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Pension Fund Management

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This section addresses how a corporation should invest its pension assets.  In practice, the average pension plan is funded somewhere in the vicinity of a 6040 stockbond mix.  Note that what is appropriate for a corporation is not necessarily also appropriate for individuals trying to fund their own retirements.

Keith Ambachtsheer, "Would the Real Investment Policy Please Stand Up?," Financial Analysts Journal, May-June 1991, pp. 7-9. This short article summarizes the Bodie and Ippolito papers below and tries to reconcile them.

Fisher Black, "The Tax Consequences of Long-Run Pension Policy," Financial Analysts Journal, July-August 1980, pp. 21-28.  This paper suggests that pension funds ought to be invested 100% in bonds.  The rationale is one of tax arbitrage:  First, the company fully funds its pension plan with 100 bonds, of the approximate same credit quality as those of the company itself.  If it needs to borrow in order to get the funds to do so, it should borrow by issuing bonds itself.  The benefit here is that the bonds in the pension fund earn pre-tax returns (because pension fund profits are not taxed).  But the company can deduct the interest payments it makes on bonds it issues.  So the company makes pre-tax returns on the bonds in its pension fund and pays post-tax interest rates on the borrowed money.  If the pension bonds and the bonds the company issued have similar duration and credit quality (which you should try to ensure), that means that the company has a guaranteed profit of the amount of taxes saved through the interest deduction.  Guaranteed profit is good.

But won't investors be concerned about the company's increased debt level?  They shouldn't be.  If they look at the combined balance sheet of the the company and its pension fund (which they should), they would notice that the company's valuation hadn't changed.  If anything, the company's balance sheet should look more attractive to investors since the risk of underfunding the pension plan has been removed.  Less risk of need for future additional pension funding is good.

Of course, another benefit is that the pension plan participants would be well served by this policy, as would the Pension Benefit Guaranty Corporation.

Irwin Tepper, "Taxation and Corporate Pension Policy," Journal of Finance, March 1981, pp. 1-13. This paper suggests that corporations should fully fund their pension plans and should fund them 100% with bonds.  This paper is largely consistent with the Black paper above.

Tongxuan Yang, "Defined Benefit Pension Plan Liabilities and International Asset Allocation," Pension Research Council Working Paper 2003-5, 2003 (283kb). "... U.S. defined benefit pension plans could benefit substantially from more international investment."

"Pension Plan Issues: Investment Framework," The Vanguard Group, February 2004. An even-handed discussion of the pros and cons of the two major strategies for pension investment: total return and asset-liability matching.

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