Article1990

The ABO, the PBO and Pension Investment Policy

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Financial Literacy, Pension, Retirement Analysis Corporate Finance and Governance Financial Analysis and Corporate Governance

Abstract

Corporate management views a defined benefit pension plan as a trust for the employees and manages the fund almost as if it were a defined contribution plan with a guaranteed floor specified by the benefit formula. In order to minimize the cost to the sponsor of providing the minimum benefit guarantee, there is a strong incentive to hedge the accumulated benefit obligation (ABO) by investing in fixed income securities with a matching duration-- that is, to immunize it. The incentive to immunize the ABO is strongest when the plan is fully funded. If the plan is overfunded, it makes sense to invest in equities and pursue a kind of portfolio insurance strategy known as contingent immunization. If the plan is very underfunded and the sponsor is in financial distress, it may be optimal to exploit the put provided by PBGC insurance through a high-risk investment strategy. Tax, regulatory, and other considerations have in the past created strong incentives to overfund the pension plan. Recent changes in accounting rules and tax law are likely to reinforce the use of fixed income immunization strategies and reduce pension fund investment in equities. While useful for estimating a firm's future cash flow, the projected benefit method is misleading in the conduct of pension fund investment policy. The PBO is not an appropriate measure of the benefits that the employer has guaranteed and therefore not a target to be hedged by pension fund investment policy. The failure of pension funds to show any significant interest in inflation-protected investment products such as CPI-linked bonds is clear evidence that they do not view their liabilities as indexed for inflation. Investing in equities provides pension funds with higher expected returns, but does not offer an effective hedge against inflation risk.

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References

1973The Pricing of Options and Corporate Liabilities 1976COMMON STOCKS AS A HEDGE AGAINST INFLATION 1976Corporate pension funding policy 1981Taxation and Corporate Pension Policy 1990Reversions of Excess Pension Assets after Takeovers 1977THE PRINCIPLES OF CORPORATE PENSION FINANCE

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