NBER WORJ(ING PAPER SERIES
PENSION FUND INVESTMENT POLICY
Working Paper No. 2752
NATIONAL BUREAU OF ECONOMIC RESEARCH
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This research is part of NBER's researchprogram in Financial Markets and
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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 Download full-text
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