(June 6, 2013) — Standard portfolio models such as CAPM ignore the relationship between the corporations and their pension plans-and that’s a problem, according to two British defined benefit (DB) experts.
Bank of England adviser David Miles and Imperial College Professor David McCarthy suggested in a paper that the resolution for the DB crisis lies in examining how shareholders, members, and trustees each value the assets. According to their research, an intrinsic asymmetry exists because shareholders hold all of the liability of the fund, when members garner all of the benefits of over performance. McCarthy and Miles built a model of asset allocation decisions, which included interest rate, longevity, and equity market risk.
Miles and McCarthy’s study found that fiduciaries will increase the equity investment when pensions have greater upside exposure than downside. That is, investment teams build riskier portfolios when they’re backstopped by shareholders and, ultimately, the Pension Benefit Guaranty Corporation (PBGC) or UK’s Pension Protection Fund.
In 2008, the average US defined benefit plan was invested 52% in equities while the average British plan was invested 51%. Under standard life-cycle models of asset allocation, the authors argued that this degree of exposure amounts to tremendous risk for pension fund sponsors.
In the UK during the 1980s, many pension surpluses arose, and these were used to both cut down contributions from the sponsors and also increase member’s benefits. However, in the US pension surpluses are generally directed towards the members, and any pension surpluses directed at employers is taxed at a punitive rate.
In many cases employers are often required to purchase insurance via PBGC premiums to cover the loss of pension benefits, and this only enhances the asymmetric nature of the payoffs received by scheme members. The two researches contend that liabilities of these schemes will increase as these schemes become closed to new members and new accruals. According to the paper, sponsors will become increasingly exposed to investment risks, longevity risks – while the members will be exposed to the risk of potential insolvency of the plan sponsor.
“Simply by allowing for the sharing of surplus and deficits in the context of an ever-more mature scheme, our model produces radically different conclusions from much prior work on occupational DB pension scheme asset allocation,” the authors wrote. The study concluded because pension funds are some of the most important players in global capital markets, pension fund governance will play an important role of the aggregate level of risk taking in the real investment in the economy.
Miles and McCarthy urged policy makers to reexamine the funding and investment regulations governing defined benefit schemes. Creating more symmetrical risk/reward relationships, they argued, will help rectify the current shaky state of the UK and US defined benefit pension systems.