Hostname: page-component-848d4c4894-sjtt6 Total loading time: 0 Render date: 2024-07-04T15:40:16.138Z Has data issue: false hasContentIssue false
  • English
  • Français

Pension Scheme Asset Allocation with Taxation Arbitrage, Risk Sharing and Default Insurance

Published online by Cambridge University Press:  10 June 2011

C. M. S. Sutcliffe
C. M. S. Sutcliffe
Affiliation:
The ISMA Centre, University of Reading, P.O. Box 242, Reading RG6 6BA, U.K., Email: C.M.S.Sutcliffe@rdg.ac.uk
Get access Rights & Permissions [Opens in a new window]

Abstract

The asset allocation is a crucial decision for pension funds, and this paper analyses the economic factors which determine this choice. The analysis proceeds on the basis that, in the absence of taxation, risk sharing and default insurance, the asset allocation between equities and bonds is indeterminate and governed by the risk/return preferences of the trustees and the employer. If the employing company and its shareholders are subject to taxation, there is a tax advantage in a largely bond allocation. Risk sharing between the employer and the employees often means that one group favours a high equity allocation, while the other favours a low equity allocation. Underpriced default insurance creates an incentive for a high equity allocation. When taxation, risk sharing and underpriced default insurance are all present, it is concluded that the appropriate asset allocation varies with the circumstances of the scheme; but that a high equity allocation is probably inappropriate for many private sector pension schemes.

Keywords

Pension FundAsset AllocationTax ArbitrageRisk SharingDefault InsuranceEmbedded Options
Type
Sessional meetings: papers and abstracts of discussions
Information
British Actuarial Journal , Volume 10 , Issue 5 , 01 December 2004 , pp. 1111 - 1131
Copyright
Copyright © Institute and Faculty of Actuaries 2004

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Alexander, B. (2002). Gentlemen prefer bonds. Masters in finance dissertation, London Business School.Google Scholar
Bader, L.N. (2003). The case against stock in corporate pension funds. Pension Section News, February, 17–19.Google Scholar
Bicksler, J.L. & Chen, A.H. (1985). The integration of insurance and taxes in corporate pension policy. Journal of Finance, 40, 3, 943–957.Google Scholar
Black, F. (1980). The tax consequences of long run pension policy. Financial Analysts Journal, 36, 4, 21–28.Google Scholar
Black, F. & Dewhurst, M.P. (1981). A new investment strategy for pension funds. Journal of Portfolio Management, 7, 4, 26–34.CrossRefGoogle Scholar
Black, F. & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81, 3, 637–659.CrossRefGoogle Scholar
Blake, D., Lehmann, B.N. & Timmermann, A. (1999). Asset allocation dynamics and pension fund performance. Journal of Business, 72, 4, 429–461.Google Scholar
Bodie, Z., Light, J.O., Mørck, R. & Taggart, R.A. (1985). Corporate pension policy: an empirical investigation. Financial Analysts Journal, 41, 5, 10–16.Google Scholar
Bodie, Z., Light, J.O., Mørck, R. & Taggart, R.A. (1987). Funding and asset allocation in corporate pension plans: an empirical investigation. In Issues in pension economics, edited by Bodie, Z., Shoven, J.B. & Wise, D. A.. University of Chicago Press.CrossRefGoogle Scholar
Brinson, G.P., Hood, L.R. & Beebower, G.L. (1986). Determinants of portfolio performance. Financial Analysts Journal, 42, 4, 39–44.Google Scholar
Brinson, G.P., Singer, B.D. & Beebower, G.L. (1991). Determinants of portfolio performance II: an update. Financial Analysts Journal, 47, 3, 40–48.Google Scholar
Bulow, J. (1981). Tax aspects of corporate pension funding policy. National Bureau of Economic Research, working paper no. 724.Google Scholar
Bunt, K., Winterbotham, M. & Williams, R. (1998). The role of the pension scheme trustee. Department of Social Security, research report no. 81, HMSO.Google Scholar
Chen, A.H. & Reichenstein, W. (1992). Taxes and pension fund asset allocation. Journal of Portfolio Management, 18, 4, 24–27.Google Scholar
Cooper, R.W. & Ross, T.W. (2001). Pensions: theories of under-funding. Labour Economics, 8, 6, 667–689.CrossRefGoogle Scholar
Cornell, B. (1999). The equity risk premium: the long-run future of the stock market. John Wiley And Sons.Google Scholar
Datta, S., Iskander-Datta, M.E. & Zychowicz, E.J. (1996). Managerial self-interest, pension financial slack and corporate pension funding. Financial Review, 31, 4, 695–720.Google Scholar
Department for Work and Pensions (2003). Simplicity, security and choice: working and saving for retirement — action on occupational pensions. HMSO, Cm 5835.Google Scholar
Dimson, E., Marsh, P. & Staunton, M. (2002). The triumph of the optimists: 101 years of global investment returns. Princeton University Press.Google Scholar
Erickson, M., Goosbee, A. & Maydew, E. (2003). How prevalent is tax arbitrage? Evidence from the market for municipal bonds. National Tax Journal, 56, 1, 259–270.Google Scholar
Exley, C.J. (2003). Pension funds and the U.K. economy, Society of Actuaries Symposium on the great controversy: current pension actuarial practice in light of financial economics, Vancouver.Google Scholar
Frank, M.M. (2002). The impact of taxes on corporate defined benefit plan asset allocation. Journal of Accounting Research, 40, 4, 1163–1190.Google Scholar
Graham, J.B. (2000). How big are the tax benefits of debt? Journal of Finance, 55, 5, 1901–1941.CrossRefGoogle Scholar
Gunderson, M., Hyatt, D. & Pesando, J.E. (1992). Wage-pension trade-offs in collective agreements. Industrial and Labour Relations Review, 46, 1, 146–160.Google Scholar
Harrison, J.M. & Sharpe, W.F. (1983). Optimal funding and asset allocation rules for defined benefit pension plans. In Financial aspects of the United States pension system, edited by Bodie, Z. & Shoven, J.B.. University of Chicago Press.Google Scholar
Ibbotson, R.G. & Kaplan, P.D. (2000). Does asset allocation policy explain 40, 90 or 100 percent of performance? Financial Analysts Journal, 56, 1, 26–33.Google Scholar
Ippolito, R.A. (1985). The economic function of underfunded pension plans. Journal of Law and Economics, 28, 3, 611–651.Google Scholar
Ippolito, R.A. (1990). The role of risk in a tax arbitrage pension portfolio. Financial Analysts Journal, 46, 1, 24–32.Google Scholar
Marcus, A.J. (1987). Corporate pension policy and the value of PBGC insurance. In Issues in Pension Economics, edited by Bodie, Z., Shoven, J.B. & Wise, D.A.. University of Chicago Press.Google Scholar
Miller, M.H. (1977). Debt and taxes. Journal of Finance, 22, 2, 261–275.Google Scholar
Modigliani, F. & Miller, M.H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48, 3, 261–297.Google Scholar
Myers, S.C. & Majluf, N.S. (1984). Corporate financial and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13, 2, 187–221.Google Scholar
Papke, L.E. (1992). Asset allocation of private pension plans. In Trends in Pensions 1992, edited by Turner, J. & Beller, D.. U.S. Department of Labour, Pensions and Welfare Benefits Administration.Google Scholar
Pratten, C. & Satchell, S. (1998). Pension scheme investment policies. Department of Social Security, research report 82, HMSO.Google Scholar
Ralfe, J., Speed, C. & Palin, J. (2003). Pensions and capital structure: why hold equities in the pension fund? Society of Actuaries Symposium on the great controversy: current pension actuarial practice in light of financial economics, Vancouver.Google Scholar
Scholes, M.S., Wolfson, M.A., Erickson, M., Maydew, E.L. & Shevlin, T. (2001). Taxes and business strategy: a planning approach. Second edition, Prentice Hall.Google Scholar
Sharpe, W.F. (1964). Capital asset prices: a theory of market equilibrium under conditions of risk. Journal of Finance, 19, 3, 425–442.Google Scholar
Sharpe, W.F. (1976). Corporate pension funding policy. Journal of Financial Economics, 3, 3, 183–193.Google Scholar
Sherris, M. (1992). Portfolio selection and matching: a synthesis. Journal of the Institute of Actuaries, 119, 87–105.CrossRefGoogle Scholar
Siegel, J.J. (2002). Stocks for the long run. Third edition, McGraw Hill.Google Scholar
Surz, R.J. (1981). Elaborations on the tax consequences of long run pension policy. Financial Analysts Journal, 37, 1, 52–54 & 60.CrossRefGoogle Scholar
Sutcliffe, C.M.S. (2005). The cult of the equity for pension funds: should it get the boot? Journal of Pension Economics and Finance, 4, 1, 57–85.Google Scholar
Tepper, I. (1981). Taxation and corporate pension policy. Journal of Finance, 36, 1, 1–13.Google Scholar
Tepper, I. & Affleck, A.R.P. (1974). Pension plan liabilities and corporate financial strategies. Journal of Finance, 29, 5, 1549–1564.Google Scholar
Thomas, J.K. (1988). Corporate taxes and defined benefit pension plans. Journal of Accounting and Economics, 10, 3, 199–237.Google Scholar
Useem, M. & Hess, D. (2001). Governance and investments of public pensions. In Pensions in the Public Sector, edited by Mitchell, O.S. & Hustead, E.C.. University of Pennsylvania Press.Google Scholar