An analysis of risk-taking behavior for public defined benefit pension plans

This paper presents the first comprehensive study on the determinants of public pension fund investment risk and reports several new important findings. Unlike private pension plans, public funds undertake more risk if they are underfunded and have lower investment returns in the previous years, consistent with the risk transfer hypothesis. Furthermore, pension funds in states facing fiscal constraints allocate more assets to equity and have higher betas. There also appears to be a herding effect in that CalPERS equity allocation or beta is mimicked by other pension funds. Finally, our results suggest that government accounting standards strongly affect pension fund risk, as higher return assumptions (used to discount pension liabilities) are associated with higher equity allocation and portfolio beta.     

Pension Accounting: How Large Australian Companies are 'Paying Up' for Superannuation

In Australia accounting requirements for companies to report on superannuation fund costs substantially lag those overseas and are unsettled. Superannuation commitments for defined-benefit funds are required to be disclosed by sponsoring employers, although corporations are not required to disclose interests in defined-contribution funds. This paper documents the extent of companies' annual report disclosures of interests in defined-benefit superannuation funds. The paper also reviews the debate on pension accounting overseas and examines the impact of AASB 1028 on the reporting practices of sponsoring firms.     

The decision to terminate overfunded pension plans

This paper examines management's decision to terminate overfunded pension plans. Plan terminations are controversial because they sometimes redistribute pension funds from employee trusts to the firm. This empirical study compares a sample of firms terminating overfunded pension plans with a sample of firms continuing overfunded plans. The examination finds that both business-related and management-related variables help to explain the termination decision. With respect to business-related variables, firms are more likely to terminate overfunded plans that do not include union employees. These firms also tend to be smaller, have tax carryforwards, and have high financial leverage. With respect to management-related variables, termination firms tend to have management compensation plans based on income and high owner control. The results suggest that management motivation to terminate overfunded plans may be increased when the decision will advance the personal interests of managers.     

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.     

Deterministic Modeling of Defined-Contribution Pension Funds

Abstract

Formulas are derived to model the response of a money purchase, defined-contribution pension fund to the following types of investment shock: (1) an instantaneous fall in the value of the fund assets and (2) a permanent, uniform reduction in the rate of earned interest. An alternative defined-contribution fund, incorporating a variable defined-benefit scale, is then proposed, and its responses to the same investment shocks are compared with those of the money purchase fund. The comparison shows that the variable defined-benefit approach offers a useful alternative to the money purchase principle for defined-contribution pension funds.     

Income Drawdown Schemes for a Defined-Contribution Pension Plan

In retirement a pensioner must often decide how much money to withdraw from a pension fund, how to invest the remaining funds, and whether to purchase an annuity. These decisions are addressed here by introducing a number of income drawdown schemes, which are relevant to a defined-contribution personal pension plan. The optimal asset allocation is defined so that it minimizes the expected loss of the pensioner as measured by the performance of the pension fund against a benchmark. Two benchmarks are considered: a risk-free investment and the price of an annuity. The fair-value income drawdown rate is defined so that the fund performance is a martingale under the objective measure. Annuitization is recommended if the expected fair-value drawdown rate falls below the annuity rate available at retirement. As an illustration, the annuitization age is calculated for a Gompertz mortality distribution function and a power law loss function.     

The Impact of Scale,Complexity, and Service Quality on the Administrative Costs of Pension Funds: A Cross‐Country Comparison

Administrative costs per participant appear to vary widely across pension funds in different countries. Using unique data on 90 pension funds over the period 2004–2008, this article examines the impact of scale, the complexity of pension plans, and service quality on the administrative costs of pension funds, and compares those costs across Australia, Canada, the Netherlands, and the United States. We find that, except for Canada, large unused economies of scale exist. Higher service quality and more complex pension plans significantly raise costs. Administrative costs vary significantly across pension fund types, with differences amounting to 100 percent.     

Scale economies in pension fund investments: A dissection of investment costs across asset classes

Using a unique dataset of 225 Dutch occupational pension funds with a total of 928 billion euro of assets under management, we provide a comprehensive cross-sectional analysis of the relation between investment costs and pension fund size. Our dataset is free from self-reporting biases and decomposes investment costs for 6 asset classes in management costs and performance fees. We find that a pension fund that has 10 times more assets under management on average reports 7.67 basis points lower annual investment costs. Economies of scale differ per asset class. We find significant economies of scale in fixed income, equity and commodity portfolios, but not in real estate investments, private equity and hedge funds. We also find that large pension funds pay significantly higher performance fees for equity, private equity and hedge fund investments.     

Smart defaults: Determining the number of default funds in a pension scheme

We propose a new methodology for the smart design of the default investment fund(s) in occupational defined contribution pension schemes based on the observable characteristics of scheme members. Using a unique dataset of member risk attitudes and characteristics from a survey of a large UK pension scheme, we apply factor analysis to identify single factors for risk aversion, risk capacity and ethical investment preferences, and then apply cluster analysis to these factors to identify two distinct groups of members across age cohorts. We find membership of these clusters depends on a number of personal characteristics, with the principal differentiating feature being that one group had previously engaged with the pension scheme, while the other had not. These identified characteristics can be utilised in the design of smart default funds, including appropriate engagement strategies.     

The tax treatment of UK defined contribution pension schemes

The paper aims to clarify the tax status of pension schemes in the UK and, by using economic and other arguments, to establish a theoretical benchmark that could be considered the ‘appropriate’ tax regime for pension saving. We consider existing tax regimes for saving (such as the ‘ISA’ regime) and theoretical regimes (such as a pure expenditure tax and a comprehensive income tax) and we compare the costs different tax regimes impose on defined contribution pension schemes. We conclude that an expenditure tax is an appropriate benchmark tax regime for pension saving, and that other tax regimes impose additional financial as well as administrative costs.     

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.     

The new joint pension scheme established by collective agreement between the Norwegian employers' confederation and the Norwegian federation of trade unions

Abstract

Norway has a statutory old age pension scheme covering the whole population over 70 years of age. Since 1959, pensions are granted without a means test. As from 1 April 1962, the annual pension amounts are 3348 crowns for a single person and 5028 crowns for a married couple. For special groups, such as seamen, fishermen and forestry workers, additional pension schemes have been established by law. Many private companies, especially the larger firms, have established staff pension schemes on a voluntary basis, either in the form of actuarial pension funds, or through collective pension insurance. Many of these schemes cover only staff employees, not workers. In other cases both groups are covered, but with relatively higher benefits for staff than for workers.     

Earnings management and the allocation of net periodic pension costs to interim periods

We examine the pattern of reported quarterly net periodic pension costs. Quarterly pension costs are one of the largest single expense items for firms with pension plans (around 15% of income before extraordinary items in our sample). Under ASC 270, net pension costs should be recognized as incurred, or as the benefit provided by the expense is realized. We find that over the period of 2004–2010, there is significant variation in the amount of quarterly pension cost firms report. In addition, we find that income-increasing changes in pension costs are significantly associated with meeting or beating analysts' forecasts in a given quarter. We also show that income-decreasing changes to net periodic pension costs that would cause a firm to miss its earnings forecast are extremely rare. Finally, we find evidence that income-increasing and income-decreasing changes in quarterly pension costs are “settled up” in the fourth quarter (e.g., they are reversed).     

The efficiency of Greek public pension fund portfolios

Greek public pension funds can invest up to 23% into risky assets and are not allowed to invest outside Greece. This paper seeks to investigate the costs of investment constraints on pension fund portfolios. In particular we try to quantify the losses that portfolios suffer due to under-diversification and sub-optimal asset allocation. We find that the high concentration of Greek equity portfolios imposes a substantial return and utility loss which is further increased when the lack of international diversification is taken into account. Restricting the weight of equities to 23% of the total portfolio, leads to sub-optimal asset allocation that costs as much as 2% (3%) per annum compared to a balanced domestic (global) benchmark.     

Corporate pension funding policy

What policy should a corporation adopt concerning the funding of a defined-benefit pension plan and the investment of the assets held in trust for the plan? Until recently, pension plans did not have to be insured, and some risk could be borne by intended beneficiaries. Federal legislation has now mandated such coverage. This paper analyzes corporate policy under three conditions which correspond, roughly, to the earlier situation (‘uninsure’ loans), the current situation (‘partially insured’ loans), and the situation required by law to be implemented in the future (‘completely insured’ plans). We show that if insurance premiums are set correctly, corporate policy in this area may not matter; otherwise the optimal policy may simply be that which maximizes the difference between the value of the insurance and its cost.     

Managerial risk taking incentives and corporate pension policy

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

Underfunding pension obligations while paying dividends: evidence of risk transfers

This research examines the differential effects of earnings, dividends, and cashflows on increases and decreases in pension liabilities. Of the 1700 firms in the Value Line Investment Survey (1997a), there were 189 firms with pension liabilities—88 (101) firms with increasing (decreasing) pension liabilities that serve as research observations. For firms with increasing pension liabilities, there is a significant correlation between the increase in pension liabilities and earnings, cashflows, and dividends. However, none of these relationships exist for firms with decreasing pension liabilities. The underfunding of pension funds is a unilateral decision by management that effectively transfers risk away from stockholders and imposes it on employees and potentially on the society at large. This risk transfer is not associated with any compensatory returns and suggests social and regulatory policies should be reconsidered.     

The international spillover effects of pension reform

This paper explores how pension reforms in countries with PAYG schemes affect countries with funded systems. We use a two-country two-period overlapping-generations model, where the countries only differ in their pension systems. We distinguish between the case where a reform potentially leads to a Pareto improvement in the PAYG country, and where this is impossible. In the latter case, the funded country shares both in the costs and the benefits of the reform. However, if a Pareto-improving pension reform is feasible in the PAYG country, a Pareto improvement in the funded country is not guaranteed.     

The effect of regulation on optimal corporate pension risk

We study firms' pension prefunding and portfolio allocation choices in a model in which firms trade off the need to compensate workers for the financial risk in their pension benefit against the cost advantage that may be gained by exploiting underpriced pension insurance. In the absence of pension insurance, the firm minimizes costs by rendering promised benefits free of risk to workers, who are assumed to be unable to hedge firm-specific risk. Various forms of government intervention, such as benefit guarantees, can alter this outcome dramatically by providing the firm with an incentive to shift risk to other parties. In this case, we find that the firm's decisions depend on, among other influences, the degree of insurance mispricing, the amount of guaranteed benefits, the stringency of minimum funding requirements, and the costs of financial distress.