Fed Study: Fully Funded, Risk-Reduced DB Plans Best for Employers

August 22, 2007 (PLANSPONSOR.com) - Defined benefit plan sponsors are actually better off properly funding their program and investing in fixed-income securities than scrimping on pension contributions in the hopes of cutting costs.

That was the conclusion of a study by three economists, “Why Do Firms Offer Risky Defined Benefit Pension Plans?” issued as part of the Finance and Economics Discussion Series by the U.S. Federal Reserve Board.

The core finding by authors David A. Love of the Department of Economics, Williams College,  and Federal Reserve economists Paul A. Smith, and David Wilcox was that employees will demand a boosted compensation level in exchange for an underfunded and riskily invested pension.

So, the three asserted, plan sponsors looking for a quick cost-cutting maneuver by holding down pension cash infusions will actually end up in a lesser financial position by having to shell out more in compensation costs.

“Minimizing pension cost alone is not the appropriate objective for firms to pursue: Firms should aim to minimize the market value of total compensation cost, not pension cost in isolation (holding the real activity of the firm constant),” the Fed study authors wrote. “We show that if workers understand the implications of pension risk, they will demand greater compensation for riskier pension promises than for safer ones, all else being equal. Thus while riskier pension promises may reduce pension cost, they do not reduce the total compensation cost of the firms in our model.”

The other half of the equation, according to the study, is tying their plan assets to their liabilities – to “(invest) those resources in fixed-income securities designed to deliver their payoffs just as pension obligations are coming due.”

The researchers wrote: “This strategy would immunize the pension fund from market fluctuations, because stock returns would be irrelevant and interest-rate changes would affect pension assets (through bond values) and liabilities (through the present value of future obligations) at the same time and by the same amounts,”

The study noted that only one U.S. firm made its pension promises close to risk-free: United Airlines invested its pension trust entirely in fixed income securities until a 1987 investment policy change. The researchers also cited the example of Boots Pharmaceutical in the U.K., which also held its pension trust entirely in fixed-income securities from 2001 to 2004, but has since partially backed away from that position (See    Boots Walks Away From UK Equities ).

The full report is    here .