.     

Information asymmetry,contract design and process of negotiation: The stock options awarding case

Stock option plans are used to increase managerial incentives, and business practices usually set the exercise price equal to the stock market price. The purpose of this paper is to underline the importance of a process of negotiation leading to a possible equilibrium contract satisfying both managers and shareholders. The two key variables of the model are the percentage of equity capital offered by the shareholders to the managers and the exercise price of the options that may be at a discount. We explicitly introduce risk aversion and information asymmetries in the form of (i) an economic uncertainty in the gain of cash flow, (ii) possibly biased information between the two parties and (iii) a noise in the valuation price of the stock in the market. The existence of a process of negotiation between shareholders and managers leading to a possible disclosure of private information is highlighted. As a conclusion, we show that “efficient” stock option plans should be granted in a context of trade-off between the percentage of capital awarded to managers and the discount in stock price.     

The elusive relation between pension discount rates and deficits

The relation between defined-benefit (DB) pension discount rates and funding status is more complex than it might first appear. Existing evidence suffers from estimation biases that make precise inference unreliable. We document the biases and quantify their impact on inference in relation to corporate window-dressing of DB funding status. Our empirical evidence from the United Kingdom suggests that pension sponsors use discretion in the choice of pension discount rate not only to reduce reported deficits but also to reduce reported surpluses.     

THE EFFECT OF SFAS 87 ON CORPORATE FUNDING OF DEFINED BENEFIT PENSION PLANS

Statement of Financia1 Accounting Standards No. 87 (SFAS 87) modifies the method of accounting for pensions by requiring companies sponsoring defined benefit pension plans to (1) recognize a balance sheet liability for unfunded pension benefits and (2) disclose their obligation for pension benefits based on expected future compensation levels (the projected benefit obligation). These requirements may affect users' perceptions of a company's financial position, especially if these plans are underfunded. This research examines whether the requirements of SFAS 87 result in increased funding of corporate pension plans to counteract possible adverse perceptions of users about these plans. The results indicate that early adopters (companies adopting SFAS 87 in 1985 and 1986) increased the funding of their defined benefit pension plans in response to SFAS 87 ; however, later adopters did not do so. These findings provide evidence that companies may alter economic policies when faced with significant changes in financial disclosure requirements. Further analysis suggests that the effect of SFAS 87 on the pension expense recognized by the sample companies provided impetus for early adoption of this pronouncement.     

Bad company. The indirect effect of differences in corporate governance in the pension plan industry

This paper analyses the role played by pension plan governance structure and how it impacts on plan fees and plan performance. The results clearly show that fees decrease significantly and performance improves when pension plan governance structures permit full alignment of interests and allow greater capacity for the decision-makers to monitor and discipline the managers. It is also observed that companies managing both employee and individual funds, tend to exploit differences in the internal corporate governance mechanisms of each type of plan in order to nurture employer-sponsored plans at the expense of individual plans. These results suggest that internal corporate governance mechanisms allowing closer alignment with the interests of participants would be preferable to focusing exclusively on setting the minimum proportion of independent directors.     

Supplementary Pension Coverage in Britain

The 1986 Social Security Act introduced far-reaching changes to the supplementary pension environment in Britain, encouraging the growth of defined contribution pension plans and especially personal pensions. This paper examines the pattern of supplementary pension coverage of employees in Britain five years after the implementation of the Act, using cross-sectional data from the Family Resources Survey 1993–94. Two-thirds of employees in Britain are covered by private contracted-out pension scheme. Employer-provided defined benefit pension schemes remain the dominant type of supplementary pension scheme. The growth of personal pension plans is more marked among manual, less-skilled, workers in smaller establishments. The paper concludes that, in the absence of further pension reform, adverse labour market conditions will exert downward pressure on private pension coverage. JEL classification:I38, J32, J38.     

The Effect of Regulations on Pension Risk Shifting: Evidence from the US and Europe

This paper provides evidence that pension regulations can incentivize or curb risk shifting in the investment of defined benefit plan assets. We document that in the US, where the pension insurance premium charged by the Pension Benefit Guaranty Corporation is largely flat, financially distressed firms with severely underfunded plans shift pension investment risk. We further find that risk shifting is mitigated in the UK after the implementation of risk‐adjusted pension insurance premiums, and in the Netherlands where full pension funding is mandatory. Overall the results in this paper lend support to the view that structural flaws in the US statutory pension insurance scheme incentivize high‐risk sponsors to gamble their pension assets when distress terminations of their plans become foreseeable.     

“De‐risking” Corporate Pension Plans: Options for CFOs

Until the stock market bubble burst in 2000–2002, most CFOs viewed their defined benefit pension plans as profit centers and relatively risk‐free sources of income. Since neither pension assets nor liabilities were reported on corporate balance sheets, and expected returns on pension stocks could be substituted for actual returns when reporting net income, the risks associated with DB plans were masked by GAAP accounting and thus assumed to have no bearing on corporate capital structure. But when stock prices and corporate profits fell together, the risks associated with conventional stock‐heavy pension plans showed up first in reduced pension surpluses (or, in many cases, deficits) and then later in higher required cash contributions and lower reported earnings. As a consequence, today's investors (and rating agencies) are viewing pension and other legacy liabilities as corporate debt, and demands for transparency and increased funding have triggered accounting changes and proposed legislative reforms that will further unmask the economics. This article aims to provide both private‐sector and public‐sector CFOs with suggestions for reducing and controlling the cost of providing for the retirement of their employees. Profitable, tax‐paying companies with DB plans should consider (1) funding any unfunded liabilities (if necessary, by issuing debt) and (2) reducing pension equity and interest rate exposures by shifting some (if not all) pension assets into bonds and defeasing the pension liability (achieving a tax arbitrage in the process). And in cases where the expected costs of maintaining DB plans outweigh the benefits, companies should consider freezing or terminating their plans and switching to a defined contribution (DC) or some form of hybrid plan. The authors also propose similar changes for public pension plans, where underfunding and mismatch problems are greater, less transparent, and in some ways less tractable than those of corporate DB plans.     

What determines corporate pension fund risk-taking strategy?

Corporate sponsors of defined benefit pension plans generally assume low investment risk when they have low funding ratios and high default risk, consistent with the risk management hypothesis. However, for financially distressed sponsors and sponsors that freeze, terminate, or convert defined benefit to defined contribution plans, the risk-shifting incentive (moral hazard) dominates. Pension fund risk-taking is also affected by labor unionization and sponsor incentives to maximize tax benefits, restore financial slack, and justify the accounting choices of pension assumptions. Sponsors shift toward an aggressive risk strategy when their pension plans emerge from underfunding, bankruptcy risk is reduced, or marginal tax rate decreases. Overall, we show that corporate sponsors adopt a dynamic risk-taking strategy in their pension fund investments.     

Smoothing Mechanisms in Defined Benefit Pension Accounting Standards: A Simulation Study*

The accounting for defined benefit (DB) pension plans is complex and varies significantly across jurisdictions despite recent international convergence efforts. Pension costs are significant, and many worry that unfavorable accounting treatment could lead companies to terminate DB plans, a result that would have important social implications. A key difference in accounting standards relates to whether and how the effects of fluctuations in market and demographic variables on reported pension cost are “smoothed". Critics argue that smoothing mechanisms lead to incomprehensible accounting information and induce managers to make dysfunctional decisions. Furthermore, the effectiveness of these mechanisms may vary. We use simulated data to test the volatility, representational faithfulness, and predictive ability of pension accounting numbers under Canadian, British, and international standards (IFRS). We find that smoothed pension expense is less volatile, more predictive of future expense, and more closely associated with contemporaneous funding than is “unsmoothed” pension expense. The corridor method and market‐related value approaches allowed under Canadian GAAP have virtually no smoothing effect incremental to the amortization of actuarial gains and losses. The pension accrual or deferred asset is highly correlated with the pension plan deficit/surplus. Our findings complement existing, primarily archival, pension accounting research and could provide guidance to standard‐setters.     

Performance evaluation of balanced pension plans

This paper examines the ability of balanced pension plan managers to successfully time the equity and bond market and select the appropriate assets within these markets. In order to evaluate both market timing abilities in these balanced pension plans, we extend the traditional equity market timing models to also account for bond market timing. As far as we know, we are among the first to apply this multifactor timing model to investigate equity and bond market timing simultaneously. This performance evaluation has been conducted on two samples of Spanish balanced pension plans, one with Euro Zone and one with World investment focus. This allows us to decompose managers’ skills into three components: selectivity, equity market timing, and bond market timing. Our findings suggest that the average stock-picking ability of pension plans is positive. World schemes tend to have positive bond timing skills, while Euro Zone pension plans are on average not able to time equity or bond markets.     

The consequences of discount rate selection for defined benefit liabilities

This paper provides evidence on the use of discount rates for calculating defined benefit liabilities (DBL), and their impact on value relevance and audit fees for Australian listed companies between 2011 and 2016. We document that the average discount rate is 3.96% but the yearly range across companies is 4.03% (2.76% excluding multinationals with multiple plans), despite the fact that AASB 119 provides guidance to use the yield of high quality corporate bonds or, if there is not a deep market, government bonds. We then find that the DBL or unfunded component (DBL less the fair value of the plan’s assets) is value relevant, but is less so when a higher discount rate is used. Furthermore, we document that audit fees are higher when the DBL is larger, or the discount rate is higher, consistent with greater audit effort and risk. Overall, this paper contributes to the accounting literature by documenting both the discretion available in discount rate selection and its consequences.     

Die Abgrenzung beitragsbezogener Pensionspläne aus Sicht des Asset-Liability-Managements

As a first step towards establishing models for the asset liability management (ALM) of contribution based pension plans of German pension funds it is important to characterize the essential properties of such plans. It is shown that it is not appropriate to assume an equivalence between such plans and a ?Beitragszusage mit Mindestleistung” (contribution based pension plan with investment guarantee). Although the plans under consideration grant the participation in the asset returns generated by the pension fund, they also guarantee a benefit level. This shows clearly that it is impossible to apply traditional ALM models for defined contribution plans — which in general provide no minimum benefit guarantee — to German pension funds without substantial alterations.     

“On the Merger of Two Companies,” Hans Gerber and Elias S. W. Shiu,July 2006

Abstract

Bankruptcy risk falls to pension plan participants if a plan sponsor fails when a defined benefit (DB) pension plan is underfunded. This article examines the incidence of that risk and how it changes when public policy provides a guarantee fund. Although government-based guarantee funds are in a unique position to provide pension protection, primarily because of the extent to which the risk of sponsor default is systematic in nature, a looming question is the extent to which such guarantees are exposed to moral hazard. The article focuses on that question using data from four Canadian provinces, including one (Ontario) that operates a guarantee fund for pensions. The findings show that plan assets per DB-plan participant increase with the earnings of workers and decrease with higher unemployment, and that level of assets also is moderated by the influence of taxes, with higher plan assets observed when and where tax rates are higher. Plans in Ontario had on average $20,035 less in asset value per participant, and Ontario plans covered by the guarantee fund had an average of $16,497 less per participant than other Canadian DB plans not backed by a guarantee fund. A separate model finds the presence of a guarantee fund to be one of a very small number of variables significant in explaining variability in the plans’ funded ratios. These empirical results are consistent with the existence of moral hazard.