NBER WORJ(ING PAPER SERIES
PENSION FUND INVESTMENT POLICY
Working Paper No. 2752
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
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
NEER Working Paper #2752
PENSION FUND INVESTMENT POLICY
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.
School of Management
Boston, MA 02215
PENSION FUND INVESTMENT POLICY
Defined Contribution versus DefinedBenefit Plans
2.1 Alternative Perspectives on DB Plans
2.2 Investment Strategy in DB PensionPlans.
2.3 The Black-Dewhurst Proposal
Research on Corporate Pension Policy
3.1 Theory of Corporate Pension PlanFunding and
Asset Allocation Policy
3.2 Empirical Studies
Hedging Against Inflation
Summary and Conclusions
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
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
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
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
least tax-advantaged securities such as corporate bonds.
In a DB plan, the employee's pension benefit entitlement is
determined by a formula that takes into accountyears of service
for the employer and, in most cases, wages orsalary. Many
defined benefit formulas also take into account the Social
Security benefit to which an employee is entitled. These are
called "integrated" plans.
In a typical DB plan, the employee might receive retirement
income equal to 1% of final salary times the number ofyears of
service. Thus, an employee retiring after 40 years of service
with a final salary of $15,000 per year would receive a
retirement benefit of 40% of $15,000, or $6,000per year.
The annuity promised to the employee is theemployer's
liability. The present value of this liability represents the
amount of money that the employer must set aside today in order
to fund the deferred annuity that conunencesupon the employee's
2.1 Alternative Perspectives on DB Plans.
Defined benefit pension funds are pools of assets that serve
as collateral for the firm's pension liabilities. Traditionally,
these funds have been viewed as separate from thecorporation.
Funding and asset allocation decisions are supposed to be made
in the best interests of the beneficiaries,regardless of the
financial condition of the sponsoring corporation.
Beneficiaries presumably want corporate pension plans to be
as well—funded as possible. Their preferences with regard to
asset allocation policy, however, are less clear. If
beneficiaries are not entitled to any windfall gains-- if the
defined benefit liabilities were really fixed in nominal terms --
rationally they would prefer that the funds be invested in the
least risky assets. If beneficiaries had a claim on surplus
assets, though, the optimal asset allocation in principle could
include virtually any mix of stocks and bonds.
Another way to view the pension fund investment decision is
as an integral part of overall corporate financial policy. Seen
from this perspective, defined benefit liabilities arepart and
parcel of the firm's other fixed financial liabilities, and
pension assets are part of the firm's assets. From this point of
view, any plan surplus or deficit belongs to the firm's
shareholders. The firm thus manages an extended balance sheet,
which includes both its normal assets and liabilities and its
pension assets and liabilities, in the best interests of
2.2 Investment Strategy in DB Pension Plans.
The practitioner literature seems to view a firm'spension
liabilities as divided into two parts — retired and active.
Benefits owed to retired participants are nominal, and benefits
accruing to active participants are real. The nominal benefits
can be immunized by investing in fixed—income securities with the
same duration or even exactly the same pattern of cash flowsas
the pension annuities.
Accruing benefits, on the other hand, call for a very
different investment policy, whose essence can be summarized as
follows. In estimating the liabilities to active participants,
the firm's actuaries make an "actuarial interest rate" assumption
that becomes the target rate for the pension asset portfolio.
Managers of the pension fund should view the possibility of
receiving a rate of return below the actuarial assumption as
having a greater negative weight than the positive weight
associated with a return above the actuarial assumption. This
factor will affect the asset allocation decision.
Portfolio insurance is an investment strategy that developed
in response to this view. It calls for maintaining an asset
portfolio with a truncated and positively skewed probability
distribution of returns. The probability of getting returns
below the actuarial rate is zero, while the probabilities of
returns above the actuarial rate are positive.
Portfolio insurance can be accomplished in a number ofways.
The most direct method is to invest in common stocks and buy
protective puts on them, which eliminates downside risk while
maintaining upside potential. Of course, the guaranteed minimum
return on such a policy will always be lower than the risk-free
rate. Another method is to invest in T—bills and buy call
The third way of providing portfolio insurance is topursue
a dynamic hedging strategy with stocks and T-bills. The strategy
involves continuous portfolio revision to replicate the payoff
structure of the two previous strategies. It involves selling
stocks when their price falls and buying them when their price
While it reduces downside risk, the adoption of portfolio
insurance principles should lead to a lower average rate of
return than on uninsured portfolios. Indeed, if pension funds
have been insuring to any significant extent by pursuing even
limited dynamic hedging strategies, one should expect to find
that their average performance falls short of the average
performance of conventionally managed portfolios.
This may help to explain the results reported in a recent
study by Berkowitz and Logue (1986). They found that the average
risk-adjusted performance of ERISA plans from 1968 to 1983 was
lower than returns experienced by other diversified portfolios in
U.S. financial markets. Reallocation between stocks, bonds and
cash equivalents had a significant deleterious effect on the
portfolio performance of ERISA plans. It should be noted that
the risk—adjusted performance measure used by Berkowitz and
Logue is not really appropriate for measuring the performance of
insured portfolios because it ignores the positive skewness of
the distribution of returns that is the main objective of
portfolio insurance strategies.
Recent changes in accounting rules may have a profound
effect on the investment policies of pension funds, reinforcing
the trend toward the use of immunization and portfolio insurance
2-For a more complete discussion of dynamic hedging see
Chapter 20 of Bodie, Kane, and Marcus (1988).
strategies. According to Rule 87 of the Financial Accounting
Standards Board (FASB), corporations must report their unfunded
pension liability on the corporate balance sheet. Previously
they reported this liability only in the footnotes to their
financial statements. Furthermore, the interest rate they use in
computing the present value of accrued benefits must be the
current rate on long term bonds.2 The result is that
fluctuations in long term interest rates will produce large
swings in reported pension liabilities that could, in the absence
of offsetting actions by the corporation, play havoc with the
firm's debt ratios.
Generally, security analysts and other observers of
corporate financial behavior expect that, in order to offset this
effect of FASS 87, corporations are likely to hedge the impact of
interest rate fluctuations on reported pension liabilities by a
strategy of duration matching, which will minimize the net effect
on unfunded pension liabilities.3 The impact on pension fund
asset allocation could be profound. There may be a significant
shift away from equities toward fixed—income securities.
2.3 The Black-Dewhurst Proposal
In 1981 Fischer Black and Moray Dewhurst created a stir
among pension plan finance specialists with a proposal that
2Corporations retain the right to use a different interest
rate assumption in their actuarial calculations for funding
decisions than they use for financial reporting purposes.
3See Leibowitz and Henricksson (1988) for a discussion of
the investment implications of focussing on the pension surplus.
carries to a logical extreme the notion that a pension plan is a
way to shelter investment income from corporate income taxes.4
That is, in order to maximize the value of a firm to its
shareholders, a firm should fully fund its pension plan and
invest the entire amount in bonds.
Black and Dewhurst propose that the firm arbitrage taxes by
substituting bonds for stocks in the pension fund. The simple
form of the proposal consists of four operations carried out at
the same time:
Sell all equities, $X, in the pension fund;
Purchase on pension account $X of bonds of the same risk as
the firm's own bonds;
Issue new debt in an amount equal to $X; and
Invest SX in equities on corporate account.
The net effect of these operations is that the firm has more
debt outstanding owed on corporate account and more bonds owned
on pension account. The market value of the firm's own shares
should thereby increase by as much as the corporate tax rate
times the amount of new debt taken on in the maneuver.
The plan adds value because the firm earns close to the
pretax rate of return on the bonds in the fund while paying the
after—tax rate on the debt issued to support theprocedure.
Given that only 20% of the dividends from thecommon stock are
4See Black, Fischer and M.P. Dewhurst, "A New Investment
Strategy for Pension Funds," Journal of Portfolio Management,
taxable, and that the tax on the capital gains can be deferred
indefinitely by not selling appreciated stock, the effective tax
rate on the equities held on corporate account will be very low.
Thus, the after-tax return on the equities will not be reduced
significantly if they are switched from pension account to
corporate account. If all value accrues to the firm's
shareholders, if the effective corporate tax rate on equities is
zero, and if the stocks held on corporate account are equivalent
to the stocks previously held by the pension fund, the gain to
shareholders has a present value of $TX where T is the firm's
marginal corporate income tax rate.
An example will clarify this proposal. The Hi-Tek
Corporation is a relatively new company with a young work force
and a fully—funded defined benefit pension plan. Hi-Tek's total
corporate assets are worth $50 million, and its capital structure
is 20% debt and 80% equity. Its pension assets consist entirely
of a well—diversified portfolio of common stocks indexed to the
S&P 500 and worth $10 million. The present value of its pension
liabilities is $10 million. Table la shows the corporate balance
sheet and Table lb the pension fund's balance sheet.
Hi—Tek's treasurer, who is in charge of the pension fund,
reads the Black-Dewhurst article and decides to implement the
proposal. The pension fund sells its entire $10 million stock
portfolio to the corporation and invests the proceeds in
corporate bonds issued by other high tech companies. The
corporation pays for the stock by issuing $10 million of new
bonds. The resulting balance sheets appear in Table 2.
According to Black and Dewhurst, the result of these
transactions should be an increase in the market value of owners'
equity of as much as $10 million times the corporate tax rate,
currently 34%. In other words, the market value of the
outstanding shares of Hi—Tek's common stock should increase by
To see why, let r be the interest rate on the debt. As a
result of the four operations above, the company now earns
r x $10 million per year in interest on the bonds it bought on
pension account while paying from its after-tax cash flow (1-T)r
x $10 million per year on the debt it issued on corporate
account. The net cash flow to the firm will be .34r x $10
million per year, the tax saving on the interest. The present
value of this saving in perpetuity is $3•4 million:
(.34r x $10 million) = $3.4 million
Note that even though Hi-Tek's debt ratio has increased from
.2 to .3, the overall risk of the firm has not changed. If we
accept the theory that the pension fund assets and liabilities
belong to the shareholders, the risk of the assets does not
change whai the $10 million of stock in the pension fund is, in
effect, transferred to corporate account.
51f the corporate tax rate on equities is greater than zero,
the gain in shareholders' equity will be smaller.
a. Corporate Balance Sheet (S million)
Liabilities and Owners' Equity
Balance Sheet ($ million)
Liabilities and Fund Balance
PV of Accrued Benefits
Table 2. Hi-Tek Corp. Balance Sheets After Black-Dewhurst
Balance Sheet (S million)
Property Plant & Equipment
b. Pension Fund Balance Sheet (S million)
Tjjijes and Fund P.il,
PV of Accrued Benefits
Table 1. Hi-Tek Corporation Balance Sheets Before Black-Dewhurst
Property Plant & Equipment
b. Pension Fund
Liabilities and Owners'
This plan implies that the company should increase its
contributions to the pension plan up to the limits allowed by the
IRS. This is because for every dollar of assets added to the
pension fund, invested in bonds, and supported by issuing new
bonds, the tax saving increases by rT per year, and the PV of
shareholders' equity increases by $T. Thus if T is .34,
shareholders' equity rises by $.34 for every dollar added to
pension assets or for every dollar switched out of stocks into
Research on Corporate Pension Policy
The financial aspects of corporate pension plans have
increasingly attracted the attention of academics. Much of this
attention has focused on theoretical analysis of the tax and
incentive aspects of corporate pensions. Models of optimal
capital structure have yielded testable implications for plan
funding and investment strategy (Black 1980; Tepper 1981), while
advances in option pricing theory have highlighted theperverse
incentives created by Pension Benefit Guarantee Corporation
(PBGC) insurance (Sharpe 1976; Treynor 1977).
As yet, however, empirical work has failed to decisively
confirm or reject these effects. Below we provide a brief
overview of the relevant theory and of previous empirical work
designed to test that theory.
3.1 Theory of Corporate Pension Plan Funding and Asset
The academic literature more and more views pension
decisions as an integral part of overall corporate financial
policy. From this perspective, employee benefits accrued under a
defined benefit pension plan are a long-term liability of the
firm. Pension assets, while collateral for these liabilities,
are assets of the firm in that the surplus/deficit belongs to the
firm's shareholders. This integrated perspective requires
managing the firm's extended balance sheet, including both its
conventional assets and liabilities and its pension assets and
liabilities, in the best interests of the shareholders.
Such a corporate financial perspective explicitly ignores
the interests of the beneficiaries, in part because their defined
benefits are insured by the PBGC.
According to this view, if
the beneficiaries are protected by the government, corporate
pension decisions become what amounts to a game between the
corporation and various government agencies and interests, a game
that can be and should be thought of as an integral part of
corporate financial policy.
The first pension decision of interest is the level-of-
funding decision: are there incentives for the firm to over- or
underfund its pension liability? The tax effects are the first,
and for most companies, the most important, part of this game.
In closely related papers, Black (1980) and Tepper (1981) argue
that the unique feature of pension funds from this integrated
perspective is their role as a tax shelter. Because firms can
effectively earn a pretax rate of return on any assets held in
the pension fund and pass these returns through to shareholders,
much as if the pension fund were an IRA orKeogh plan, the
comparative advantage of a pension fund lies in its ability to be
invested in the most heavily taxed assets. As Black and Dewhurst
have demonstrated, the potential increase in the value of
shareholders' equity resulting from a tax-sheltering strategy is
This means that pension funds should be invested entirely
in taxable bonds, instead of common stock, real estate, or other
assets that in effect are taxed at lower marginal tax rates for
most shareholders, and that the corporation should fund its
pension plan to the maximum extent allowed by the IRS so as to
maximize the value of this tax shelter to shareholders. The tax
effects of pensions should therefore induce corporations to
follow extreme policies. Fully funded or overfunded pension
plans should place their assets entirely in taxable bonds.
A second effect that may influence the level of funding,
the "pension put" effect, is associated with the work ofSharpe
(1976), Treynor (1977), and Harrison and Sharpe (1983). Briefly,
the PBGC's insurance of pension benefits in effect gives the firm
a put option. As with any option, the value of this put
increases with the risk of the underlying asset.
Thus, as long
as the PBGC neither regulates pension fund risk nor accelerates
its own claim at the first sign of financial distress, the firm
has an incentive to undermine the PBGC's claim. It can do so and
maximize the value of its put option by funding itspension plan
only to the minimum permissible extent and investing the pension
assets in the riskiest possible securities. This of course is
the exact opposite policy from the decision suggested by the tax
effects described above.
These two theories point to specific firm characteristics as
the key determinants of corporate pension policies:
profitability, risk (including leverage), and tax-paying status.
Two major studies have explored the empirical relationship
between the financial characteristics of corporations and their
asset allocation policies. They are described in detail below.
3.2 Empirical Studies
Friedman (1983) was the first to test empirically for the
impact of firm financial characteristics on pension policy.
Integrating data from the Standard & Poor's Coinpustat file and
Form 5500 data for 1977, he examined the relationship between
asset allocation and measures of business risk and leverage. He
estimated a number of relationships of the following form: the
dependent variable was some aspect of the pension decision such
as unfunded liabilities or the proportion of pension assets
invested in bonds; independent variables included measures of
conventional financing, such as ordinary balance sheet
liabilities, plus one other control variable such as firm
profitability, risk, and tax-paying status.
Friedman concluded that pension decisions are indeed related
to other aspects of the corporate financing decision. He found
that unfunded liabilities and the proportion of pension assets
invested in bonds are both positively related to ordinary balance
sheet liabilities. He also found that a reverse relationship
holds, with balance sheet leverage depending positively on
unfunded pension liabilities, regardless of the control variable
used — a "risk—offsetting effect."
Results with tests of individual variables such as tax-
paying status, however, do not favor any strong conclusion (and
often change sign with specification), thus raising rather than
resolving questions. This may be the result of bias induced by
firm-to—firm variability in actuarial assumptions used in
calculating reported liabilities. That is, reported liabilities
may have differed across firms in the sample solely as a result
of discount rate assumptions.
Bodie, Light, Morck, and Taggart (1987) demonstrated that
reported liabilities were systematically biased because of the
way firms chose the discount rates that they used in calculating
the present value of accrued benefits. They examined the asset
allocation choices for 215 firms using data collected in 1980 and
estimated reduced form relationships between pension decisions
and'the firm's tax-paying status, profitability, and risk. Their
data come from FASS 36 filings for 1980, which include interest
rate assumptions, so they were able to adjust reported
liabilities roughly to a common rate. In this initial
adjustment, they found that the reporting of pension fund
liabilities was systematically linked to company profitability
through the choice of a discount rate. More profitable firms
tended to choose lower discount rates and thus to report greater
The first pension decision examined in Bodie et al. was the
extent of funding, measured by pension assets as a fraction of
vested pension liabilities. There was strong evidence that firm
profitability is positively related to funding, but no
statistically significant relationship between funding and risk
or tax—paying characteristics. Some evidence of the pension put
effect was found when the sample was split by riskiness of the
The study also examined asset allocation. The proportion of
assets held in fixed-income securities was related to the same
firm characteristics listed above. A significant fraction of
firms invested their pension assets entirely in fixed-income
securities, and the proportion of assets allocated to fixed-
income securities was positively related to the level of funding.
Hedging Against Inflation.
As we pointed out earlier, DB pension funds often view their
accruing pension liabilities to active employees as fixed in real
as opposed to nominal terms. In that case, a portfolio is
efficient if it offers the minimum variance of real rate of
return for any given mean real rate of return.
Most textbook expositions of portfolio selection theory,
however, and indeed most real world applications of that theory,
are cast in nominal terms. Typically, Treasury bills are taken
as the risk-free asset, and the optimal combination of risky
assets is constructed on the basis of the covariance matrix of
nominal returns. All efficient portfolios are combinations of
cash and the optimal nominally risky portfolio.
Since January 1988, however, U.S. investors have had
available to them the possibility of investing in virtually risk-
free securities linked to the U.S. consumer price level. Thenew
securities were issued by the Franklin Savings Association of
Ottawa, Kansas in two different forms. The first is certificates
of deposit, called Inflation-Plus CDs, insured by the Federal
Savings and Loan Insurance Corporation (FSLIC), and paying an
interest rate tied to the Bureau of Labor Statistics Consumer
Price Index (CPI). Interest is paid monthly and is equal to a
stated real rate plus the proportional increase in the CPIduring
the previous month. As of this writing (September1988), the
real rate ranges from 3% per year for a one—year maturity CD to
3.3% per year for a ten—year maturity.
The second form is twenty-year noncallable collateralized
bonds, called Real Yield Securities, or REALs. These offer a
floating coupon rate of 3% per year plus the previous year*s
proportional change in the CPI, adjusted and payablequarterly.
A recent issue of similar bonds includes aput option.
Two other financial institutions have recently followed the
lead of Franklin Savings.6 it seems as if we have reached a
milestone in the history of the financial markets in the U.S..
61n August 1988 Anchor Savings Bank became the second U.S.
institutionto issue REALS, and in September 1988 JHNAcceptance
Corporation issued modified index-linked bonds subject to a
nominal interest rate cap of 14% per annum.
For many years prominent economists from all ends of the
ideological spectrum have been arguing in favor of the U.S.
Treasury's issuing such securities, and scholars have speculated
about why private markets for them have not hitherto developed.7
The existence of CPI-linked bonds makes possible inflation-
protected retirement annuities. Retired people have long been
considered the most vulnerable to inflation risk, but proposals
for private market solutions to their problem have been stymied
by the lack of a real risk-free asset.8
Bodie (1980), for example, proposed the idea of a variable
annuity offering at least limited protection against inflation
risk, but his proposal lacked appeal primarily because of the
low mean real rate of return available on money market instru-
ments (between 0 and 1% per year), the best available inflation
hedge at that time.9 With the availability of virtually risk-
free securities offering real rates in excess of 3% per year, the
situation is markedly different. Pension funds and other
providers of retirement benefits, who currently offer only
nominal annuities, could also offer attractive real annuity
7See, for example, the analysis in Fischer (1986).
8Feldstein (1983) and Summers (1983) have both argued that
the elderly may in fact already be over—indexed because of their
claims to Social Security benefits and their ownership of real
9Bodie suggested improving the inflation protection afforded
by money market instruments by hedging them against unanticipated
inflation with a very small position in a well—diversified
portfolio of commodity futures contracts.
options to retirees.
To illustrate how such a real annuity option mightwork,
assume that you are an individual who at retirement is entitled
to a benefit with a present value of $100,000. Your retirement
plan currently offers you a conventional nominal annuitycomputed
on the assumption of a nominal interest rate of 8%per year and
a life expectancy of 15 years. Assuming the first payment is to
be received immediately, the annual benefit is $10,818. The
plan hedges its liability to you by investing in risk-free
nominal bonds paying a nominal rate of 8%per year.
From your perspective the real value of this stream of
benefits is uncertain. Consider the purchasingpower of the
final benefit payment to be received 14years from now. If the
rate of inflation turns out to be 5%per year, the real value of
the final benefit will be $5,464, about half thevalue of the
first payment. If the rate of inflation turnsout to be 10% per
year, the real value of the final payment drops to $2,849.
Contrast this with a hypothetical real annuity.
plan can now invest your $100,000 to earn a real risk-free rate
of 3% per year it could offeryou a real annuity computed on the
assumption of 3% per year. Your annual benefit would be$8,133
guaranteed in real terms. While the initialpayment is lower
than under the nominal option, the real valueof the benefit is
insured against inflation.
It is important to realize that the realannuity need not
start at a lower value than the conventionalnominal annuity.
Bodie and Pesando (1983) have shown how real annuities can be
designed with the same starting value as conventional nominal
annuities. Such a real annuity would have to have a downward
tilt to the benefit stream, just like the expected real value of
the benefit stream from the nominal annuity. The essential
difference would then be that the real annuity would be insured
against inflation while the nominal annuity would not.
The idea of indexing retirement annuities after retirement
is only one aspect of inflation—proofing private pension plans.
Another is the indexation of benefit accruals under private
defined benefit (DB) plans. The accrual patterns and real
benefit streams under virtually all private DB plans in the U.S.
are extremely sensitive to inflation. Inflation reduces the real
value of DB entitlements because pension benefits are fixed in
nominal terms once an employee stops working for the plan
sponsor or once the sponsor terminates the plan. This reduces
the value of accrued benefits to all participating employees, but
it especially affects those who switch employers during their
For example, suppose you are 45 years old and have worked
for the same employer for 20 years. Assume that your DB plan
promises 1% of final salary per year of service; that your most
recent salary was $50,000; that normal retirement age is 65, and
that your life expectancy is age 80. Your claim on the pension
fund is a deferred annuity of $10,000 per year starting at age 65
and lasting for 15 years.
If you leave your current employer, what do you have?
Since the benefit is not indexed to any wage or price level the
way Social Security is, the benefit will be losing real value as
the price level goes up. Assuming inflation of 5% per year, the
value of $1 will have fallen to $.38 by the time you retire, so
your first year's benefit of $10,000 will have a real value of
only $3,800, and that value will continue to fall each year as
inflation continues. If, however, you stay with your employer,
and your salary increases at the rate of inflation, and your
employer indexes your benefit to the cost of living after
retirement, then you will have an annuity worth $10,000 of
today's purchasing power per year for life.
Looking at the situation in terms of present values and
assuming a nominal discount rate of 8% per year and a real
discount rate of 3% per year, your accrued benefit if you switch
jobs or if the plan is terminated has a present value of $18,364.
If you continue, with complete indexation both before and after
retirement the accrued benefit has a present value of $66,097.
One simple alternative to the current system of DB pensions
is to offer pension benefits whose value is defined in real
terms. This is most readily accomplished by indexing the
starting level of benefits either to an index of wages (the way
Social Security is indexed) or to an index of prices like the
CPI even for employees who leave the firm. Similarly, a cost of
living provision could be included in the benefit formula after
To the extent that pension plans actually were to offer
indexed benefits to their employees, pension fund asset
allocation could be profoundly affected. A switch to indexed
pensions would probably result in hedging strategies involving
investment in long—term securities linked to the price level.
Summary and Conclusions
Pension fund investment policy depends critically on the
type of plan: defined contribution versus defined benefit.
Both types of plan normally are exempt from taxation, but
defined benefit plans have unique features that can lead
their sponsors to pursue investment policies that differ
radically from those of defined contribution plans.
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
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 DB plans concludes
that, if their objective is shareholder wealth maximization,
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 has so far failed to decisively confirm
or reject the predictions of this theory of corporate
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.
Berkowitz, Logue andAssociates, Inc., "Study of the
Investment Performance of ERISA Plans," Prepared for the
Office of Pension and Welfare Benefits; Department of Labor,
July 21, 1986.
Black, Fisher, "The Tax Consequences of Long Run Pension
Policy," Financial Analysts Journal, September—October 1980,
Black, Fischer and M.P. Dewhurst, "A New Investment Strategy
for Pension Funds," Journal of Portfolio Management, Summer
Bodie, Zvi, "An Innovation for Stable Real Retirement
Income," The Journal of Portfolio Management, Fall 1980, pp.
Bodie, Zvi, Jay 0. Light, Randall Morck and Robert H.
Taggart, Jr., "Corporate Pension Policy: An Empirical
Investigation," in Issues in Pension Economics, Bodie,
Shoven and Wise, ed., Chicago: University of Chicago Press,
Bodie, Zvi, Kane, Alex and Marcus, Alan J., Investments,
Irwin, Homewood Illinois, 1989.
Bulow, Jeremy, "What are Corporate Pension Liabilities,"
Quarterly Journal of Economics, 97, August 1982.
Feldstein, Martin, "Private Pensions as Corporate Debt," in
Ben Friedman, ed., Changing Roles of Debt and Equity in
Financing U.S. Caøital Formation, University of Chicago
Friedman, Benjamin M., "Pension Funding, Pension Asset
Allocation and Corporate Finance: Evidence from Individual
Company Data," in Financial Asoects of the United States
Pension System, Chicago: University of Chicago Press,
10. Harrison, M.J. and Sharpe, W. F., "Optimal Funding and Asset
Allocation Rules for Defined Benefit Pension Plans," Chapter
4 of Bodie and Shoven, eds., Financial Aspects of U.S.
Pension Systems, University of Chicago Press, 1983.
11. Leibowitz, Martin L., Henriksson, Roy D., "Portfolio
Optimization within a Surplus Framework," Financial Analysts
Journal, Vol. 44, No. 2: March/April 1988.
12. Sharpe, William F., "Corporate Pension Funding Policy," Download full-text
Journal of Financial Economics, June 1976, PP. 183-193.
13. Tapper, Irwin, "Taxation and Corporate Pension Policy,"
Journal of Finance, March 1981, pp. 1-13.
14. Treynor, Jack, "The Principles of Corporate Pension
Finance," Journal of Finance, May 1977, pp. 627-638.