Pension Fund Investment Policy

Abstract

The purpose of this paper is to survey what is known about the investment policy of pension funds. Pension fund investment policy depends critically on the type of plan: defined contribution versus defined benefit. For defined contribution plans investment policy is not much different than it is for an individual deciding how to invest the money in an Individual Retirement Account (IRA). The guiding principle is efficient diversification, that is, achieving the maximum expected return for any given level of risk exposure. The special feature is the fact that investment earnings are not taxed as long as the money is held in the pension fund. This consideration should cause the investor to tilt the asset mix of the pension fund towards the least tax-advantaged securities such as corporate bonds. For defined benefit plans the practitioner literature seems to advocate immunization strategies to hedge benefits owed to retired employees and portfolio insurance strategies to hedge benefits accruing to active employees. Academic research into the theory of optimal funding and asset allocation rules for corporate defined benefit plans concludes that if their objective is shareholder wealth maximization then these plans should pursue extreme policies. For healthy plans, the optimum is full funding and investment exclusively in taxable fixed-income securities. For very underfunded plans, the optimum is minimum funding and investment in the riskiest assets. Empirical research so far has failed to decisively confirm or reject the predictions of this theory of corporate pension policy. Recent rule changes adopted by the Financial Accounting Standards Board regarding corporate reporting of defined benefit plan assets and liabilities may lead to a significant shift into fixed-income securities. The recent introduction of price-level indexed securities in u.s. financial markets may lead to significant changes in pension fund asset allocation. By giving plan sponsors a simple way to hedge inflation risk, these securities make it possible to offer plan participants inflation protection both before and after retirement.

Full text

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NBER WORJ(ING PAPER SERIES
PENSION FUND INVESTMENT POLICY
Zvi Bodie
Working Paper No. 2752
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
October 1988
This research is part of NBER's researchprogram in Financial Markets and
Monetary Economics. This paper was prepared underDepartment of Labor
Contract Number J-9-P-8-0097. Any opinionsexpressed are those of the author
not those of the National Bureau of EconomicResearch or the Department of
Labor.

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NEER Working Paper #2752
October 1988
PENSION FUND INVESTMENT POLICY
ASTRACT
The purpose of this paper is tosurvey what is known about
the investment policy of pension funds.
policy depends critically on the type ofplan: defined
contribution versus defined benefit. Fordefined contribution
plans investment policy is not much differentthan it is for an
individual deciding how to invest themoney in an Individual
Retirement Account (IRA). The guidingprinciple is efficient
diversification, that is, achieving the maximumexpected return
for any given level of riskexposure. The special feature is the
fact that investment earnings are nottaxed as long as the money
is held in the pension fund. Thisconsideration should cause the
investor to tilt the asset mix of thepension fund towards the
least tax—advantaged securities suchas corporate bonds.
Pension fund investment
For defined benefit plans the practitionerliterature seems
to advocate immunizationstrategies to hedge benefits owed to
retired employees and portfolio insurancestrategies to hedge
benefits accruing to activeemployees. Academic research into
the theory of optimal funding andasset allocation rules for
corporate defined benefit plans concludes that iftheir objective
is shareholder wealth maximizationthen these plans should pursue
extreme policies. For healthy plans, theoptimum is full funding
and investment exclusively in taxablefixed—income securities.
For very underfunded plans, theoptimum is minimum funding and
investment in the riskiest assets.
failed to decisively confirm orreject the predictions of this
theory of corporate pension policy.
Empirical research so far has
Recent rule changes adopted by the FinancialAccounting
Standards Board regarding corporatereporting of defined benefit
plan assets and liabilitiesmay lead to a significant shift into
fixed-income securities. The recentintroduction of price-level-
indexed securities in U.S. financialmarkets may lead to
significant changes in pension fund assetallocation. By giving
plan sponsors a simple way to hedge inflationrisk, these
securities make it possible to offerplan participants inflation
protection both before and after retirement.
Zvi Bodie
School of Management
Boston University
Boston, MA 02215

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PENSION FUND INVESTMENT POLICY
Zvi Bodie
October 1988
CONTENTS
page
1.
Introduction
1
2.
Defined Contribution versus DefinedBenefit Plans
i
2.1 Alternative Perspectives on DB Plans
3
2.2 Investment Strategy in DB PensionPlans.
.
.
4
2.3 The Black-Dewhurst Proposal
7
3.
Research on Corporate Pension Policy
12
3.1 Theory of Corporate Pension PlanFunding and
Asset Allocation Policy
12
3.2 Empirical Studies
15
4.
5.
Hedging Against Inflation
17
Summary and Conclusions
.
23
6.
References
25

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1.
Introduction
The purpose of this paper is to explore the investment
policy of pension funds. In the U.S. today, assets ofpension
plans amount to almost $1.8 trillion, representing thelargest
single pool of investable funds. An understanding of the
principles and practices of pension fund investmentmanagement is
critical for plan sponsors, for their professionalmoney
managers, and for the government officials charged with
regulating and/or insuring pension plans.
The paper addresses several questions:
What are the unique features of pension plans that
might cause them to adopt investment policies that
differ from those of other investors?
•
What does academic research tell us about thetheory
and practice of pension fund investment policy?
•
What are the likely future trends in pensionplan asset
allocation?
2.
Defined Contribution versus Defined Benefit Plans
Although employer pension programs vary in design, usually
they are classified into two broad types: defined contribution
(DC) and defined benefit (DB). These two categories are
distinguished in the law under the Employee Retirement Income
Security Act (ERISA).
The DC arrangement is conceptually the simpler of the two.
Under a DC plan, each employee has an account into whichthe
employer and the employee (in a contributory plan) makeregular
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contributions. Benefit levels depend on the total contributions
and investment earnings of the accumulation in the account.
Defined contribution plans are in effect tax-deferredsavings
accounts held in trust for the employees.
Contributions usually are specified as a predetermined
fraction of salary, although that fraction need not be constant
over the course of a career. Contributions from both parties are
tax—deductible, and investment income accrues tax-free. At
retirement, the employee typically receives an annuity whose size
depends on the accumulated value of the funds in the retirement
account.
Often the employee has some choice as to how the account is
to be invested. In principle, contributionsmay be invested in
any security, although in practice most plans limit investment
options to various bond, stock, and money market funds. The
employee bears all the investment risk; the retirement account is
by definition fully funded, and the firm has no obligationbeyond
making its periodic contribution.
For defined contribution plans investment policy is not much
different than it is for an individual deciding how to investthe
money in an IRA. The guiding principle is efficient
diversification, that is, achieving the maximum expected return
for any given level of risk exposure. The special feature isthe
fact that investment earnings are not taxed as long as the money
is held in the pension fund. This considerationshould cause the
investor to tilt the asset mix of the pension fund towardsthe
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