CREATING VALUE IN PENSION PLANS (OR, GENTLEMEN PREFER BONDS)

Pension funds are typically one‐half to two‐thirds invested in equities because equities are expected to outperform other financial assets over the long term, and the long‐term nature of pension fund liabilities seems well suited to absorbing any short‐term return volatility. What's more, U.S. GAAP currently makes it possible to take credit in advance for the higher anticipated earnings on equity investments without acknowledging their inherent risk. But by allowing the higher expected returns from stocks to reduce a company's current pension expenses, the accounting treatment conflicts with some very basic principles of finance (in particular, the idea that investors must earn higher returns on riskier investments just to “break even”), conceals systematic biases in the actuarial analysis, and gives managers considerable latitude to manipulate the bottom line. The authors suggest a startlingly different approach. They argue that pension assets should be invested entirely in duration‐matched debt instruments for two reasons: (1) to capture the full tax benefits of pre‐funding their pension obligations and (2) to improve overall corporate risk profiles by converting general stock market risk into firm‐specific operating risk, where corporate managers should have a comparative advantage and can generate real value. Investing exclusively in bonds would take better advantage of the tax‐exempt status of pension plans and greatly reduce fund management costs, while at the same time helping o shore up fund quality and sharpening corporate executives' focus on their real operating assets.