Feb 22, 2009

Pension funds and financial economics

Pension funds are experiencing a double-whammy: losses at a time when companies can least afford to fund them. This highlights the advantages of a pension asset allocation devoted entirely to fixed income. This financial economics approach does a better job of matching the duration of a pension's assets with its liabilities. Stockholders would no longer require a risk premium for the company's pension assets, decreasing the firm's cost of capital. Consequently, enterprise value would be higher and hurdle rates for capital budgeting decisions would be lower, encouraging investment and job creation. Finally, better tax efficiency can be achieved by using scarce tax-advantaged accounts to hold income generating bonds rather than equities, which are already tax efficient.

Unfortunately, misaligned incentives in the current pension regime make this change unlikely. Would any rational person claim that a dollar of stocks is worth more than a dollar of bonds? Oddly, this is the fundamental assumption of current pension accounting rules. Corporations can reduce their funding requirements by holding more equities since the expected return is higher. However, this fails to account for the added risk borne by employees (and taxpayers, via the PBGC), who are the beneficiaries of the plan. Under these rules, corporate managers are divided between doing what is best for short-term investors versus what is in the interests of long-term employees.

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