Accounting Recognition And The Determinants Of Pension Asset Allocation

Accounting Recognition and the
Determinants of Pension Asset Allocation z
ELIAMIR*
SHLOMO
BENARTZI" zyxwv
* zyxwv
We identib and test motives for corporate pension asset allocations using
a proprietary usset allocation database covering the 1988-1994 period.
Wefocus on the question zyxwv
o
f whether the recognition of additional mini-
mum pension liability in accordance with zyxwv
SFAS No. 87 affects asset al-
location, Our results are consistent with the claim that companies allocate
their pension assets to avoid the recognition of an additional minimum
liability. In particular, companies that are close to the recognition thresh-
old prefer jixed-income investments rather than equity investments. By
investing infixed-income securities, firnis increase the correlation between
perisiori assets and liabilities, reducing the likelihood of a pension deficit.
Our results also suggest that firtiis allocate lheir pension assets between
equities and fixed-income investments to reduce the volatility of pension
contributions. Finally, we find that larger jirms and firnis with a young
workforce invest more in equity securities than infixed-income securities.
1. Introduction
Financing defined-benefit pension plans has always been a major decision for
many sponsoring corporations. While some firms allocate most of their pension
assets to equity securities, others allocate primarily to fixed-income securities. The
case of American Airlines provides a perspective on the magnitude of the asset
allocation issue, The airline has been gradually switching its pension asset alloca-
tion from bonds to stocks. Based on historical returns, the effect of this switch
represents an additional annual rate of return of 6 percent (Ibbotson [1997]),which
is equivalent to 131 percent of the corporation's 1995 net income. By comparison,
*Graduate School of Business, Columbia University, and the Recanati Graduate School of Man-
**The Anderson School at UCLA.
We thank Pen.riorts zyxwvutsr
arid Invesrrnenfsand Rynrt Lubs for sharing their data with us. We also thank
David Aboody, Zvi Bodie, Michael Brennan, Jeffrey Callen (the editor), Pat Hughes, Krishna Kumar
(the referee), Steve Lilien (the discussant), Rani Michaely, and Michael Williams and seminar partic-
ipants at the London Business School, Tel Aviv University, UCLA, and the 1998 JAAF Conference
for helpful comments. Eli Amir is grateful to the Israel Institute of Business Research at Tel Aviv
University for financial assistance. Shlorno Benartzi is grateful to CIBER for financial assistance.
agement, Tel Aviv University.
32 1

322 JOURNAL OF ACCOUNTING, AUDITING zyx
& FINANCE zy
for the Standard & Poor’s 500 firms (S&P zyxwv
500),6 percent of the aggregate pension
assets amounts to 20 percent of the aggregate 1995 net income.
This study investigates the allocation of pension assets between stocks and
bonds over fiscals 1988-94, during which Statement of Financial Accounting Stan-
dards (SFAS) No. 87, zyxwvut
Employers’ Accouritirigfor Pensions (FASB [1985]), was in
effect. This standard requires firms to disclose the fair value of pension assets and
the present value of the pension obligation in notes to the financial statements.
However, under certain conditions, the standard also requires firms to recognize
the unfunded accumulated benefit obligation (ABO) as an additional minimum
liability. Consequently, this study examines whether the method of providing in-
formation (recognition versus disclosure) affects pension asset allocation.
To illustrate how asset allocation can be used to avoid the recognition of
additional minimum pension liability, consider the following example. In 1987,
American Airlines had pension assets of $1.90 billion and accumulated pension
obligations of $1.70 billion. In early 1987, shortly prior to the effective date of
SFAS No. 87, the airline’s pension fund replaced most of its stocks and short-term
bonds with long-term bonds (Jereski [19871). After the change, the airline had
$1.75 billion in a bond portfolio whose duration was almost identical to that of the
$1.70 billion pension obligation. The remaining $0.15 billion was invested in
stocks. By choosing a pension portfolio that is highly correlated with the obligation,
the airline reduced the likelihood of the pension assets falling short of the obli-
gations and the likelihood of having to recognize an additional minimum liability.
In general, firms can reduce the likelihood of having to recognize an additional
minimum liability by choosing a portfolio of bonds that is highly correlated with
the pension obligation. Hence, the popular term “immunized bond portfolio.” In
contrast to bonds, the fluctuation of stocks relative to the pension obligation is
unpredictable, especially over relatively short periods. Thus, stocks cannot be used
to avoid the recognition of an additional minimum liability.
We also investigate how the following nonaccounting factors affect asset al-
location. First, is pension asset allocation affected by funding levels? If such a
relation exists, is it linear? Second, does the asset allocation decision depend on
the firm’s demographics? That is, do firms with a young workforce (and thus a
longer investment horizon) invest more in equity securities than firms with a rel-
atively mature workforce? Finally, do firms offset risk by choosing a portfolio with
a higher allocation to bonds and a lower allocation to stocks?
We use a proprietary asset allocation database covering the 1988-94 period to
explain cross-sectional variations in the percentage of pension assets allocated to
equities. We find that firms with a relatively high probability of recognizing an
additional minimum liability prefer fixed income securities to equities. This result
highlights the effect of pension recognition versus disclosure on pension asset al-
location. We also find that funding affects asset allocation in an inverted-U relation.
As we discuss in the next section, this result is consistent with firms choosing a
mix of stocks and bonds that reduces the volatility of pension contributions. In

PENSION ASSET ALLOCATION 323
addition, we find that firms with a young workforce and low risk prefer stocks to
bonds.
We proceed in Section zyxwvu
2 with a review of the relevant literature on pension
asset allocation as it applies to funding levels, firni demographics, risk, and the
recognition of additional minimum liability. Section 3 combines the explanatory
variables reviewed in Section 2 into an empirical model that we use to examine
motives for pension asset allocation. We also discuss our proprietary database,
sample selection, and variable definitions. In Section 4, we present descriptive
statistics on asset allocation and results that explain the cross-sectional variation in
the percentage allocated to equity securities. Section 5 summarizes the results. zy
2. Background and Predictions
2.1 Minimum Liability Recognition under SFAS No. 87
SFAS No. 87 requires the zyxwvu
disclosure of pension assets and obligations in foot-
notes to the financial statements. Under certain conditions, however, the statement
also requires the immediate recognition of a pension liability (FASB [1985, par.
36-38]). In particular, once the accumulated benefit obligation exceeds the fair
value of the plan assets, the firm must recognize the unfunded portion of the ob-
1igation.I To the extent that it has already recognized all or part of the unfunded
ABO as “accrued pension costs,” the zyxw
f
i
r
m must recognize only the difference
between the unfunded ABO and the accrued pension costs. Hence, the term “ad-
ditional minimum liability.”*
Once an additional minimum liability is required, it is important to identify
the source of the unfunded obligation. Portions of the unfunded obligation that are
driven by (I) ex post benefit increases (i.e., unamortized prior service costs) or hy
(2) an unfunded obligation that existed on the adoption date of SFAS No. 87 (i.e.,
unamortized transitional obligation) are recognized as a minimum liability against
an intangible asset. To the extent that the additional minimum liability exceeds the
sum of unamortized prior service cost and transition obligation, however, any re-
maining liability must be charged to shareholders’ equity. Unlike the measurement
of pension expense, where various smoothing mechanisms are built into SFAS No.
87, the minimum liability requirements are triggered immediately. Therefore, we
focus on the effect of pension accounting on the balance sheet rather than the effect
on net income.
To illustrate the minimum liability requirements, consider the following ex-
ample (also depicted in Table zyxwvu
1). As of December 3 zyxw
1, 1992,Westinghouse Electric
Corp. had a PBO of $4,957 million, which comprised an ABO of $4,568 million
based on current salary levels, plus a salary increase adjustment of $389 million.
I . The accumulated benefit obligation is based on current zyxwv
salary levels, whereas the projected
benefit obligation (PBO) is based on projected salary levels. Thus, the ABO is smaller than the PBO.
2. SFAS No. 87 also requires the disclosure of asset composition. However, SFAS No. 132 (FASE
[19981) eliminates this requirement (Amir and Benartzi [19981).

& FINANCE zy
TABLE zyxw
1
Pension Disclosure for Westinghouse Electric Corp.
(Dollars in Millions)
Pension Items I2/31/92 12/31/91
Accumulated benefit obligation $4,568 $4,774
Effect of salary increases 389 324
Projected benefit obligation 4,957 5,098
Market value of pension assets (4.265) (4,856)
Unfunded projected obligation 692 242
Unamortized actuarial losses ( I. 140) zyx
(643)
Unamortized prior service costs (7) (13)
Unamortized transition obligation -
(341) (450)
Accrued pension costs (prepaid) (796) (864)
Since the market value of the plan assets was $4,265 million, there was an
unfunded obligation of $692 million. However, deferred actuarial losses of $1,140
million, $7 million of prior service costs, and a transition obligation of $341 million
allow Westinghouse to recognize a zyxwvu
prepaid pension cost of $796 million in the
absence of the minimum liability provisions.
Minimum liability provisions require the recognition of the excess of the ABO
over the market value of the plan assets ($4,568 - $4,265 = $303 million). Since
the firm has actually recognized a prepaid pension assef of $796 million, the zy
ad- zy
ditional liability equals $1,099 million ($796 + $303). Of the $1,099 million min-
imum liability, $348 million are recognized as an intangible asset, because they
are associated with unamortized prior service costs and the transition obligation.
The remaining $751 million are charged directly to owners’ equity as other com-
prehensive income item (see SFAS No. 130, FASB [1997]). In this case, the min-
imum liability requirements resulted in a higher liability, lower owners’ equity and
lower comprehensive income. Also, the firm’s debt-to-equity ratio increased from
2.20 to 3.42.
Managers may consider recognition and disclosure as two distinct methods of
providing information for several reasons. First, the market places a higher weight
on items that are recognized rather than merely disclosed in notes to the financial
statements (Amir and Ziv [19971). Second, many debt covenants are negatively
affected by the explicit recognition of a liability on the balance sheet, although
they are unaffected by footnote disclosures. Third, recognition of a minimum lia-
bility increases the debt-to-equity ratio, which in turn may result in lower credit
rating for the firm. These arguments suggest that managers may attempt to mini-
mize the recognized pension liability by avoiding the minimum liability
requirement.
Managers can actually avoid the recognition of additional minimum liability
by choosing a different mix of stocks and bonds (Bodie [1990]; Brownlee and

PENSION ASSET ALLOCATION zyxwvu
325
Marshall [1994]). In particular, firms that invest in bonds have a high correlation
between the pension assets and obligations, which reduces the likelihood of facing
a pension deficit. Thus, a more conservative asset allocation (i.e., higher allocation
to bonds) ensures that the unfunded ABO does not cross the minimum liability
recognition threshold, if a bear market develops. To the extent that managers try
to avoid recognizing additional minimum liability, we would expect firms that are
close to the recognition threshold to invest more in bonds and less in stocks. Also,
we would expect firms with small debt covenant slack to invest more in bonds and
less in stocks.
2.2 Funding Levels
The deductibility of pension contributions for tax purposes induces companies
to prefund their pension plans. Firms that are subject to the highest tax rates have
the greatest incentive to fund their pension plans.3 Since returns on the pension
assets are not taxed, the assets should be invested in the most heavily taxed se-
curities, which are presumably bonds (Black [1980]; Tepper [1981]). On its own,
the tax argument suggests that all firms invest in bonds regardless of their funding
leveL4
As pension plans are insured by the Pension Benefit Guaranty Corporation
(PBGC), the firm shares the downside investment risk with the PBGC. Essentially,
the firm owns a put option on the unfunded pension obligation, which enables it
to avoid paying the pension obligations by giving the PBGC the plan assets plus
30 percent of the firm’s value. Harrison and Sharpe (1983) calculate the optimal
asset allocation in the presence of tax considerations and the PBGC put option.
They argue that the funding and asset-allocation decisions are joint and extreme.
Companies should either (1) overfund the pension plan and allocate all the assets
to bonds or (2) underfund and allocate all the assets to equities. The first strategy
maximizes the tax benefits, whereas the second one maximizes the value of the
PBGC put option. Although in practice the funding or asset-allocation decision is
rarely an extreme one, we expect a negative relation between funding levels and
allocations to equities.s
One caveat is that the value of the PBGC put option has declined over time.
In 1986, the PBGC changed its premium policy from charging firms a flat rate per
employee to a flat rate plus a variable rate per $1,000 of underfunding. Because
underfunded plans are charged higher premiums, the value of the PBGC option
3. Francis and Reiter (1987) find that funding ratios are positively associated with finance-related
incentives (tax benefits and capital availability) and negatively associated with labor-related incentives
(plan generosity and union power). They also find that financial reporting incentives, such as renego-
tiation costs that are associated with debt covenants, affect funding ratios.
4. lppolito (1990) challenges the tax-advantage of bonds in the pension portfolio after the Tax
Reform Act of 1986.
5. Bicksler and Chen (1985) show that interior asset allocation solutions can prevail once market
imperfections, such as pension termination costs, exist.

& FINANCE
has been substantially reduced. Therefore, the incentive to allocate pension assets
to equity securities to increase the return variance, which in turn increases the value
of the PBGC put option, may be of a second-order nature.
Bader (199 zyxwvu
1) offers a different approach to asset allocation management. He
argues that firms attempt to minimize the volatility of their pension contributions.
These contributions are fairly predictable for moderate funding levels, but less
predictable as funding levels become more extreme. Plans with deep deficits could
be subject to the accelerated funding requirements of zyxw
ERISA, whereas overfunded
plans could drift in and out of the maximum funding allowed by tax regulations6
To reduce the volatility of pension contributions, both extremely overfunded and
underfunded plans should invest in bonds, while only moderately funded plans
should favor equities. Bader’s (1991) argument predicts an inverted-U relation be-
tween funding levels and the percentage invested in equities. This is in contrast to
Harrison and Sharpe (1983), who predict a negative relation between funding levels
and equities.
The existing evidence on the association between funding levels and asset
allocation is mixed. Friedman (1 983) finds that the funding ratio has no noticeable
effect on asset allocation. However, Bodie et al. (1984) find a negative correlation
between the funding ratio and the percentage allocated to equities. It is plausible
that the conflicting evidence is a result of a nonlinear relation between funding and
asset allocation, a possibility that was ignored by earlier studies.
2.3 Firm Demographics and Investment Horizon
Firms may wish to match the assets and obligations of the pension fund be-
cause better matching reduces the likelihood of the assets falling short of the ob-
ligations, which in turn reduces the volatility of the pension contributions.The type
of assets that match the obligations depends on the investment horizon of the
pension plan. The obligations of plans that cover mostly retirees (i.e., short in-
vestment horizons) are mainly affected by interest rates. The assets that are most
correlated with interest rate fluctuations, and hence match the obligations, are
bonds. In contrast, the obligations of plans that cover young employees (i.e., long
investment horizons) are also affected by salary increases. Stocks are presumably
more correlated with salary increases than bonds.’ To match the pension assets and
obligations, plans with young employees should invest more in stocks and less in
6. The full funding limitation prevents firms from making tax-deductible contributions to over-
funded pension plans. The limit is 150 percent of the ABO averaged over the last four years.
7. We obtained annual salary growth rates from the Bureau of Labor Statistics, zyx
Bnploymeni zy
Cosrzy
Trend 01ihe Privaie Industry. In addition, we obtained annual stock and bond returns from Ibbotson
(1997). Using these data, we calculated the correlation between annual salary growth rates and annual
stock returns over the 1977-96 period. Using nominal rates, the correlation is -0.12. We also calculated
the correlation between annual salary increases and annual bond returns and found a correlation of
-0.32. It seems that while stocks do not provide a good hedge against salary increases, they serve zy
as
a better hedge than bonds. See also Bodie (1976) for a detailed discussion of stocks as a hedge against
inflation.

bonds. Consequently, we expect a positive correlation between investment horizon
and the percentage allocated to equitiesx zyxw
2.4 zyxwvutsr
Firm Risk
It has been argued that corporate risk management is not limited to the cor-
poration itself, but extends to the corporate pension fund as well. Consistent with
this view, Friedman (1983) documents a negative relation between firm risk, which
he measures as income variability, and the percentage of pension assets invested
in equities. Bodie et al. (1984) confirm Friedman’s results, finding a negative as-
sociation between bond ratings and equity allocations. It appears that firms tend to
offset high risk by investing more in bonds and less in stocks.
We interpret the relation between firm risk and pension asset in two ways.
First, companies with more diversified operations prefer to assume more risk in
their pension fund. To the extent that larger firms are more diversified, we would
expect a positive association between firm size and equity allocation. Second, off-
setting risk using the pension fund may reflect managers’ preference to avoid con-
tributing to the pension fund when operating cash flows are relatively low. One
way to avoid large swings in the required contributions is to match the pension
assets and obligations. In particular, firms with high risk can invest their pension
assets in a portfolio of bonds that has the same duration as the pension obligations.
Thus, we expect a negative relation between the variability of operating cash flows
and equity allocation.
3. Empirical Design
We test the four predictions stated above using a model that explains the
percentage of funds allocated to equities (%EQUITY). The effect of the minimum
liability on asset allocation is represented by two variables: ( I ) the effect of a down
market on the recognized additional minimum liability (MINLIAB) and (2) the
percentage effect of a down market on the debt-to-equity ratio (DEXFF). We use
the debt-to-equity ratio as a proxy for debt covenant slack (Press and Weintrop
[1990]). To test the effect of funding policy on asset allocation we include both
the funding ratio of the pension plan (FUNDING) and FUNDING’. While Harrison
and Sharpe (1983) predict a negative coefficient on FUNDING and a zero coeffi-
cient on FUNDING2,Bader (199I) predicts a negative coefficient on FUNDING2,
that is, an inverted U-shape relation. We also include the investment horizon of
the fund (HORIZON) and two risk variables-the volatility of operating cash flows
8. The British Rail pension fund provides an interesting illustration of the association between
investment horizon and asset allocation. The pension fund used to allocate two thirds of its assets to
stocks and one third to bonds. In 1994, the fund was carved into equal pieces for retirees and active
employees (Pensions and Investments zyxwvut
[19941). After the split, the retirees had 45 percent of their assets
in stocks and the active employees had 80 percent in stocks.

328 zyxwvutsrq
JOURNAL zyxwvu
OF ACCOUNTING, AUDITING zyx
& FINANCE
(o(CF)), and firm size (SIZE). We expect negative coefficients on MINLIAB,
D E X F F and o(CF) and positive coefficients on HORIZON and SIZE.
%EQUITY,, = zyxwv
a,,,+ a,,MIN-LIAB,, + a,, DE-EFF,,
+ a,, FUNDING;, + a.,, FUNDING,, (1)
+ a,, HORIZON,, + a6,o(CF),, + a,, SIZE,,+&,,
Equation (1) also includes industry controls based on either two-digit SIC
codes or the Sharpe (1982) classification (not reported). These industry controls
were statistically insignificant, and they did not affect the results. Finally, financial
disclosures regarding postretirement benefits may be significantly affected by the
selection of actuarial assumptions (Amir and Gordon [1996]). To control for ac-
tuarial effects, we estimate eq. zyxwv
(1) for companies with relatively high and low
pension discount rates, where a high discount rate is defined relative to the sample
median.
We obtain proprietary asset allocation data from surveys conducted by Pen-
sions and Investments in September of each year, covering the largest 1,000pen-
sion funds. When a firm sponsors several defined benefit pension plans, the
database reports the combined allocation of the different pension plans. Unlike
earlier studies that cover a single year (Friedman [19831; Bodie et al. [1984]), we
analyze asset allocation data over the 1988-94 period.’ Unfortunately, survey data
for years prior to 1988 are unavailable, which prevents us from analyzing asset
allocation behavior prior to the issuance of SFAS No. 87.
The Department of Labor Form 5500 filings, an alternative source that was
used by Friedman (1983), often omit asset allocation data. In particular, many firms
combine different asset categories into “pooled funds,” which makes it difficult
to determine the exact mix of stocks and bonds. Therefore, we use the Pensions
and Investment (1988-94) survey data.
To be included in our sample, the sponsor had to satisfy the following criteria.
First, the sponsor had to be a publicly traded corporation with complete asset
allocation data. As indicated in Table 2, we obtain complete asset allocation data
for between 288 and 357 publicly traded corporations per year, yielding 2,263
observations over the sample period. Many of the pension funds surveys by Pen-
sions and Investments were omitted because they are sponsored by private firms,
unions, and government entities rather than by publicly traded corporations. Sec-
ond, to increase the power of our tests, we deleted 238 observations of corporations
that listed more than zyxwvu
5 percent of their pension assets as “unclassified” (2,025
observations). Third, to ensure that asset allocation data and financial data are
measured over the same period, we limited our sample to June through December
fiscal year-end, three months around the measurement of asset allocation ( I ,750
9. The considerable variation in interest rates and stock prices during the sample period (1988-
94) has a significant effect on the funding ratio of the pension plan. Simulations we conducted show
that it is typical for a pension plan to fluctuate between 20 percent underfunding and 10 percent
overfunding.

PENSION ASSET ALLOCATION
TABLE zyxw
2
Sample Selection
329 zy
~~ zyxwvutsrqponmlkjihgfedcbaZ
Selection Criterion 1988 1989 1990 1991 1992 1993 1994 All
Public corporations that completed
the Pensions and Investments survey
of asset allocation
Less than zyxwvutsr
5% of the assets are
unclassified
June through December fiscal year-
end
Complete Compustat data (pension
assets and liabilities. actuarial
assumptions, positive book value of
equity, and current and past
earnings)
288
274
220
167
323
286
261
193
343
31I
274
201
326
297
269
144
357
309
250
145
294
254
218
I37
332
294
258
156
2,263
2,025
1,750
1.143
The industry distribution of the total sample is as follows: ( I ) basic industries, 153; (2) capital
goods, 144; (3) construction, 34; zyxwvu
(4)consumer goods, 353; (5) energy, 52; (6) finance, 49; (7) trans-
portation, 72; (8) utilities, 286. The sample consists of 368 distinguishable firms.
observations). Finally, the necessary Compustat data on the sponsoring firm also
needed to be available (I, 143 observations).'"
To measure the firm's sensitivity to the recognition of an additional minimum
liability, we adopt an approach consistent with the one taken in SFAS No. 106
(FASB [1990]). In that standard, the FASB requires companies to disclose the
effect of a one percent change in the health care cost trend rate on the postretire-
ment benefit liability. Similarly, we calculate the (hypothetical) effect of a signif-
icant decline in the market value of pension assets on the magnitude of the
additional minimum liability (MINLIAB). Firms whose reported liabilities are
very sensitive to down markets may invest their plan assets conservatively to avoid
the recognition of additional minimum liability. By contrast, firms whose reported
liabilities are insensitive to market movements may invest their plan assets ag-
gressively to achieve long-term growth. Thus, we expect a negative correlation
between MINLIAB and %EQUITY.
To calculate the MINLIAB variable we first record the additional minimum
liability that is recognized in the financial statements. Then, assuming that the
10. The specific Compustat items required are (in parentheses): industry classification, at least 5
years of earnings (18) data over the preceding 10 years, common shares outstanding (25). positive book
value of equity (60). total liabilities (181). share price (199). pension discount rate (246), ABO (285
plus '293). PBO (286 plus 294). pension assets at fair value (287 plus 296). accrued pension costs (290
plus 300). unamortized prior service costs (288 plus 297). zyxwv
salary growth rate (335). and cash flows
from operations (308). Prior to 1987. we construct cash from operations as funds from operations (1 lo),
minus the change in current assets (4). plus the change in current liabilities zyxw
(5).plus the change in cash
( I ), minus the change in the current portion of long-term debt (34).

330 zyxwvuts
JOURNAL OF ACCOUNTING, AUDITING zyx
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market value of plan assets declines by 30 percent, we recalculate the additional
minimum liability.'' If the ABO is smaller than the plan assets remaining after the
30 percent decline, the additional minimum liability is set to zero. Otherwise, if
the ABO is greater than the remaining plan assets, the additional minimum liability
is set equal to the difference between the ABO and the sum of the plan assets and
the accrued pension cost, providing that this difference is positive. Furthermore,
we calculate the change in the additional minimum liability before and after the
30 percent market decline. This change is calculated separately for underfunded
and overfunded plans, and then the changes are summed together. Finally, we
deflate the change in the additional minimum liability by the beginning of the
period ABO to control for the size of the pension plan.
The variables MINLIAB and FUNDING are highly correlated (Pearson =
-0.65 and Spearman = -0.79). Nevertheless, firms with underfunded pension
plans may still be far from recognizing an additional minimum liability. For ex-
ample, Procter and Gamble reported a funding ratio of 0.716 at the end of 1994.
Yet, the company could have lost 25 percent of its plan assets without recognizing
an additional minimum liability.
To measure the effect of minimum liability recognition on debt covenant slack,
we first calculate the debt-to-equity ratio without minimum liability. Then, using
the procedure described above, we calculate the debt-to-equity ratio assuming
a 30 percent decline in the market value of pension assets. Finally, we calculate
the percentage change in the debt-to-equity ratio resulting from a market decline
We calculate funding levels (FUNDING) as pension assets divided by the
ABO. To mitigate the effect of cross-sectional differences in discount rates used
to measure the ABO, we multiply the ABO by the assumed discount rate and divide
it by the yield on long-term government bonds (Ibbotson [1997]). To reduce the
effects of outliers, we set values greater than zyxwv
2.5 to 2.5.12
Since data on the pension funds' investment horizons are not publicly avail-
able, we estimate HORIZON as the number of years to retirement:
( D E I F F ) .
HORIZON,, = log(PBO,,/ABO,,)/Iog( I + g,,), zyx
(2)
where PBO and ABO are the projected and accumulated pension obligation, re-
spectively, and g is the assumed salary growth rate. The construction of HORIZON
is based on the following rationale. Consider the pension as an obligation to pay
$1 in perpetuity starting N years from today, where N represents the number of
years to retirement. The present value of the pension payments based on current
salary levels and a discount rate r (i.e., the ABO) is [I/(] + r)N * (l/r)],and the
present value based on future salary levels (i.e., the PBO) is [(l + zy
g)N/(l + z
1 1 . An assumed 30 percent decline is arbitrary. We repeated our tests with 20 percent and 40
12. We also used a multivariate approachto mitigate the effect of outliers. Specifically,we deleted
percent declines obtaining similar results.
observations with a studentized residual above 2 in absolute value and obtained similar results.

PENSION ASSET ALLOCATION 33 zy
1
r)” zyxwvuts
* (Ilr)]. The ratio of PBO to ABO is (1 + g)”, and solving for zyx
N yields the
measure in eq. (2).
We use the volatility of operating cash flows as a proxy for risk (o(CF)).This
variable is defined as the standard deviation of operating cash flows over the pre-
ceding 10 years, deflated by the book value of equity. We exclude observations
with negative book values of equity, and we set values greater than 0.5 to 0.5 to
reduce the effect of outliers. We also use the logarithm of the firm’s market value
of equity in millions at fiscal year-end, SIZE, as an additional measure of firm risk.
4. zyxwv
Results
4.1 Descriptive Statistics
At the end of 1994, defined benefit pension plans allocated 59.77 percent of
their assets to stocks, 35.63 percent to fixed income securities and the remaining
4.60 percent to other types of investments (Table 3). This asset allocation is close
to the 60/40 mix of stocks and bonds often used by practitioners as a benchmark.’?
Over our sample period, the allocation to stocks increased by roughly ten percent-
age points, reflecting the long bull market.I4 The allocation to international stocks
tripled from 2.13 percent to 6.58 percent, reflecting increased investment
globalization.
The dependent variable in our analysis is the percentage of pension assets
allocated to domestic and international stocks (%EQUITY). However, the distinc-
tion between stocks and bonds may be difficult due to the use of derivative secu-
rities. As Bodie (1990, p. 32) points out, a company may convert stocks to bonds
by writing covered call options. Moreover, 41 percent of the plan sponsors in our
sample report that they use derivatives. Our main concern is that %EQUITY may
be measured with error due to the use of derivatives.
Therefore, we compute the asset allocation of plan sponsors that do not use
derivatives. For this subsample, the average portfolio has 58.93 percent in stocks,
36.12 percent in fixed-income securities, and 4.95 percent in other types of in-
vestments. Clearly, the asset allocation for this subsample is almost identical to
that of the overall sample. Nonetheless, we executed all of our tests using only
plan sponsors that refrain from using derivatives and obtained similar results to
those of the overall sample.
Table 4, panel A, presents the cross-sectional distribution of %EQUITY by
year. %EQUITY varies significantly across firms with a standard deviation of 16.09
percent for the pooled sample. However, only a few firms select an extreme allo-
cation of either 100 percent stocks or 100 percent bonds. Most choose a mix of
13. Arnbachtsheer (1987) and Benartzi and Thaler (1995, 1998)offer alternative explanations for
14. The average allocation to equities in 1980 zyxwv
w
a
s 46.4 percent (Bodie et al. [1984]).
the 60/40 mix.

332 zyxwvutsr
JOURNAL OF ACCOUNTING, AUDITING zyx
& FINANCE
TABLE 3
The Average Composition of Pension Assets by Year
Asset Category 1988 1989 1990 1991 1992 1993 1994 All
(Observations) (167) (193) (201) (144) (145) (137) (156) (1,143)
Cash equivalents
Domestic bonds
International bonds
Guaranteed invest.
Contracts
Annuities
Total fixed income
Domestic stocks
International stocks
Total stocks
Real-estate equity
Mortgages
Mortgage-backed securities
Oil & gas partnerships
LBOs
Venture capital
Private placement
Unclassified
Total other
Grand total
1I .72%
26.22
0.29
4.02
0.57
42.82
48.5 zyxwvut
1
2.13
50.64
4.90
0.28
0.50
0.01
0.04
0.56
0.10
0.15
6.54
100.00
9.11%
28.28
0.42
3.96
0.52
42.29
49.89
2.75
52.64
4.00
0.14
NIA
0.02
0.1I
0.50
0.08
0.21
5.06
100.00
10.28% 5.90%
29.58 30.51
0.40 0.28
4.10 16.5
1.25 063
45.61 38.97
45.55 52.55
3.13 3.51
48.68 56.06
4.25 3.65
0.49 0.35
N/A NIA
0.03 0.05
0.09 0.10
0.50 0.48
0.11 0.13
0.22 0.22
5.69 4.98
100.00 100.00
4.82% 4.15%
32.76 31.07
0.34 0.50
209 1.8.5
0 39 0.68
40.40 3825
51.28 53.03
3.94 4.90
55.22 57.93
3.31 2.71
0.35 0.27
NIA NIA
0.00 0.01
0.01 0.01
0.34 0.39
0.02 007
0.29 0.3.5
4.38 3.81
100.00 100.00
4 23%
28 60
0 66
165
0 49
35 61
5’3 19
6 58
59 77
2 83
0 92
NIA
0 01
0 06
0 44
0 03
0 11
4 60
100 00
149%
29 41
0 41
2 90
0 61
40 90
SO 26
3 7s
54 02
3 74
0 40
0 07
0 02
0 07
0 46
0 08
0 2s
5 09
10000
Asset categories may not be identical across time. resulting in missing (N/A) values.
stocks and bonds. This is in contrast to Harrison and Sharpe (1983) who argue that
all firms should select an extreme allocation.
To examine the frequency of asset allocation revisions, we calculate changes
in %EQUITY over one, two, and three years (nonoverlapping periods). Most firms
maintain a constant allocation to stocks (Table 4, panel B). Over a one-year period,
more than 80 percent of the firms remained within 10 percentage points of their
beginning allocation to stocks. Over a three-year period, 80 percent of the firms
decreased their allocation to stocks by less than 4 percent, or increased it by less
than 16 percent. Given the stability of equity allocation over time, we focus on
cross-sectional differences in asset allocation rather than time-series changes.Is
We also investigate whether the allocation to equities is mean reverting. We
15. Technically, OLS may not be the best estimation procedure because %EQUITY is limited to
a [O,I] range. We reestimated our multivariate regression using a logistic transformation of the %EQ-
UITY variable. The results are not sensitive to this transformation.

PENSION ASSET ALLOCATION 333 zy
TABLE zyxw
4
The Distribution of Equity Investments zyx
Pariel zyxwvutsrq
A: The distribution of equity investments by year
Statistic 1988 1989 1990 1991 1992 1993 1994 All
(N) (167) (193) (201) (144) (145) (137) (156) (1,143)
Mean 50.64% 52.64% 48.68% 56.06% 55.22% 57.93% 59.78% 54.02%
Std. deviation 16.13 16.33 18.34 13.52 14.58 14.92 1454 16.09
Minimum 0.00 0.00 0.00 7.00 0.00 0.00 2.00 0.00
10th percentile 30.00 34.00 25.00 37.00 35.00 40.00 40.00 33.00
Median 52.00 55.00 51.00 59.00 57.00 59.00 62.50 57.00
90th percentile 68.00 70.00 67.00 70.00 70.00 73.00 74.00 71.00
Maximum 88.00 100.00 100.00 90.00 95.00 85.00 95.00 100.00
Panel B: The distribution of changes in equity investments
Statistic Annual Changes Two-Year Changes Three-Year Changes
(N) (614) (270) zyxw
(165)
Mean I .75%
Std. Deviation 9.40
Minimum -58.00
10th percentile -6.00
Median I .oo
90th percentile 9.00
Maximum 62.00
4.09%
12.58
-67.00
-6.00
3.oo
I5.oo
61.00
5.16%
9.96
-23.00
-4.00
4.00
16.00
50.00
Equity investments are the percentage of pension assets allocated to domestic and international
equities. Changes in equity investments are based on nonoverlapping periods.
begin by forming quintiles according to the equity allocation in 1988. The number
of observations decreases over time, because some firms that participated in the
1988 survey did not participate in subsequent surveys. Next, we examine the equity
allocation of the top and bottom quintiles. An increase in the equity allocation of
the bottom quintile and a decrease in the equity allocation of the top quintile would
indicate mean reversion.
To ensure that the results are not driven by a shift in the overall distribution
of equity allocations, we rank firms in two different ways. In panel A of Table 5,
we rerank equity allocations into quintiles each year. We use this analysis as a
benchmark to detect an overall shift in the distribution. In panel B of Table 5, we
rank equity allocations into quintiles once in 1988.
The results suggest that over our sample period there was a shift in the distri-
bution of all quintiles toward a higher equity allocation (panel A). For example,
firms in the bottom quintile increased their equity allocation from 24.91 percent in
1988 to 42.62 percent in 1994, whereas firms in the top quintile increased their

& FINANCE zy
TABLE 5
Mean Allocation to Equities by Quintiles
Quintile of 1988 1989 1990 1991 1992 1993 1994
Equity Investments (N = 167) zyxwvu
(N = 103) (N = 96) (N = 76) (N = 68) (N = 62) (N = 68) zy
f m e l zyxwvutsrq
A: Equity investments ranked again every year
I (less equities) 24.91% 32.40% 25.68% 35.93% 34.08% 31.00% 42.62%
2 45.97 48.33 45.22 51.31 50.79 5364 55.21
3 52.29 54.47 54.1I 58.33 59.50 61.47 63.60
4 59.78 60.60 61.48 64.38 65.00 68.67 69.62
5 (more equities) 69.61 70.70 71.16 75.71 73.50 74.92 77.31
All 50.64 53.57 51.80 56.91 57.07 58.18 61.63
fariel E: Equity investments ranked in 1988 only
I (less equities) 24.91 38.18 39.30 43.06 44.33 41.07 50.33
2 45.91 48.52 44.06 51.00 51.46 58.00 57.14
3 52.29 55.26 51.93 56.47 57.09 62.56 61.17
4 59.78 61.91 60.43 60.64 63.36 64.30 65.75
5 (more equities) 69.61 67.65 6400 71.39 68.80 68.73 74.20
All 50.64 53.57 51.80 56.91 57.07 58.18 61.63
Equity investment is the percentage of pension assets allocated lo domestic and international
equities. The number of firms decreases over time because many of the firms included in the 1988
Pensions and Investments survey were not included in the subsequent surveys.
equity allocation from 69.61 percent to 77.31 percent over the same period. We
also find some evidence of mean reversion in equity allocation. When forming
quintiles based on 1988 allocations without subsequent reclassifications, firms in
the bottom quintile increased their equity allocation from 24.91 percent in 1988 to
50.33 percent in 1994 (panel B). While the increase from 24.91 percent to 42.62
percent is attributed to the overall shift in the distribution, we attribute the addi-
tional increase to 50.33 percent to mean reversion in equity allocation. Similarly,
firms in the top quintiles increased their equity allocation from 69.61 percent to
74.20 percent. While the increase to 77.31 percent is attributed to the overall trend,
we attribute the decrease to 74.20 percent to mean reversion. Clearly, most of the
intertemporal changes in equity allocations are due to an overall shift in the dis-
tribution; much less is driven by mean reversion. As firms hardly change their
equity allocation beyond the overall trend, our %EQUITY measure represents the
long-term asset allocation.
Table 6 provides means and standard deviations for the regression variables
by year. The effect of a hypothetical 30 percent decline in the plan assets on the
additional minimum liability (MINLIAB) increased over the sample period from
an average of 6 percent of the ABO in 1988 to an average of 16 percent in 1994.
This variable varies significantly across firms. About a quarter of the firms are
unaffected by the 30 percent drop, whereas another quarter of the firms recognize
an additional minimum liability that is more than 20 percent of the ABO (not

TABLE 6 zyxw
Descriptive Statistics on the Regression Variables by Year
Variable 1988 1989 1990 1991 1992 1993 1994 All
“1 Statistic (167) (193) (201) (144) (145) (137) (156) (1,143)
%EQUITY
MIN-LI AB
DIE-EFF
FUNDING
FUNDING’
HORIZON
o(CF)
SIZE
Mean 50.64
STD 16.13
Mean 0.06
STD 0.08
Mean 0.12
STD 0.70
Mean 1.50
STD 0.4I
Mean 2.42
STD I31
Mean 4.00
STD 3.07
Mean 0.12
STD 0.09
Mean 3.30
STD 0.50
52.64 48.68
16.33 18.34
0.06 0.10
0.08 zyxwvu
0.1I
0.07 0.1I
0.20 0.49
1.41 1.35
0.37 0.35
2.14 I 9 3
1.15 1.07
3.83 3.71
2.63 2 34
0.12 0.1I
0.09 0.08
3.39 3.31
0.49 0.49
56.06 55.22
13.52 14.18
0.08 0.1I
0.11 0.13
0.07 0.1I
0.20 0.24
1.26 1.20
0.31 0.33
1.70 1.55
0.92 0.89
3.60 3.49
1.97 1.67
0.12 0.13
0.10 0.12
3.42 3.35
0.48 0.54
57.93 59.78 54.02
14.92 14.54 16.09
0.16 0.16 0.10
0.12 0.13 0.12
0.30 0.27 0.14
0.91 0.81 0.57 zy
1.1 I 1.19 1.30
0.32 0.32 0.37
1.33 1 53 1.83
0.91 0.91 1.10
3.50 3.17 3.63
1.84 1.51 2.26
0.13 0.11 0.12
0.13 0.1I 0.10
3.45 3.39 3.37
0.46 0.51 0.50
Variable definitions:
%EQUITY = The percentage of pension assets invested in domestic and international equities.
MIN-LIAB = The effect of a 30% drop in the plan assets on the additional minimum liability
divided by the accumulated benefit obligation.
D/E_EFF = The percentage change in the debt-to-equity ratio as a result of a 30% decline in
the market value of pension assets.
FUNDING = The ratio of pension assets’ fair value to ABO, adjusted for a common discount
rate (values above 2.5 are set to 2.5).
HORIZON = The number of years to retirement, measured as log(PBO/ABO) divided by
log(l + zyxwvu
g). where g is the assumed salary growth rate.
a(CF) = The standard deviation of cash flows (earnings before extraordinary items plus
depreciation expense) over the preceding 10 years, deflated by the book value of
equity. Values above 0.5 are set to zyxwvu
0.5.
= The log of the market capitalization of the firm.
SIZE
reported in a table). We also computed the effect relative to owners’ equity (also
not reported in a table). Over the 1988 to 1994 period, the average effect of a 30
percent decline in the market value of plan assets on the additional minimum
liability increased from 4 percent of owners’ equity in 1988 to 10 percent in 1994.
The number of firms that actually recognized an additional minimum liability
varies from 35 in 1989 to 51 in 1994. For these firms, the average additional
minimum liability as a percentage of owners’ equity varied from 2.52 percent in

& FINANCE
1989 to 10.70 percent in 1993. The magnitude of the reported additional minimum
liability, however, understates recognition considerations. Firms can “manage” the
recognition of additional minimum liability by choosing conservative investment
strategies. Hence, our MINLIAB variable focuses on the potential recognition of
additional minimum liability in the event of a market decline, rather than the re-
ported minimum liability.
The minimum liability requirements may have a significant effect on the debt-
to-equity ratio. Our calculation indicates that a 30 percent decline in the market
value of pension assets may result in an increase in the debt-to-equity ratio of 30
and 27 percent in 1993 and 1994, respectively. Over the entire sample period, a
30 percent decline in the market value of pension assets may increase the debt-to-
equity ratio by 14 percent, on average.
The average funding ratio (FUNDING) decreased from 1.50 in 1988 to 1.19
in 1994, reflecting tighter full-funding limits imposed by the tax authorities that
resulted in smaller pension contributions (Pensions and Investments Age [19891;
Bader [1991]). The average investment horizon (HORIZON) was 4 years in 1988,
decreasing to 3.17 in 1994. At first, this average seems low. However, many of
the plan participants had already retired; for these retirees, the ABO and the PBO
are virtually identical and HORIZON is set to zero. The low HORIZON may also
be the result of switching younger employees from defined benefit to defined con-
tribution plans. In 1980, for example, 16 percent of the participants in retirement
plans reported that their primary plan was a defined contribution one. By 1993,
that number rose to 42 percent and it keeps rising (EBRI [1997]). Finally, we
observe that o(CF) and SIZE exhibit stability over the sample period.I6 zyx
4.2 The Determinants of Pension Asset Allocation
In Table 7, we examine the relation between each of the explanatory variables
and %EQUITY, using a nonparametric portfolio analysis. Each independent vari-
able is divided into five equal-size portfolios, where portfolio 1 (5) contains firms
with the lowest (highest) values. To avoid clustering of a given year in one of the
portfolios, the portfolio classification is done on a year-by-year basis. This analysis
provides an opportunity to communicate and interpret our main results in a rela-
tively simple and intuitive manner.
The effect of a market decline on the additional minimum liability (MIN-
LIAB) is statistically significant in explaining the allocation to equities. Firms with
the largest effect on the additional minimum liability allocate 49.94 percent to
equities, whereas firms with the smallest effect on the additional minimum liability
allocate 56.42 percent to equities zyxwvu
(t = -4.25). A similar result is obtained with
D/E_EFF. Companies for which the effect of the minimum liability requirement
on the debt-to-equity ratio is low allocate 55.05 percent to equities. In contrast,com-
16. Except for the high correlation between MINLIAB and FUNDING (Pearson = zyx
-0.65, Spear-
man = zyxwvuts
-0.79), pairwise correlations between the explanatory variables are mild.

PENSION ASSET ALLOCATION
TABLE 7
Mean Equity Investments by Quintile of the Independent Variable
(1,143 Observations 1988-94) zyx
337 zy
Quintile of the Independent Variable
t Test for
Quintiles
Independent Variables
Used to Form Quintiles (Low) zyxwvu
1 2 3 4 5 (High) 5 versus 1
MlN-LIAB
D/E-EFF
FUNDING
HORIZON
SIZE
o(CF)
56.42
55.05
50.95
50.26
54.27
50.41
55.66 55.14 52.91 49.94 -4.25
55.91 54.16 54.58 50.72 -2.80
52.19 55.98 57.38 52.92 1.19
55.04 53.71 53.64 57.41 4.99
55.18 55.10 55.27 50.21 -2.61
54.85 52.52 53.94 58.32 5.66
Quintiles of the in-.pendent variat ~ s are formed by year. The independent variables are defined
as follows:
D U F F = The percentage change in the debt-to-equity ratio as a result of a 30%decline in
HORIZON = The number of years to retirement. measured as log (PBO/ABO) divided by log
(1 + g), where g is the assumed salary growth rate.
a(CF) = The standard deviation of cash Rows (earnings before extraordinary items plus
equity. Values above 0.5 are set to 0.5.
S I E
panies for which the effect of the minimum liability requirements on the debt-to-
equity ratio is high allocate only 50.72 percent to equities. The difference between
the two portfolios is significant at the 0.01 level zyxw
( t = 2.80).
These results are consistent with firms’ attempts to avoid the recognition of
an additional minimum liability. In particular, firms that are closer to the recog-
nition threshold select a relatively high allocation to bonds, which are highly cor-
related with the pension obligations. As a result, the pension assets and the
obligations are matched and the likelihood of crossing the minimum liability rec-
ognition threshold is reduced.
The relation between the funding ratio of the pension plan (FUNDING) and
equity allocation is consistent with an inverted U-shape. The allocation to equities
increases monotonically from 50.95 percent for the first quintile to 57.38 percent
for the fourth quintile, and then it decreases to 52.92 percent for the fifth quintile.
We also find a positive association between investment horizon and equity allo-
cation. Pension plans with a short investment horizon allocate 50.26 percent to
equities, whereas plans with a long horizon allocate 57.41 percent (t = 4.99). This

& FINANCE
behavior is consistent with attempts to match the pension assets and obligations,
subject to the employees’ age. In particular, consistent with Ambachtsheer ( I987),
pension plans with a short horizon hedge against interest rate fluctuations by choos-
ing bonds, whereas plans with a long horizon hedge against future salary increase
by choosing stocks.”
Risk, which is measured as the variability of operating cash flows (o(CF)),is
also statistically significant in explaining the allocation to equities. Firms with sta-
ble operating cash flows allocate 54.27 percent to equities, whereas firms with
volatile operating cash flows allocate 50.21 percent to equities zyxw
( t = -2.61). This
finding suggests that firms with volatile operating cash flows invest in bonds to
match their pension assets and obligations, which in turn reduces the likelihood of
having to make a large contribution when operating cash flows are low. Finally,
we find that large firms allocate more funds to equities than small firms. In partic-
ular, the smallest quintile of the firms in our sample allocate 50.41 percent to
equities, while the largest quintile allocate 58.32 percent to equities zyx
(t = 5.66).
Table 8 presents estimation results for eq. ( I ) for the entire sample and for
two subsamples-companies with high and low pension discount rates. To avoid
overstatement of the t statistics, each regression includes only one observation per
firm. Specifically, we replace the multiple observations per firm with the time-
series average of the dependent and independent variables. Furthermore, to alleviate
concerns about multicollinearity between MINLIAB and FUNDING, we report
several specifications for each sub-sample.
The relation between MINLIAB and %EQUITY is negative, as expected. This
coefficient is significantly smaller than zero at the 0.05 level (one-tailed test) for
the total sample and for the subsample of companies with below-median pension
discount rates. However, this coefficient is not significant for companies with rel-
atively high discount rates. This result is consistent with the claim that companies
avoid minimum liability recognition by selecting a more conservative pension port-
folio. However, companies with low discount rates exhibit a stronger relation be-
tween MIN-LIAB and %EQUITY, perhaps because these companies were unable
to increase their pension discount rates further to reduce the effect of the minimum
liability requirement.
17. One concern with regard to the HORIZON variable is flat benefit plans, in which payments
are determined by years in service rather than by salary levels. For these plans, the ABO and the PBO
are identical. Accordingly. the HORIZON variable is set to zero even though the employees are possibly
young. To overcome this concern, we compute an alternative measure of investment horizon, using
data on postretirement benefits other than pensions. SFAS No. zyxw
106 requires firms to report zyx
a breakdown
of the postretirement obligations by retirees, fully eligible active employees and other active employees
(FASB [1990]). We use the portion of the total postretirement obligations that is attributed to other
active employees (ACTIVE) as a proxy for investment horizon. A high value of ACTIVE is associated
with a young workforce and a long investment horizon. We repeated the portfolio analysis with the
ACTIVE variable replacing our HORIZON variable. Consistent with our reported results, firms whose
postretirement obligations are attributed to retirees (low ACTIVE) allocate 5 Izyxwv
.58 percent to stocks,
whereas firms whose postretirement obligations are attributed to active employees (high ACTIVE)
allocate 58.50 percent to stocks (significant at the 0.05 level).

TABLE 8
The Determinants of Pension Funds’ Allocations to Equities:
Multivariate Regressions zyxw
Min-Liab D/E-EFF FUNDING FUNDING’ HORIZON o(CF) SIZE
Adj. zyxwvutsr
R’ [-I [-I [+I [-I [+I [-I [+I
(N) zyxwvutsrqp
(0 (0 (0 (t) ( 0 (0 (0 zy
Panel zyxwvutsrq
A:
0.06
367
0.07
367
0.08
367
0.08
367
All observations
-21.70
-2.57
-1.44
-1.19
-20.82
- I .92
- 19.92 - 1.27
-1.83 -1.05
Pnriel B: Below-median discount rates
0.05 -32.50
183 -2.21
0.05 4.81
183 0.59
0.08 -43.37
I83 -2.35
0.08 -52.66 12.36
183 -2.70 1.45
Panel C:
0.06
I84
0.12
I84
0.12
184
0.12
I84
Above-median discount rates
- 14.84
-1.43
-I .83
- I .56
-5.42
-0.42
-5.17 -1.83
-0.40 -1.55
43.63
3.42
34.20
2.43
32.17
2.26
48.66
2.30
21.88
0 97
25.39
1.13
60.37
3.42
61.78
3.19
57.07
2.93
-15.10
-3.52
- 12.92
-2.8’1
- 12.29
-2.71
-16.54
-2.45
-9.98
-1.44
- I I .oo
- 1.59
-21.51
-3.50
-22.12
-3.43
-20.71
-3.20
-0.16
-0.42
0.45
1.17
0.28
0.71
0.24
0.60
0.20
0.34
1.45
2.30
0.88
1.37
1.oo
1.55
-0.61
-1.21
-0.39
-0.81
-0.37
-0.74
-0.44
-0.89
-15.1 I 5.06
- 1.73 3.26
-8.37 4.67
-0.91 3.04
-12.20 4.87
-1.38 3.18
-9.38 4.81
-1.01 3.13
-12.61 5.17
- 1.00 2.11
-12.1 1 4.62
-0.89 1.89 zy
-14.11 4.97
- 1.08 2.04
-19.86 5.19
-1.456 2.14
-19.45 5.18
-1.61 2.63
-4.15 5.22
-0.32 2.74
-12.14 5.33
- 1.01 2.78
-3.97 5.25
-0.30 2.75
OLS estimates for six pooled regressions, where each firm is represented by the time-series average
of the dependent and independent variables ( k , one observation per firm). The dependent variable is
%Equity, predictions for the coefficient estimates are provided in brackets.
Variable Definitions:
%EQUITY = The percentage of pension assets invested in domestic and international equities.
D/EEFF = The percentage change in the debt-to-equity ratio as a result of a 30% decline in
HORIZON = The number of years to retirement, measured as log (PBO/ABO) divided by log
(1 fg). where g is the assumed salary growth rate.
o(CF) = The standard deviation of cash flows (earnings before extraordinary items plus
equity. Values above 0.5 are set to zyxwvu
0.5.
S I E

& FINANCE
When we add the percentage effect of a down market on the debt-to-equity
ratio ( D E X F F ) to the model its coefficient is negative as expected. However, the
coefficient is not statistically significant. The coefficient on MINLIAB remains
negative and significant at the 0.05 level (one-tailed test).
FUNDING and %EQUITY exhibit an inverted-U shape relation. The coeffi-
cient on FUNDING* is negative in all specifications and significant at the 0.05
level or better in the total sample and for firms with relatively high discount rates.
The coefficient on FUNDING is positive in all models and significant at the 0.05
level or better in the total sample and for companies with high discount rate.Ix
Consistent with Bader's (1991) argument, the results suggest that extremely over-
funded and underfunded pension plans prefer bonds to stocks, perhaps to match
the pension assets and obligations. This behavior potentially minimizes the vola-
tility of pension contributions, as underfunded plans avoid the accelerated funding
requirements and overfunded plans avoid crossing the full-funding limits. Dividing
the coefficient on FUNDING by twice the coefficient on FUNDING2 indicates that
the highest allocation to equities occurs around a funding ratio of I .3. Interestingly,
the maximum allocation to stocks is obtained between the accelerated funding
threshold (i.e., FUNDING < 1.00)and the full funding threshold (i.e., FUNDING
> ISO), which provide some credence to this result.
Notice that the coefficients on FUNDING and FUNDING2 are smaller for
companies with below-median discount rates. There are two reasons for this inter-
esting finding. First, the lower coefficient could be a consequence of the high
correlation between MINLIAB and FUNDING. Indeed, when MINLIAB is omit-
ted from the model, the coefficient on FUNDING (48.66, zyxw
t = 2.30) increases and
becomes significant at the 0.01 level (one-tailed test). However, even without
MINLIAB, the relation between %EQUITY and FUNDING is flatter for com-
panies with below-median discount rates than for companies with above-median
discount rates (48.66 versus 60.37 and - 16.54 versus -2 1.5 zyx
I). The reason for this
finding is that companies with lower discount rates are simply more overfunded
than companies with high discount rates. The average FUNDING for companies
with below-median (above-median) discount rates is 1.44 ( I . 17) suggesting that
companies with high funding ratios afford a lower discount rate and at the same
time allocate their funds taking into account potential adverse financial conse-
quences (i.e., minimum liability recognition). In contrast, companies with relatively
low funding ratios increase the pension discount rate and allocate their funds to
decrease the potential volatility of pension contributions caused by the closeness
of the pension fund to the accelerated funding requirements. These companies tend
to ignore the financial consequences of their pension asset allocation, as reflected
by the insignificant coefficients on MINLIAB.
Firms with stable cash flows have, on average, a higher equity allocation than
18. If FUNDING' is omitted from the model, the coefficient zyxw
on FUNDING becomes negative
and significant at the 0.01 level in the pooled model.

firms with volatile cash flows, which is consistent with efforts to offset high risk.
However, the coefficients are insignificant in all the specifications. The coefficients
on HORIZON are also not reliably different from zero. Finally, large firms allocate
more to equities than small firms. The coefficient on SIZE is positive in all models
and significant at the zyxwvu
0.01 level or better in all specifications. We view this result
as corroborating evidence to the risk explanation. That is, larger (less risky) firms
afford higher risk in managing the pension portfolio by allocating more funds to
equities. Smaller (riskier) firms, on the other hand, offset some risk by allocating
more funds to bonds. zyxwvu
5. Summary and Conclusions
We identify and test motives for corporate pension asset allocations using a
proprietary asset allocation database covering the 1988-94 period. We focus on the
role of accounting standards in pension asset allocation. In particular, we investigate
whether the method of information release, balance sheet recognition versus foot-
note disclosure, affects pension asset allocation. Using portfolio analysis and mul-
tivariate regressions, we can compare firms that zyxwv
disclose similar funding ratios in
footnotes, but will zyxwvuts
recognize different amounts of additional minimum liability in
case of a market decline.
We find that firms that are close to the recognition threshold have a relatively
high allocation to bonds. Since bonds are highly correlated with the pension obli-
gations, these firms match their pension assets and obligations and reduce the like-
lihood of crossing the recognition threshold. We also find that firms allocate their
pension assets between equities and fixed-income investments to reduce the vola-
tility of pension contributions. Specifically, pension plans that are extremely over-
funded or underfunded invest conservatively to avoid crossing the minimum and
maximum funding limits. Finally, we find evidence that firms attempt to offset high
risk by choosing conservative pension asset allocations.
Whether the tendency of firms to avoid minimum Lability recognition by re-
ducing allocations to equity securities maximizes shareholders’ wealth is still an
open question. In particular, it is unclear whether the recognition of additional
minimum liability imposes contracting costs that are greater than the expected
benefits from a long-term investment in stocks. American Airlines, for example,
selected a conservative portfolio for its defined benefit pension plan in response to
SFAS No. 87. Interestingly,the airline has maintained its defined contribution funds
in stocks only. Had American Airlines kept its defined benefit funds in stocks over
the last decade, its share value would have been $27 higher. One possible expla-
nation for this puzzle is that frequent performance evaluations drive pension fund
managers to focus on short-term results and avoid equity investments (Benartzi and
Thaler [19951).

342 JOURNAL zyxwv
OF ACCOUNTING, AUDITING zyx
& FINANCE
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