Management of Defined-Benefit Pension Funds and Shareholder Value
Asthana, Sharad, Lipka, Roland, Quarterly Journal of Business and Economics
Total defined-benefit pension assets of U.S. companies today are substantial and run into several trillion dollars. For a typical firm, these pension assets are over 15.0 percent of the firm's total assets, over 35.0 percent of its market value, and over 55.0 percent of its book value. (1) The pension asset management policy significantly affects the future returns on these assets and, therefore, the contributions to be made by the firm. Understanding the incentives of pension fund managers helps us to predict asset allocation decisions and fund performances better. Knowing how plans adjust to past performance also helps in the use accounting numbers to forecast future earnings.
Performance measurements are indispensable to hiring fund managers, checking their performance, and firing them if necessary (Arnott, 1997). Plan sponsors are increasingly interested in establishing performance-related termination thresholds for investment managers. Managers are terminated when they underperform the applicable benchmark by either an absolute amount or by a certain percentage of the benchmark return. A major criterion to judge the pension fund manager's performance is the return earned by his or her pension asset portfolio. Higher returns imply lower employer contributions to the defined-benefit pension fund in the future. For higher expected returns, fund managers have to invest in riskier portfolios and on the efficient frontier. Most sponsoring firms establish fund management policies that state the desirable risk-return profiles for their pension funds. These policies are typically guidelines and fund managers have adequate freedom to determine the riskreturn profile of their portfolios.
We find that dismal performance (relative to funds with similar risk profiles) prompts managers to reallocate their assets in the subsequent periods. This result persists even after controlling for riskiness of the asset portfolio, firm and plan sizes, funded status, profitability, leverage, and age distribution of participants. We also observe that these actions of the managers result in improved portfolio performances even after controlling for investment risk and the mean-reversion phenomenon of asset returns. Further, we observe that the market responds negatively to pension asset reallocations to riskier portfolios. Finally, we observe that shareholder value is positively affected by good performance. These results persist even after controlling for a firm's risk, profitability, leverage, and funded status. Thus, we find that the pension gains that ensue from improvements in plan performance and that are included in accounting income are a fundamental and predictable part of doing business. As such, these gains impact future pension costs and indirectly impact what has become known as "core earnings" (Standard & Poor, 2002). Hence, we question Standard & Poor's treatment that excludes pension gains from core earnings.
Theory and Development of Hypotheses
According to McGill and Grubbs (1984), the total accumulation of assets in a pension plan comes from contributions and returns on investments of pension assets, after adjustments for benefits paid and administrative expenses. The return on investments reduces the future costs of a defined benefit pension plan and increases the benefits under a defined contribution plan. (2) Thus, productive deployment of pension assets is a major concern of both the sponsoring firm and regulatory authorities. For the sponsoring firm a sound investment policy reduces the future cash outflows from the firm to the defined-benefit plan. For the regulatory authorities it reduces the chances of default on the part of defined benefits plan and subsequent payments of benefits by the Pension Benefit Guaranty Corporation (PBGC). Management of pension plan assets is regulated at both federal and state levels. …