The effect of pension accounting on corporate pension asset allocation

Transcription

1 The effect of penson accountng on corporate penson asset allocaton El Amr* London Busness School Regent s Park London NW1 4SA, Unted Kngdom Tel: +44 (0) , Fax: +44 (0) eamr@london.edu Yanlng Guan School of Busness The Unversty of Hong Kong, Hong Kong ylguan@busness.hku.hk Denns Oswald Ross School of Busness Unversty of Mchgan Ann Arbor, MI dennso@umch.edu 10 March 2009 *Correspondng author.

2 The effect of penson accountng on corporate penson asset allocaton Abstract We examne the mpact of new penson dsclosures and subsequent full penson recognton under FRS 17 and IAS 19 n the Unted Kngdom and SFAS 158 n the Unted States on penson asset allocaton. These standards requre recognton of net penson surplus/defct on the balance sheet and actuaral gans/losses n other comprehensve ncome. Therefore, these standards ntroduce volatlty nto comprehensve ncome and balance sheets. We dentfy a dsclosure perod durng whch UK companes dsclosed all the requred data under FRS 17 n the notes wthout recognton. We also dentfy a full recognton perod startng one year before untl one year after the adopton of FRS 17/IAS 19 (UK) and SFAS 158 (US). We predct and fnd that UK companes, on average, shfted penson assets from equty to debt securtes durng both the dsclosure and the full recognton perods. We also fnd that whle before the adopton of SFAS 158 US companes mantaned a stable allocaton to equtes and bonds, these companes, on average, shfted funds from equtes to bonds around the adopton of SFAS 158. Cross-sectonal analyss shows that the shft away from equtes s related to changes n fundng levels, shorter nvestment horzons, ncreased fnancal leverage, and the expected mpact of the new standards on shareholders' equty. Keywords: Defned Beneft Plans, Penson Asset Allocaton, Penson Surplus/ Defct, FRS 17, IAS 19, SFAS 158. JEL Codes: G11, G15, G23, G38, M41, M48

3 1. Introducton We nvestgate the effect of new penson dsclosures and subsequent recognton requrements of penson surplus/defct on the allocaton of penson assets to equty and debt securtes. In November 2000, the Accountng Standards Board (ASB) n the Unted Kngdom ssued Fnancal Reportng Standard (FRS) No. 17, Retrement Benefts (ASB 2000), whch ntally had to be adopted n June In 2002, ASB extended the transtonal perod of FRS 17 to fscal years startng on or after January 2005, whch concded wth the adopton of Internatonal Fnancal Reportng Standards (IFRS) n Europe. Effectvely, UK companes had to adopt the revsed Internatonal Accountng Standard (IAS) No. 19 (IASB 2004), whch s smlar to FRS 17. In September 2006, the Fnancal Accountng Standards Board (FASB) ssued SFAS 158 (FASB 2006), whch replaced SFAS 87 (FASB 1985) and became effectve n December Between fscal 2000 and the adopton of FRS 17/IAS 19, UK companes provded new dsclosures on the status of ther penson plans. At the adopton of FRS 17/IAS 19, UK companes recognzed the penson surplus/defct on the balance sheet (net of deferred tax); actuaral gans or losses are recognzed mmedately n other comprehensve ncome (shareholders equty). Smlarly, SFAS 158 requres full recognton of the penson surplus/defct on the balance sheet and mmedate recognton of actuaral gans/losses and pror servce cost n other comprehensve ncome. The recognton of net penson surplus/defct as an asset/lablty on the balance sheet and actuaral gans/losses n other comprehensve ncome under FRS 17/IAS 19 and SFAS 158 ntroduces volatlty to balance sheets of UK and US companes, especally f penson assets are mostly nvested n equty securtes. In partcular, reportng actual returns on penson assets njects volatlty nto shareholders equty, whle the recognzed net penson asset/lablty could be a sgnfcant porton of a company s book value and market 1

4 captalzaton. 1 One way to reduce the volatlty of the penson defct/surplus and the volatlty of comprehensve ncome and shareholders equty s to match penson assets wth penson labltes, for example, by selectng penson assets whose far value s postvely correlated wth the far value of the penson lablty, namely bonds. 2 Alternatvely, companes could termnate penson plans (Thomas 1989) or convert defned beneft plans nto defned contrbuton and cash balance plans (D Souza, Jacob and Lougee 2008; Swnkels 2006). However, these latter actons may ncur tax and labor negotaton costs. We consder one dsclosure regme for UK companes, from fscal 2001 untl one year before the adopton of FRS 17/IAS 19, and two full recognton regmes -- one for UK and one for US companes -- from one year before adopton untl one year after the adopton of FRS 17/IAS 19 n the Unted Kngdom and SFAS 158 n the Unted States. We predct that UK companes wth defned beneft penson plans wll shft penson assets from equty to debt securtes durng the dsclosure perod. Ths s because of the ncreased vsblty of penson plans due to market-based dsclosures and the antcpaton of the effect of full penson recognton on the volatlty of shareholders equty and comprehensve ncome. We also predct that both UK and US companes wll shft penson assets from equty to debt securtes durng the full recognton perod due to the recognton of penson surplus/defct on the balance sheet and the hgher antcpated volatlty of shareholders equty and comprehensve ncome. 3 1 At the end of 2001, the combned penson surplus for the FTSE 100 was 5 bllon, but by md July 2002, the net penson was a defct of 25 bllon (Reynolds 2002). 2 The Commttee on Investment of Employee Beneft Assets estmated that swtchng to far-value penson accountng would result n approxmately $290 bllon beng shfted from equtes to bonds. 3 In 2001, Boots plc lqudated all ts equty holdngs n ts 2.3 bllon penson fund and moved the proceeds nto long-dated bonds (Ralfe 2002; McLesh 2001). In the Unted States, General Motors reduced the share of equtes n the penson portfolo from 47% n December 2005 to 38% n December 2006 and to 26% n December

5 To test our predctons, we use penson asset allocaton data for 1,829 and 2,611 frmyear observatons for UK and US companes, respectvely, over the perod 2000 through We fnd that UK companes, on average, shfted funds from equty to debt securtes durng the FRS 17 dsclosure perod and that both UK and US companes shfted penson assets from equtes to bonds durng the full recognton perod of FRS 17/IAS 19 and SFAS 158, respectvely. Ths shft s expected to reduce the volatlty of shareholders equty and comprehensve ncome. In addton to the effects of changes n dsclosure and recognton requrements, contemporaneous changes n fundng levels due to mnmum fundng requrements, shorter nvestment horzons, changes n plan coverage, and ncreased fnancal leverage could trgger smlar asset allocaton changes. Multvarate cross-sectonal analyss reveals that, controllng for other factors that affect asset allocaton, the shft from equty to debt securtes n UK and US companes s more sgnfcant n companes wth larger penson plans relatve to shareholders' equty. Collectvely, the results support the argument that new penson accountng standards n the Unted Kngdom and the Unted States affected corporate penson asset allocaton, ncrementally to other economc factors. Ths study contrbutes to the lterature by analyzng how accountng rules affect penson asset allocatons n an nternatonal settng usng both UK and US companes. The evdence n ths study llumnates the possble captal market effects of full recognton penson accountng as companes may contnue to swtch penson assets from equty to debt securtes. The remander of ths study s organzed as follows. In secton 2, we develop the hypotheses to be tested. Secton 3 descrbes the research desgn. Sample selecton and descrptve statstcs are ncluded n Secton 4. Secton 5 provdes the emprcal results, whle Secton 6 provdes concludng remarks. 3

6 2. Hypotheses Issued n 2000, FRS 17 requred UK companes to dsclose the present value of ther defned beneft penson oblgatons and the market value of penson plan assets, as well as actuaral assumptons and detals on asset allocaton. These new dsclosures ncreased the transparency of the penson plan, thereby facltatng nvestor, credtor, and employee scrutny of the fnancal mpact of penson plans. Specfcally, underfunded companes would be perceved as rsker because penson defcts are a form of debt. Also, the exstence of mnmum fundng requrements combned wth a sgnfcant allocaton of penson assets to equty securtes would requre the company to make addtonal penson contrbutons f equty values declned. To the extent that asset values are correlated, the sponsorng frm s operatng cash flows are lkely to be lower when the net penson defct ncreases to a level that must be mmedately funded due to statutory fundng requrements (Bader 1991; Amr and Benartz 1999). Consequently, the possblty of hgher penson contrbutons at a tme when the sponsorng frm s cash flows are relatvely low and the uncertanty assocated wth ther tmng and magntude also ncreases sponsorng companes perceved rsk. Sponsorng frms mght prefer to hedge aganst potental volatons of statutory fundng requrements by reducng the volatlty of the penson surplus/defct and mprovng the matchng of penson assets and labltes (Blake 2001). Better matchng s acheved by allocatng more penson assets to debt (that s, bonds and other nterest bearng securtes), nstead of equty securtes. As the market value of bonds s generally less volatle than that of equtes, and snce penson labltes largely depend on the prevalng yeld on hgh qualty bonds, such a polcy would result n lower volatlty of the penson defct/surplus and a lower probablty of volatng fundng requrements (Harrs, Mchaeldes, Huh and van Bezooyen 2001). In addton, we predct that the antcpated adopton of FRS 17 and the recognton of the full penson lablty on subsequent balance sheets would also encourage 4

7 shftng penson assets to bonds. Ths leads to our frst hypothess: Hypothess 1: UK companes wth defned beneft penson plans wll shft penson assets from equty to debt securtes durng the FRS 17 dsclosure perod. FRS 17/IAS 19 n the Unted Kngdom and SFAS 158 n the Unted States both requre recognton of the net penson defct/surplus on the balance sheet, recognton of pror servce costs n net ncome and recognton of actuaral gans/losses n other comprehensve ncome. Therefore, n addton to ncreasng the amount of balance-sheet debt for underfunded plans, adopton of the new standards n both countres s expected to ncrease the volatlty of total labltes, shareholders equty, and comprehensve ncome for sponsors of defned beneft plans. Full penson recognton could have contractual mplcatons. For contracts based on balance sheet fgures, hgher recognzed debt ncreases the lkelhood of volatng exstng debt covenants. Second, hgher volatlty of shareholders equty ncreases the probablty of volatng equty-based covenants. Thrd, a recognzed penson defct wth a correspondng decrease n dstrbutable retaned earnngs would decrease the ablty to pay dvdends. To mtgate the effect of adopton on exstng contracts, we expect companes to shft penson assets from equty to debt securtes durng the adopton of full penson recognton. Ths argument leads to our second hypothess: Hypothess 2: UK and US companes wth defned beneft penson plans wll shft penson assets from equty to debt securtes durng the full recognton perod (adopton of FRS 17/IAS 19 n the Unted Kngdom and SFAS 158 n the Unted States). The mpact of the new penson standards s expected to be more sgnfcant when the penson plan s larger relatve to shareholders equty. For example, Charter plc, a UK-based 5

8 engneerng company, reported 2003 penson assets wth a market value of mllon and shareholders equty of 24.9 mllon; Thus a 5.4% declne n the market value of penson assets, holdng the penson lablty constant, would elmnate ts shareholders equty. Furthermore, a declne n the yeld on hgh-qualty corporate bonds could elmnate shareholders equty, as the penson oblgaton ncreases when the dscount rate declnes. Thus, we would expect companes wth larger penson plans relatve to shareholders equty to shft more assets from equty to debt securtes durng the dsclosure and full recognton perods. Companes wth larger penson plans wll also experence larger actuaral gans/losses, f more penson assets are nvested n equty securtes. To reduce the volatlty effects of actuaral gans/losses on shareholders equty, they would be motvated to shft penson assets from equty to debt securtes. 4 Consequently, we hypothesze that the shft from equty to debt securtes wll be more sgnfcant for companes wth larger penson plans relatve to shareholders equty. We would expect ths relaton for UK companes durng both the dsclosure and full recognton perods and for US companes durng the full recognton perod. Hypothess 3a: The shft of penson assets from equty to debt securtes by UK companes durng the dsclosure perod s postvely correlated wth the relatve sze of the penson plan. Hypothess 3b: The shft of penson assets from equty to debt securtes by UK and US companes durng the full recognton perod s postvely correlated wth the relatve sze of the penson plan. 4 Shftng to less rsky penson assets, however, also mples a lower expected return on penson assets on the ncome statement (Fernandez 2002). 6

9 Whle ths study hghlghts the asset allocaton effects of new penson accountng standards, pror lterature dentfes three other factors that affect penson asset allocaton: fundng levels, nvestment horzon, and offsettng frm rsk. 5 Both UK and US companes were subject to mnmum fundng requrements before our sample perod. These requrements were modfed durng our sample perod 2000 through For example, the US Penson Protecton Act (2006) requres defned beneft penson plans to attan full fundng status by ncreasng penson contrbutons to the plans. Any shortfalls must be covered wthn seven years. In the Unted Kngdom, mnmum fundng requrements were ntroduced by the Pensons Act (1995). However, the Pensons Act (2004) replaced these mnmum requrements wth statutory fundng objectves that n essence requre each plan to hold suffcent assets to meet ts labltes and set out tme lmts wthn whch any underfundng must be covered (Webb 2007). 6 These new statutory requrements n both countres are expected to result n hgher fundng levels. Pror lterature s mxed as to the effect of fundng levels on asset allocaton. Stll, Harrson and Sharpe (1983) suggest that as penson plans become less underfunded, the allocaton to equtes should declne. Thus, ncreased fundng requrements could trgger a declne n the allocaton to equtes ndependent of new accountng standards. Investment maturty could also affect asset allocaton. As penson plans become more mature, the nvestment horzon s shortened, whch s expected to trgger a shft of penson assets from equtes to bonds. Fnally, pror studes document a negatve relaton between frm rsk and the allocaton to equtes, as companes offset frm rsk by usng a more conservatve penson 5 Black (1980), Feldsten and Selgman (1981), Tepper (1981), and Harrson and Sharpe (1983), among others. 6 The UK Pensons Act (2004) also establshes the Penson Protecton Fund (PPF), whch wll compensate members of defned beneft penson plans f after Aprl 2005 the employer becomes nsolvent. Smlar to the PBGC n the Unted States, ths fund wll be funded by leves mposed on defned beneft penson plans. In addton, the act requres plans to appont conversant trustees, mposes strcter reportng requrements, and establshes a new penson regulator wth extended powers to nvestgate and mpose sanctons. Fnch (2005) argues that the 2004 Pensons Act requres penson trustee boards to take nto account the fnancal strength of the plan sponsor, whch s nfluenced by FRS 17. 7

10 asset allocaton polcy. Therefore, a change n penson asset allocaton could be assocated wth changes n frm rsk, ndependent of new accountng standards. Although our man focus s on the mpact of the new accountng standards, we control for these factors n our emprcal tests. 3. Emprcal desgn Penson assets are classfed n the notes to the fnancal statements nto stocks, bonds, and other. Stocks and bonds together account for about 90% of total penson funds n our UK and US samples. Other ncludes assets such as mortgage-backed securtes, venture captal, prvate placement, and propertes. To test hypotheses 1 and 2, we analyze penson asset composton over the perod 2000 through 2007 for a sample of UK and US companes. Specfcally, we test whether UK companes shfted penson funds from equtes to bonds durng the dsclosure perod and the full recognton perod and whether US companes shfted funds from equtes to bonds durng the full recognton perod. We also examne whether fundng levels, nvestment horzon, and frm rsk changed over the sample perod. To test hypotheses 3a and 3b, we construct a model that explans cross-sectonal varaton n the percentage of penson funds allocated to equty securtes (requity t ): requity DIVP 6 t t IMPACT 0 TAXR 7 1 t t SDCF 8 FUND t 2 t SIZE 9 FUND t 3 2 t CLOSE 10 HOR t 4 t t LEV 5 t (1) requity t s the rato of penson assets allocated to equty securtes dvded by total penson assets for frm at the end of fscal year t. IMPACT t measures the potental mpact of the new accountng standards on company n year t; we use two measures of the sze of the penson plan relatve to shareholders' equty: 8

11 () EXPOS1 t : The far value of penson assets deflated by book value of shareholders equty n year t. Ths varable captures the exposure of shareholders equty to the volatlty n the market value of penson assets. () EXPOS2 t : The projected beneft oblgaton (PBO) deflated by book value of shareholders equty n year t. Ths varable captures the exposure of shareholders equty to the volatlty n dscount rates. Tax and regulatory factors affect asset allocatons through fundng levels. In general, the tax-deductblty of penson contrbutons should nduce companes to pre-fund ther penson plans; companes that are subject to hgher tax rates should have greater ncentves to prefund ther plans. Black (1980) and Tepper (1981) argue that, snce returns on penson assets are not taxed, these assets should be nvested n the most heavly taxed securtes, presumably bonds. Ther argument suggests no assocaton between fundng levels and asset allocatons as all companes nvest n bonds regardless of fundng levels. In contrast, Harrson and Sharpe (1983) argue that the Penson Beneft Guaranty Corporaton (PBGC) provdes US companes wth a put opton on extremely underfunded penson oblgatons. Ths put opton combned wth lmted tax deductblty on overfunded plans means that fundng and asset-allocaton decsons are jont and extreme. To maxmze tax benefts on the one hand and the value of the PBGC opton on the other hand, companes should ether overfund the penson plan and allocate all the assets to bonds or underfund and allocate all the assets to equtes. Although n practce fundng/allocaton decsons are rarely extreme, ths argument supports a negatve relaton between fundng levels and allocatons to equtes. However, the value of the PBGC put opton n the Unted States has declned over tme and, n partcular, snce the 1986 Tax Reform Act. Also, an analog to the PBGC dd not exst n the Unted Kngdom untl Therefore, the ncentve to allocate penson assets to 9

12 equtes n cases of extreme underfundng may be of second order mportance. Bader (1991) argues that companes strve to mnmze the volatlty of future penson contrbutons. These contrbutons are farly predctable for moderate fundng levels, less so for more extreme levels. To reduce the volatlty of penson contrbutons, he argues that extremely overfunded and underfunded plans should nvest n bonds, whle moderately funded plans should ncrease allocatons to equtes. Hs argument suggests an nverted U- shaped relaton between fundng levels and the allocaton to equtes. Based on these arguments, we nclude both FUND t and FUND 2 t to accommodate the possblty of a nonlnear relaton between fundng levels and allocaton to equtes. 7 The fundng status (FUND) s measured as the far value of penson assets dvded by the accumulated beneft oblgaton (ABO). 8 Investment horzon plays a role n penson asset allocaton. Whle penson oblgatons to retrees are relatvely short-term and are prmarly affected by nterest rates, oblgatons to actve employees are relatvely long-term and are prmarly affected by salary ncreases. Value changes for bonds are more correlated wth nterest rate changes, and value changes for stocks are more correlated wth salary ncreases. Thus, companes wth relatvely young (mature) workforces should nvest more n stocks (bonds). Consequently, we expect a postve correlaton between nvestment horzon, HOR t, and allocaton to equtes. HOR t s measured as the natural logarthm of the rato of PBO to current servce cost. Overall, an older (younger) workforce should lead to a smaller (larger) rato of PBO to servce cost, ndcatng a shorter (longer) nvestment horzon. To mtgate the problem of measurement error n the horzon varable (HOR t ), we 7 Amr and Benartz (1999) document an nverted-u relaton between fundng status and the percentage nvested n equtes. 8 Snce ABO s not avalable for UK companes, we estmate ABO based on the formula proposed n Amr and Benartz (1999): ABO = PBO / (1+G) N, where G s the projected rate of salary ncrease (collected from fnancal statements) and N s a measure of nvestment horzon, equal to the rato of PBO to the current servce cost. 10

13 nclude another varable that s assocated wth nvestment horzon. Ths varable, CLOSE t, takes nto account recent shfts away from defned beneft to defned contrbuton penson plans and closures of defned beneft plans to new entrants (McSherry 2006). CLOSE t s an ndcator varable equal to one f the prncpal defned beneft plan s closed to new entrants and zero otherwse. As the nvestment horzon of closed plans s, on average, shorter, we would expect a negatve relaton between ths varable and allocatons to equtes. Our model also ncludes varables that capture the nfluence of debt contracts and dvdend payout polcy. Once the penson surplus/defct s recognzed on the balance sheet, the penson asset/lablty and correspondng nvestment portfolo may be affected by certan contractual arrangements. In partcular, companes closer to volatng debt covenants have stronger motves to mprove asset/lablty matchng n order to reduce the varablty of recognzed penson defcts, hence the lkelhood of debt covenant volaton. Better asset/lablty matchng would also reduce the volatlty of shareholders' equty and future penson contrbutons, whch n turn would reduce the volatlty of dvdends. We would expect companes wth tghter debt covenants and hgher dvdend payout ratos to allocate more of ther assets to bonds. To capture these effects, we nclude fnancal leverage (LEV t ) and the dvdend payout rato (DIVP t ). We would expect the coeffcents on these varables to be negatvely assocated wth the allocaton to equty securtes. Fnancal leverage (LEV t ) s measured as long term debt dvded by the sum of long term debt and market value of equty for frm n year t. Dvdend payout rato (DIVP t ) s measured as dvdends per share dvded by retaned earnngs per share. If retaned earnngs are negatve, then the varable s measured as the average dvdends per share over the current and past two years dvded by average retaned earnngs per share over the current and past two years. 9 9 Normally, dvdend payout rato s measured as dvdends over net ncome. However, to avod excludng companes wth negatve ncome, we deflate dvdends by retaned earnngs. 11

14 Companes subject to hgher tax rates have greater ncentves to allocate penson assets to bonds, as bonds are more heavly taxed. Therefore, we nclude the effectve tax rate (TAXR t ), measured as total tax expense dvded by pre-tax ncome n year t. If current pretax ncome s negatve, we use the average tax expense over the current and past two years dvded by the average pre-tax ncome over the current and past two years. Fredman (1983) and Bode, Lght, Morck, and Taggart (1984) fnd that companes offset hgh corporate rsk by nvestng more penson assets n bonds. Ths polcy may reflect management preference to avod contrbutons to the penson plan when operatng cash flows are low. Therefore, we would expect a negatve correlaton between the varablty of operatng cash flows and equty allocaton. In addton, we would expect a postve assocaton between frm sze and allocaton to equtes, as larger companes have lower operatng rsk. The volatlty of operatng cash flows (SDCF t ) s measured as the standard devaton of operatng cash flows over the current and past four years, deflated by book value of common equty. Frm sze (SIZE t ) s measured as the natural logarthm of market value of equty. To test our hypotheses, we defne two dependent varables: the frst s the change n the percentage of assets allocated to equtes by UK companes durng the dsclosure perod. The dsclosure perod s fscal 2001 to the year before the adopton of FRS 17/IAS 19: rdisclose = requity (Year 2001) - requity (Pre-Adopton Year). 10 The second dependent varable s the change n percentage of assets allocated to equtes durng the full recognton perod. For UK (US) companes, ths perod begns one year before the adopton of FRS 17/IAS 19 (SFAS 158) and ends one year after the adopton: radopt = requity (Pre-Adopton Year) - requity (Post-Adopton Year). 10 Techncally, the dsclosure perod begns n However, we use 2001 as the startng year because many observatons for 2000 are mssng. 12

15 We estmate Equaton (2) for UK companes only. Each ndependent varable s the dfference between the level of the varable at the end of the dsclosure perod (fscal 2004) and the level at the begnnng of the perod (fscal 2001). rdisclose LEV 5 IMPACT DIVP TAXR FUND 2 SDCF 8 FUND 3 SIZE 9 2 HOR CLOSE 10 4 t (2) We estmate Equaton (3) for both UK and US companes around the full recognton perod. To control for long-term asset allocaton trends, we nclude rdisclose to capture asset allocaton changes before adopton. For US companes, rdisclose s measured as allocaton to equtes n fscal 2001 mnus the allocaton to equtes n fscal Controllng for pror allocatonal effects allows us to draw stronger nferences on the ncremental effect of accountng standards on penson asset allocaton. radopt LEV 5 rdisclose 11 IMPACT 0 DIVP TAXR FUND 2 FUND 2 SDCF SIZE HOR 4 CLOSE 10 (3) Each ndependent varable n Equaton (3) s the dfference between the level of the varable after adopton and ts level before adopton. For UK companes other than early adopters, ths normally mples the change between fscal 2006 and fscal 2004; for US companes ths normally mples the change between fscal 2007 and fscal We use ordnary least squares to estmate the above equatons. 13

16 4. Sample selecton and descrptve statstcs The ntal UK sample contans 250 of the 350 FTSE companes that sponsor defned beneft penson plans durng 2000 through We deleted seven companes that elected the corrdor method allowed under IAS 19. Informaton on market value of penson assets, actuaral present value of penson labltes, penson actuaral assumptons, actuaral gans/losses, and detals of penson asset allocaton are collected from annual fnancal statements. All other fnancal data for UK companes are from Datastream. Data for US companes' penson asset allocatons untl 2004 are collected from Pensons and Investments, a survey of the largest 1,000 penson funds n the Unted States. Of these, approxmately 300 penson funds relate to defned beneft plans of publcly traded frms. Asset allocaton data for 2005 through 2007 are collected from notes to the annual fnancal statements. Fnancal data for US companes are from Compustat. After removng observatons wth mssng data, the sample conssts of 4,440 frm-year observatons, of whch 1,829 observatons are for UK companes and 2,611 observatons are for US companes. Table 1 provdes descrptve statstcs for our UK and US samples. Over the sample perod, both UK and US companes allocate, on average, 62% of ther penson assets to equtes. The sze of the penson plan relatve to shareholders' equty s larger n UK than n US frms, as reflected by hgher means of EXPOS1 and EXPOS2 (sgnfcant at the 0.01 level). Ths dfference could lead to more sgnfcant allocatonal effects n the Unted Kngdom than n the Unted States. Fundng levels (FUND) and nvestment horzon (HOR) are larger n UK companes than n US companes (sgnfcant at the 0.01 level). Average dvdend payout ratos (DIVP) and effectve tax rates (TAXR) are smlar across UK and US companes, but medan DIVP s larger n UK companes (at the 0.01 level), and the medan US company has a hgher effectve tax rate than the medan UK company (at the 0.01 level). 14

17 US companes are less rsky (at the 0.01 level for both means and medans) as reflected by lower volatlty of cash flows (SDCF) and larger frm sze (SIZE). However, US companes are more hghly leveraged than UK companes (at the 0.01 level). Fnally, 47% of UK defned beneft penson plans are closed to new entrants (mean CLOSE = 0.47), whereas 12% of US plans are closed to new entrants (sgnfcant at the 0.01 level), whch could lead to a hgher allocaton to bonds n UK companes due to shorter nvestment horzons. 11 (Table 1 about here) Most UK companes adopted IAS 19 n 2005, the mandatory year of adopton. However, 54 UK companes n our sample early-adopted FRS 17 durng 2002 through Pror lterature suggests that the tmng of adopton of new accountng standards s affected by the fnancal statement mpact of the new standard and by contractng costs (Amr and Zv 1997). Usng logstc regressons to dentfy the characterstcs of UK companes that elected early adopton of FRS 17, we fnd (results not tabulated) that early adopters have, on average, smaller (at the 0.05 level) ratos of penson assets to shareholders' equty (EXPOS1) and longer (at the 0.05 level) nvestment horzons (HOR). All other varables examned (requity, FUND, LEV, SIZE, CLOSE) were not sgnfcant (at the 0.10 level) n explanng the adopton decson. These results are consstent wth the clam that UK companes that were less affected by FRS 17 were more lkely to adopt the standard earler. Table 2 provdes data on the composton of penson assets for UK companes (top panel), 54 UK early adopters of FRS 17 (mddle panel) and US companes (bottom panel). Over 2000 through 2007, UK companes decreased ther average allocaton to equtes by 19.8% and ncreased ther allocaton to bonds by 12.7%. UK early adopters of FRS 17 exhbt a smlar pattern untl 2003, wth a sharper declne n the allocaton to equtes n 11 All contnuous explanatory varables are wnsorzed at 1% and 99% to mtgate the effect of extreme observatons, except TAXR t and DIVP t, whch are wnsorzed at 5% and 95% to remove negatve values. 15

18 2004. Durng 2000 through 2005, US companes had a relatvely stable allocaton to equtes and bonds, followed by a declne n the allocaton to equtes durng 2005 through (Table 2 about here) Fgure 1 depcts the trend of penson asset allocatons around the adopton of FRS 17/ IAS 19 n the Unted Kngdom (Fgure 1a), SFAS 158 n the Unted States (Fgure 1b) and early adopters of FRS 17 (Fgure 1c). For each company, we dentfy the adopton year as AY(0) and plot mean percentages of penson assets allocated to equtes and bonds around the adopton year. Fgure 1a presents nformaton for the entre UK sample between AY(-3) and AY(+2). The fgure exhbts a declne n penson funds nvested n equtes and an ncrease n the percentage nvested n bonds, especally n AY(+1) and AY(+2), consstent wth the argument that the new accountng standard caused UK companes to transfer penson assets from equtes to bonds. Fgure 1b presents nformaton for US companes between AY(-3) and AY(+1). 13 Whle there s an apparent declne n penson funds nvested n equtes and an ncrease n the percentage nvested n bonds after adopton of SFAS 158, these changes appear slght. Fgure 1c presents movements n asset allocaton for UK early adopters. As n Fgure 1a, we observe sharp declnes n the allocaton to equtes around the adopton of the new standard. (Fgure 1 about here) 12 Asset allocatons are nfluenced by relatve changes n market values of stocks and bonds. For example, n 2001 the market value of UK bonds ncreased by 1%, and the market value of equtes decreased by 13%. Thus, a penson portfolo of 75% equtes and 25% bonds would become 72.1% equtes and 27.9% bonds wthout rebalancng. Usng annual changes n UK and US stocks and bonds ndces, we adjusted asset allocatons to relatve changes n market values of stocks and bonds snce Ths way, we solate the effect of corporate rebalancng on asset allocatons. We fnd that the declne n the allocaton to stocks and the ncrease n the allocaton to bonds are more transparent n both the UK and the US samples. 13 AY(+2) s fscal 2008, and thus data are unavalable at ths tme. 16

19 5. Emprcal results Table 3, Panel A, provdes results of analyses of changes n UK frms penson asset allocatons durng the FRS 17 dsclosure perod (Hypothess 1). The results show that UK companes ncreased (decreased) ther allocaton to bonds (equtes) durng the dsclosure perod; average allocatons to bonds ncreased by 5.4% (sgnfcant at the 0.01 level), whle average allocatons to equtes decreased by 4.3% (sgnfcant at the 0.01 level). Smlarly, early adopters of FRS 17 ncreased the average allocaton to bonds by 3.4% (sgnfcant at the 0.02 level) and decreased the average allocaton to equtes by 3.6% (sgnfcant at the 0.02 level). These results support Hypothess 1; UK companes decreased ther exposure to equtes durng the dsclosure perod of FRS 17. For comparson, durng 2001 through 2005, the perod before adopton of SFAS 158, US companes decreased ther average allocaton to bonds by 3% and ncreased the average allocaton to equtes by 5% (sgnfcant at the 0.01 level). Panel B of Table 3 presents results of analyses of changes n penson asset allocatons durng the adopton of full penson recognton under IAS 19/FRS 17 n the Unted Kngdom and SFAS 158 n the Unted States (Hypothess 2). The test statstc s based on the dfference between %Equty (and %Bond) n the pre-adopton and the post-adopton years. On average, UK companes ncreased ther allocatons to bonds by 3.7% and decreased ther allocatons to equtes by 4.6% around the adopton of full recognton under FRS 17/ IAS 19 (both changes are sgnfcant at the 0.01 level). Early adopters of FRS 17 ncreased the allocaton to bonds by 4.8% and decreased the allocaton to equtes by 6.6% (both changes are sgnfcant at the 0.01 level). US companes also changed ther asset allocaton around the adopton of SFAS 158, ncreasng the average allocaton to bonds by 2.5% and decreasng the average allocaton to equtes by 3.9% (both changes are sgnfcant at the 0.01 level). 17

20 The results n Panel B of Table 3 support Hypothess 2. In partcular, the evdence suggests that both UK and US companes shfted penson assets from equty to debt securtes. In addton, the magntude of ths shft s, on average, smlar n both countres. 14 (Table 3 about here) Whle the results n Table 3 support Hypotheses 1 and 2, pror lterature suggests three alternatve reasons for the observed changes n penson asset composton: (1) hgher fundng requrements, (2) shorter nvestment horzons, and (3) an ncrease n overall frm rsk. We examne the behavour of these factors startng three years before adopton of full penson recognton untl two years after adopton n the Unted Kngdom and one year after adopton for US companes. The results are presented n Table 4. Average fundng levels (FUND) ncreased (at the 0.01 level) for both UK and US companes around the adopton of the new standards. These ncreases could explan the shft from equtes to bonds n UK and US companes. Investment horzons, the natural logarthm of the projected beneft oblgaton over current servce cost (HOR), ncreased around the adopton of the new standards n both countres (sgnfcant at the 0.01 level), nconsstent wth a swtch from equtes to bonds. We further examned the proporton of companes closng ther defned beneft plans to new entrants (CLOSE). Closng the fund to new entrants reduces the nvestment horzon over tme and could trgger a shft from equtes to 14 We measured the average fundng rato for each UK frm durng the FRS 17 dsclosure perod and dvded the sample nto two sub-samples of 107 UK companes wth average fundng levels above and below the medan (not tabulated). We fnd that UK companes wth fundng levels below the sample medan decreased ther average allocaton to equtes from 67.8% to 63.6% durng the dsclosure perod; companes wth fundng levels above the sample medan decreased ther allocaton to equtes from 65.3% to 60.8%. (Both changes are sgnfcant at the 0.01 level.) We repeated ths analyss for UK and US companes durng the full recognton perod. We fnd that the 90 UK companes wth average fundng levels below the sample medan durng that perod decreased ther allocaton to equtes from 67.8% to 62.7%, and the 90 companes wth average fundng levels above the sample medan decreased ther allocaton to equtes from 58.9% to 54.6%. (Both changes are sgnfcant at the 0.01 level.) Furthermore, the 144 US companes wth average fundng levels below the sample medan decreased ther allocaton to equtes from 64.6% to 60.5% durng the SFAS 158 adopton perod; the 144 US companes wth average fundng levels above the sample medan decreased ther allocaton to equtes from 64.8% to 61.1%. (Both changes are sgnfcant at the 0.01 level.) Thus, the results n Table 3 hold for companes wth relatvely hgh and low fundng levels. 18

21 bonds. As Table 4 shows, the proporton of closed plans ncreases n the Unted Kngdom (from 0.51 before adopton to 0.60 after adopton) and n the Unted States (from 0.24 before adopton to 0.35 after adopton). These ncreases, whch are sgnfcant at the 0.01 level, could explan the movement of penson assets from equtes to bonds. As for frm rsk, we fnd that mean leverage (LEV) decreased over tme and mean frm sze (SIZE) ncreased over tme n both countres. Ths reducton n frm rsk s nconsstent wth the swtch of penson assets from equtes to bonds, and thus a change n rsk s not a potental explanaton for the shft of penson assets from equtes to bonds. The mddle panel of Table 4 presents results for UK early adopters. We fnd that fundng levels and frm rsk remaned relatvely stable from three years before adopton untl two years after adopton. Investment horzon ncreased from the year before adopton untl the year after adopton (sgnfcant at the 0.09 level), and the proporton of closed plans ncreased from 0.36 to 0.42 around the adopton of FRS 17 (sgnfcant at the 0.08 level). Thus, the only alternatve explanaton to the swtch of penson assets from equtes to bonds n UK early adopters s the ncrease n the proporton of closed plans. (Table 4 about here) To examne the effects of new accountng standards, fundng levels, nvestment horzon, and frm rsk n a multvarate settng, we frst estmate equaton (2), n whch the dependent varable s the change n the allocaton to equtes durng the dsclosure perod (rdisclose) before the adopton of FRS 17/IAS 19. As Table 5 shows, the coeffcents on the mpact varables (ΔEXPOS1 and ΔEXPOS2) are postve, as expected, and sgnfcant at the 0.05 level. Ths result, whch supports Hypothess 3a, suggests that UK companes wth larger 19

22 penson plans relatve to shareholders' equty shft more funds from equtes to bonds n the dsclosure perod. 15 In addton, results n Table 5 show that UK companes that experenced an ncrease n fundng levels over the dsclosure perod shfted more assets from equtes to bonds, as reflected by postve (sgnfcant at the 0.10 level) coeffcents on ΔFUND. In addton, companes that experenced an ncrease n the nvestment horzon shfted less assets from equty to debt securtes, as reflected by the negatve coeffcents on ΔHOR (sgnfcant at the 0.05 level). We also fnd that companes that experenced an ncrease n effectve tax rates (ΔTAX) shfted more penson assets to bonds, as expected, and companes wth hgher fnancal leverage (ΔLEV) shfted more assets to bonds, possbly to mtgate the effect of recognton on the volatlty of shareholders' equty. Furthermore, companes that closed ther penson plans to new entrants durng the dsclosure perod shfted more assets from equtes to bonds, as reflected by the postve coeffcents on ΔCLOSE (sgnfcant at the 0.01 level). Fnally, the coeffcents on ΔDIVP, ΔSDCF, and ΔSIZE are not dfferent from zero (at the 0.10 level) suggestng that changes n dvdend payout and changes n overall frm rsk dd not motvate UK companes to shft penson assets away from equtes durng the dsclosure perod. The results n Table 5 suggest that durng the dsclosure perod, UK companes shfted penson assets from equtes to bonds because of changes n fundng levels, nvestment horzons, effectve tax rates, fnancal leverage, and plan scope. In partcular, companes that closed ther penson plans to new entrants shfted more funds from equtes to bonds. However, after controllng for these effects, UK companes wth larger penson plans relatve to shareholders' equty shfted more penson assets from equty to debt securtes durng the 15 The Pearson correlaton between ΔEXPOS1 and ΔEXPOS2 s 0.80 (0.66); between ΔEXPOS1 and ΔFUND 0.20 (0.09), and between ΔEXPOS2 and ΔFUND, (-0.15) for UK (US) companes. 20

23 FRS 17 dsclosure perod. We attrbute these fndngs, whch support Hypothess 3a, to the new dsclosure requrements of FRS 17. In partcular, these new penson dsclosures prompted companes wth larger penson plans relatve to shareholders' equty to reduce the potental effects of volatlty n penson asset values and penson labltes on reported shareholders equty, as penson plans become more vsble and transparent. (Table 5 about here) To test Hypothess 3b, we estmate equaton (3), whch explans the change n the allocaton to equty securtes durng the full recognton perod of FRS 17/IAS 19 n the Unted Kngdom and SFAS 158 n the Unted States. Table 6 reports the results. Startng wth the UK sample, the coeffcents on the man test varables, ΔEXPOS1 and ΔEXPOS2, are postve, as expected, and sgnfcant at the 0.05 level. Ths result, whch supports Hypothess 3b, suggests that UK companes wth larger penson plans relatve to shareholders' equty shfted more assets from equty to debt securtes around the adopton of FRS 17/IAS 19. In addton, the coeffcents on ΔFUND are negatve (sgnfcant at the 0.05 level), suggestng that UK companes that experenced a decrease n fundng levels shfted more penson assets from equtes to bonds. Also, the coeffcents on ΔTAXR are postve (sgnfcant at the 0.01 level), as expected, suggestng that companes wth hgher effectve tax rates shfted more penson assets to bonds. Furthermore, the coeffcents on ΔLEV are postve (sgnfcant at the 0.05 level), as expected, suggestng that companes wth hgher debt shfted more penson assets to bonds to reduce the effect of full recognton on the volatlty of shareholders' equty. The coeffcents on ΔCLOSE are postve, as expected, and sgnfcant at the 0.05 level, consstent wth the argument that companes that closed ther penson plans to new entrants durng the adopton perod shfted more funds from equtes to bonds. Fnally, the postve coeffcents on rdisclose suggest that companes that shfted 21

24 more funds from equtes to bonds before adopton contnued to shft assets to bonds durng the adopton perod. The coeffcents on nvestment horzon (ΔHOR), dvdend payout (ΔDIVP), and frm rsk (ΔSDCF, ΔSIZE) are not sgnfcant, at the 0.10 level, n explanng changes n penson asset allocatons durng the full recognton perod of FRS 17/IAS 19. Overall, these fndngs are consstent wth the clam that UK companes wth larger penson plans relatve to shareholders' equty shfted more penson assets from equty to debt securtes durng the FRS 17/IAS 19 full recognton perod ncrementally to the effects of changes n fundng levels, effectve tax rates, fnancal leverage and plan coverage. 16 Table 6 also presents results for estmatng equaton (3) usng US data. The coeffcents on the man test varables, EXPOS1 and EXPOS2, are postve and sgnfcant at the 0.10 level or better, whch supports Hypothess 3b. Ths result suggests that, smlar to UK companes, US companes wth larger penson plans relatve to shareholders' equty shfted more assets from equty to debt securtes durng the SFAS 158 full recognton perod. In addton, US companes that pay more dvdends shfted more funds to bonds to reduce the effect of the new standard on the stablty of dvdends, and US companes wth hgher effectve tax rates and larger fnancal debt shfted more penson assets to bonds. Unlke the results for UK companes, the coeffcents on ΔFUND, ΔCLOSE, and rdisclose are not sgnfcant (at the 0.10 level) n explanng the shft of penson assets from equty to debt securtes. Smlar to the results for UK companes, changes n nvestment horzons (ΔHOR) and changes n overall frm rsk (ΔSDCF, ΔSIZE) are also not sgnfcant, at the 0.10 level, n explanng the shft away from equty securtes. Overall, our 16 We also estmated equaton (3) for UK early adopters (42 observatons wth complete data). We fnd (results not tabulated) postve coeffcents on ΔEXPOS1 and ΔEXPOS2 (sgnfcant at the 0.10 level), as expected, suggestng that early adopters wth larger penson plans relatve to shareholders' equty shfted more funds from equtes to bonds. We also fnd a postve coeffcent on ΔLEV (sgnfcant at the 0.10 level), suggestng that companes wth larger fnancal leverage shfted more funds to bonds possbly to reduce the lkelhood of volatng debt-related covenants. 22

25 fndngs are consstent wth the argument that US companes shfted penson assets from equtes to bonds to reduce the mpact of the new standard on the volatlty of shareholders' equty. (Table 6 about here) To examne the nteracton between fundng levels and the other regresson varables, we parttoned the UK and US samples at the medan fundng level (as descrbed n note 14) and estmated equatons (2) and (3) after excludng ΔFUND and ΔFUND 2 (not tabulated). The results for UK companes are smlar to those reported n Tables 5 and 6. In partcular, the shft of penson assets from equty to debt securtes s assocated wth ΔEXPOS1 and ΔEXPOS2 (at the 0.05 level) n both sub-samples and n both the dsclosure and full recognton perods. Regardng US companes, the coeffcents on ΔEXPOS1 and ΔEXPOS2 are postve and sgnfcant (at the 0.05 level) only for companes wth fundng levels below the sample medan; these coeffcents are not relably dfferent from zero n companes wth fundng levels above the sample medan. Evdently, the shft of penson assets to bonds s partcularly relevant for US companes wth lower fundng levels, because the probablty of volatng statutory fundng requrements s larger. 6. Conclusons FRS 17 and IAS 19 (Revsed) changed accountng and reportng of defned beneft plans n the Unted Kngdom by ntally ntroducng new market-based penson dsclosures (FRS 17) and subsequently requrng full balance sheet recognton of the penson surplus/defct (IAS 19). In December 2006, the FASB ssued SFAS 158, replacng the partal recognton method of SFAS 87 wth full balance sheet recognton of defned beneft post-retrement plans. These standards requre that actuaral gans/losses be recognzed n other comprehensve ncome. We nvestgate whether the penson dsclosures requred by FRS 17 23

26 and the recognton requrements of IAS 19 and SFAS 158 affect the penson asset allocatons of UK and US companes. We dentfy a dsclosure perod durng whch UK companes dsclosed the requred data under FRS 17 n the notes to the fnancal statements wthout recognzng the penson surplus/defct on the balance sheet. In addton, we dentfy a full recognton perod around the adopton of FRS 17/IAS 19 n the Unted Kngdom and SFAS 158 n the Unted States. We predct a shft from equty to debt securtes by UK companes durng the dsclosure perod due to the hgher vsblty of pensons n the Unted Kngdom and the antcpaton of full recognton and a smlar shft durng the full recognton perod, around the adopton of FRS 17/IAS 19 n the Unted Kngdom and SFAS 158 n the Unted States. We fnd that durng the FRS 17 dsclosure perod UK companes reduced ther penson fund exposure to equty securtes and ncreased ther allocatons to debt securtes. We also fnd that UK companes decreased ther allocatons to equtes durng the FRS 17/IAS 19 full recognton perod. Smlarly, US companes decreased ther allocatons to equtes followng the adopton of SFAS 158. Cross-sectonal analyss reveals that the shft from equty to debt securtes s more pronounced n companes wth penson plans that are larger relatve to shareholders equty. In our analyss, we also consdered alternatve explanatons to the shft of penson funds from equtes to bonds. We fnd that the shft from equty to debt securtes durng the UK dsclosure perod s postvely assocated wth ncreases n fundng levels, effectve tax rates, and fnancal leverage and negatvely assocated wth ncreases n nvestment horzons. In partcular, UK companes that closed ther penson plans to new entrants shfted more penson assets from equtes to bonds, as the average age of plan partcpants ncreases and the nvestment horzon s shortened. Increases n effectve tax rates and fnancal leverage also explan the shft of penson assets from equtes to bonds n UK and US companes 24

27 durng the full recognton perod. However, changes n fundng levels and plan coverage are assocated wth shfts n penson assets n the Unted Kngdom but not n the Unted States. Nevertheless, the potental mpact of the new penson accountng standards on the volatlty of shareholders' equty ncrementally explans the cross-sectonal varaton n the shft away from equtes n both the Unted Kngdom and the Unted States around the adopton of the new penson accountng standards. 25

28 Acknowledgments We thank an anonymous revewer, Davd Blake, Elroy Dmson, Trevor Harrs, John Pckles, Laurens Swnkels, Rchard Taffler, and semnar partcpants at the 2008 CAR&E conference, Columba Unversty, INSEAD, Unversty of Hong Kong, London Busness School, Unversty of North Carolna, Tel Avv Unversty, and Unversty of Warwck for many useful comments. We also thank X L and L Zhang for research assstance and London Busness School and Unversty of Hong Kong for research fundng for ths project. 26

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