Optimal investment and funding policy of US defined-benefit pension plans
The assets of private defined-benefit pension plans represent a significant proportion of the US retirement savings market and affect the share value of sponsoring companies. This paper gives an overview of the optimal pension investment (allocation of funds by asset class) and funding policy. Summarizing the literature, the author considers how to manage a defined-benefit pension plan in the light of tax considerations, insurance premiums payable to the Pension Benefit Guaranty Corporation, and corporate liability. The paper analyses market imperfections (transaction costs, financial distress, regulation etc.) that affect optimal funding level and asset allocation. The conclusion is drawn that companies have to tailor their pension policies to their individual circumstances. Instead of corner solutions, it is rational for most to fund their pension plans in a stable way, according to applicable laws and regulations, and to select a balanced (equity/bond) asset mix. Optimal pension investment and funding policy is dynamic and should evolve in line with changes in the sponsoring company's circumstances. This helps to explain the vertical and horizontal discrepancies in funding levels and asset allocations between different pension plans.
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