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SOCIAL SCIENCE RESEARCH NETWORK
EMPLOYEE BENEFITS, COMPENSATION & PENSION LAW ABSTRACTS
Sponsored by Pension Governance, LLC
Vol. 8, No. 8: March 1, 2007
Editor: PAMELA J. PERUN
Urban Institute
PAMELA@PLANETNOW.COM
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Topic of This Issue:
Defined Benefit Plans
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T A B L E O F C O N T E N T S
"Managing the Risk in Pension Plans and Recent Pension Reforms"
RICHARD W. KOPCKE
Federal Reserve Bank of Boston
"Risk Shifting versus Risk Management: Investment Policy in
Corporate Pension Plans"
JOSHUA D. RAUH
University of Chicago - Graduate School of Business,
National Bureau of Economic Research (NBER)
"The Recent Evolution of Pension Funds in the Netherlands: The
Trend to Hybrid DB-DC Plans and Beyond"
EDUARD PONDS
Netspar, ABP Investments
BART VAN RIEL
Government of the Netherlands - Social Economic Council
"The Decline of Defined Benefit Retirement Plans and Asset Flows"
JAMES M. POTERBA
Massachusetts Institute of Technology (MIT) - Department
of Economics, National Bureau of Economic Research
(NBER)
"Longevity Risk and Private Pensions"
PABLO ANTOLIN
OECD
"De-risking Corporate Pension Plans: Options for CFOs"
RICHARD B. BERNER
Morgan Stanley Dean Witter & Co. Inc.
BRYAN BOUDREAU
Morgan Stanley Dean Witter & Co. Inc.
MICHAEL PESKIN
Morgan Stanley Dean Witter & Co. Inc.
"Risk Allocation in Retirement Plans: A Better Solution"
DONALD E. FUERST
Mercer Human Resource Consulting
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"Managing the Risk in Pension Plans and Recent Pension Reforms"
FRB of Boston Public Policy Discussion Paper No. 06-7
Contact: RICHARD W. KOPCKE
Federal Reserve Bank of Boston
Email: richard.kopcke@bos.frb.org
Auth-Page: http://ssrn.com/author=241455
Full Text: http://ssrn.com/abstract=961409
ABSTRACT: This paper examines the characteristics of three
funding strategies for pension plans and analyzes the investment
strategies that complement these strategies. Although the primary
focus is on defined benefit plans, which include Social Security,
it also applies to employees' defined contribution plans, which,
when their beneficiaries set specific goals for their future
retirement benefits, are essentially defined benefit plans. The
findings suggest that pension plans should use interest rates on
Treasury securities instead of yields on corporate bonds to
calculate the value of their liabilities. Defined benefit plans,
including Social Security, could stabilize the balance between
the value of their assets and their obligations if they financed
only the value of the benefits that their beneficiaries have
accrued and they invested their assets in Treasury securities. In
this case, the required contribution per dollar of wages would
need to change significantly with the rate of growth of
employment. By funding the obligation entailed by employees'
projected income at retirement, contributions per dollar of wages
would change less with the growth of employment. However, in this
case, plans would need to invest in a broader range of assets -
including Treasury inflation-protected securities, stocks, and
real assets - to prevent the balance between their assets and
liabilities from varying too greatly. Furthermore, plans would
need to hold surplus assets to minimize the risk of becoming
underfunded.
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"Risk Shifting versus Risk Management: Investment Policy in
Corporate Pension Plans"
Contact: JOSHUA D. RAUH
University of Chicago - Graduate School of
Business, National Bureau of Economic Research
(NBER)
Email: jrauh@gsb.uchicago.edu
Auth-Page: http://ssrn.com/author=345896
Full Text: http://ssrn.com/abstract=931237
ABSTRACT: Firms financed with debt face conflicting incentives
with respect to the management of cash flow risks. Risk reduction
can benefit liquidity constrained firms, but increased risk
taking can increase the value of shareholders' equity through
asset substitution when firms are close to default. In this paper
I examine these conflicting motivations in a setting where risk
shifting incentives should be particularly strong: the investment
of defined benefit pension plans sponsored by U.S. companies.
Empirically, firms with poorly funded pension plans allocate a
greater share of pension fund assets to safer securities such as
government debt and cash, whereas well-funded plans invest more
heavily in volatile asset classes such as equity. Among large
public firms, those with better credit ratings allocate greater
shares of pension fund assets to equity and smaller shares to
government debt and cash. These relations hold both in the
cross-section and within firms and plans over time. The higher
the probability of bankruptcy, the safer the observed pension
fund asset allocation. Furthermore, the realized investment
return volatility of plans that eventually terminate in financial
distress is no greater than that of plans that do not terminate.
I conclude that the incentive to limit the cash flow risk from
pensions plays a considerably larger role than risk shifting in
explaining pension fund investment policy among U.S. firms.
______________________________
"The Recent Evolution of Pension Funds in the Netherlands: The
Trend to Hybrid DB-DC Plans and Beyond"
Contact: EDUARD PONDS
Netspar, ABP Investments
Email: eduard.ponds@abp.nl
Auth-Page: http://ssrn.com/author=644731
Co-Author: BART VAN RIEL
Government of the Netherlands - Social Economic
Council
Email: b.van.riel@ser.nl
Auth-Page: http://ssrn.com/author=92104
Full Text: http://ssrn.com/abstract=964428
ABSTRACT: According to the classification in official statistics,
Dutch pension plans have mainly preserved their DB character in
recent years. The dominant reaction of pension funds to the fall
in funding ratios at the beginning of this century has been a
switch from final-pay schemes to average-wage schemes. This
contrasts sharply with the experience in the United States and
the United Kingdom, where the fall in pension funding ratios has
accelerated the switch from DB to DC schemes.
This paper scrutinizes the recent evolution of Dutch pension
plans: how does the evolution of Dutch pension funds diverge from
that of Anglo-Saxon pension funds, and how can we explain this
divergence? Using an ALM framework, we argue that the current
average-wage pension plans may be better viewed as hybrid DB-DC
schemes, as indexation of all liabilities has been made
solvency-contingent. Because these hybrid plans make use of two
steering mechanisms to control solvency risk, Dutch pension funds
display a high effectiveness in minimizing the risk of
under-funding.
The current hybrid schemes reflect a compromise between the
various stakeholders. We examine the institutional basis for this
compromise, and contrast this with the situation in Anglo-Saxon
pension funds, where primarily employers are responsible for
absorbing funding deficits, which gives them in turn more grip on
pension plan design issues. In addition, we look at the role of
unions, the strong preferences within the Dutch society for
collective risk-sharing, and the underlying high level of social
trust, as explanations for the divergence with the experience in
the US and the UK.
For the longer term, we foresee that Dutch pension plans will
shift further towards stand-alone multimember plans, often being
called collective DC. This will be accompanied by more
differentiation in risk exposure between younger and older
members.
Collective risk-sharing will thus remain an important element in
Dutch pension funds. In this sense, the evolution of Dutch
pension schemes diverges from the developments of Anglo-Saxon
pension funds, where risks are shifted more to the individual.
Finally, we argue that collective risk-sharing has some important
advantages over individual risk-sharing.
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"The Decline of Defined Benefit Retirement Plans and Asset Flows"
NBER Working Paper No. W12834
Contact: JAMES M. POTERBA
Massachusetts Institute of Technology (MIT) -
Department of Economics, National Bureau of
Economic Research (NBER)
Email: poterba@mit.edu
Auth-Page: http://ssrn.com/author=21561
Full Text: http://ssrn.com/abstract=958486
ABSTRACT: Demographic change can have an important effect on the
stock of assets held in defined benefit pension plans. This paper
projects the impact of changes in the age structure of the U.S.
population between 2005 and 2040 on the stock of assets held by
these plans. It projects the contributions to and withdrawals
from these plans. These projections are combined with estimates
of the future evolution of assets in 401(k)-like plans to
describe the prospective impact of demographic change on the
stock of assets in retirement plans. Information on
demography-linked changes in asset demand is a critical input to
evaluating the potential impact of population aging on asset
returns.
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"Longevity Risk and Private Pensions"
OECD Working Paper on Insurance and Private Pensions No. 3
Contact: PABLO ANTOLIN
OECD
Email: PABLO.ANTOLIN@OECD.ORG
Auth-Page: http://ssrn.com/author=223897
Full Text: http://ssrn.com/abstract=962028
ABSTRACT: This paper examines how uncertainty regarding future
mortality and life expectancy outcomes, i.e. longevity risk,
affects employer-provided defined benefit (DB) private pension
plans liabilities. The paper argues that to assess uncertainty
and associated risks adequately, a stochastic approach to model
mortality and life expectancy is preferable because it permits to
attach probabilities to different forecasts. In this regard, the
paper provides the results of estimating the Lee-Carter model for
several OECD countries. Furthermore, it conveys the uncertainty
surrounding future mortality and life expectancy outcomes by
means of Monte-Carlo simulations of the Lee-Carter model.
In order to assess the impact of longevity risk on
employer-provided DB pension plans, the paper examines the
different approaches that private pension plans follow in
practice when incorporating longevity risk in their actuarial
calculations. Unfortunately, most pension funds do not fully
account for future improvements in mortality and life expectancy.
The paper then presents estimations of the range of increase in
the net present value of annuity payments for a theoretical DB
pension fund. Finally, the paper discusses several policy issues
on how to deal with longevity risk emphasizing the need for a
common approach.
______________________________
"De-risking Corporate Pension Plans: Options for CFOs"
Journal of Applied Corporate Finance, Vol. 18, No. 1, pp.
25-35, Winter 2006
Contact: RICHARD B. BERNER
Morgan Stanley Dean Witter & Co. Inc.
Email: Richard.Berner@morganstanley.com
Auth-Page: http://ssrn.com/author=602254
Co-Author: BRYAN BOUDREAU
Morgan Stanley Dean Witter & Co. Inc.
Email: bryan.boudreau@msdw.com
Auth-Page: http://ssrn.com/author=656971
Co-Author: MICHAEL PESKIN
Morgan Stanley Dean Witter & Co. Inc.
Auth-Page: http://ssrn.com/author=656972
Full Text: http://ssrn.com/abstract=921680
ABSTRACT: 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.
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.
______________________________
"Risk Allocation in Retirement Plans: A Better Solution"
Journal of Applied Corporate Finance, Vol. 18, No. 1, pp.
95-103, Winter 2006
Contact: DONALD E. FUERST
Mercer Human Resource Consulting
Email: don.fuerst@mercer.com
Auth-Page: http://ssrn.com/author=656977
Full Text: http://ssrn.com/abstract=921684
ABSTRACT: The corporate world is reconsidering the
cost-effectiveness of defined benefit pension plans while
contemplating a change to defined contribution plans. This
article begins by examining the three primary risks faced by
sponsors of most DB pension plans - investment risk, interest
rate risk, and longevity risk - and shows how shifting these
risks to employees through a DC plan would affect both the
corporation and the individual. Although DC plans clearly help
companies manage risks, they provide at best an incomplete
solution for individual participants.
This article describes an innovation in pension design - the
Retirement Shares Plan (RSP) - that combines many of the best
features of DB and DC plans. An RSP provides:
- predictable and stable cost to the plan sponsor, with little
chance of unfunded liabilities;
- lifetime income, guaranteeing that retirees will never outlive
their benefits;
- a benefit accrual pattern comparable to that of traditional
pension plans that preserves value for older, long-service
employees; and
- potential inflation protection for retirees.
The RSP accomplishes this by allocating risk to sponsors and
individuals differently than either a traditional DB plan or a DC
plan. Unlike most DB plans, the RSP shifts investment and
interest rate risks from plan sponsors to participants. Unlike DC
plans, the RSP keeps longevity risk with the sponsor.