With pension plans increasingly under the microscope in many companies, a recent 8-year study in the US examined the role of board composition in determining pension policies. The results indicate that outside directors play a valuable role in maintaining the interests of pension beneficiaries, with regards to both pension plan funding levels and asset allocations, and particularly in times of financial distress they help to keep the board on course to meeting its obligations toward pension plan beneficiaries.
Key Topics: Board of directors; Board composition; Outside directors; Pension policies; Defined benefit pension plans
Title of Reviewed Article: The Association between Board Composition and Corporate Pension Policies
Researchers: Nikos Vafeas (University of Cyprus) and Adamos Vlittis (Cyprus Institute of Marketing).
Publication: The Financial Review, 2016, Vol. 51 No. 4, pp. 481-506.
Setting the Scene
Company boards of directors have a central role to play in corporate pension policies, and when it comes to defined benefit pension plans that role can be significant in the pension plan funding levels. While boards can delegate some of their pension responsibilities, typically they are involved in pension policy determination, and responsible for monitoring pension fund investments and funding (Anantharaman & Lee, 2014).
Company boards have a fiduciary responsibility to pension plan beneficiaries, who are effectively debtholders of the company, to safeguard their interests. On the other hand, they have a duty to act on behalf of shareholders, and these two responsibilities can at times be conflicted. The board could, for example, shift risk from shareholders by keeping the company’s pension plans underfunded and investing in riskier assets.
Research indicates that this fiduciary responsibility towards pension plan participants mitigates the incentive to underfund pension plans and encourages directors to take a more conservative asset allocation strategy, particularly when the company is approaching a state of distress (Becker & Stromberg, 2012). Research has shown that companies with good external corporate governance tend to take on more risk by investing more heavily in equity (Phan & Hegde, 2013). Similarly, Cocco and Volpin (2007) found that pension plans with a greater number of executive directors as trustees invested more of plan assets into equities.
The benefits to risk shifting increase as a company gets closer to bankruptcy, however there is mixed empirical evidence on the role pension underfunding plays in risk shifting (Bereskin, 2011; Rauh, 2009), although there is some evidence to suggest that board composition can play a role in pension related risk taking decisions (Pathan, 2009).
Theoretically, all board members (inside and outside directors), should have an equal commitment to meeting their obligations to shareholders and pension plan beneficiaries, although in reality inside board members may experience greater pressure to side with shareholders, for various reasons such as the perceived threat of losing their job.
The researchers put forward two study hypotheses:
Hypothesis 1 – “As the probability of default rises, the tendency to shift risk through pension plan underfunding is mitigated by increases in the proportion of outside directors serving on the board.”
Hypothesis 2 – “As the probability of default rises, the tendency to shift risk through pension asset allocation choices is mitigated by increases in the proportion of outside directors serving on the board.”
How the research was conducted
This study examined 960 US companies over the period 2002 – 2010, who had defined pension plan obligations. The study population and data was sourced primarily from the COMPUSTAT Pension annual data file, the Corporate Library, proxy statements, and 10-K report reports.
Data was collected on various factors relating to defined benefit pension plan characteristics and board composition. The researchers then developed a model to test their hypotheses.
Key Research Findings
The average defined benefit pension plan was found to be underfunded by 19.3% and invests 60.4% of its assets in equities.
The average board consisted of 10.45 directors, 83.5% of which were outside directors.
Average company assets were $21.6 billion and average defined pension plan assets were $1.6 billion.
Both Hypotheses 1 and 2 were supported by the results, with outside directors mitigating the tendency to shift risk through pension plan underfunding and asset allocation as the probability of default increased.
Companies with more outside directors on the board were found to have better funded plans and also invested a greater proportion of plan assets in equity. A 10% proportional increase in the number of outside directors increased funding status by 0.55%.
Companies with better funded plans, with more stable cash flows, and are further from distress, invested more of plan assets in equity.
Funding status was also positively related to size of the board.
The results of this study provide evidence that pension management policies are influenced by the composition of the company’s board of directors. When it comes to pension governance, the results indicate a number of benefits to having a high proportion of outside directors on the company board, with better funded and governed pension plans having more outside directors.
Consistent with the research hypotheses, outside directors play an important role in mitigating companies taking the approach of shifting risk through pension plan underfunding and asset allocation as default approaches. The results suggest that when companies are close to distress, outside directors continue to act in the interests of the pension plan beneficiaries, with respect to both asset allocation choices and funding levels, and according to their fiduciary responsibilities.
Organizational and Reward Implications
The results provide strong support to prior research which linked pension policies management outcomes with board composition (Phan & Hegde, 2013; Anantharaman & Lee, 2014). This study highlights the importance of outside directors in maintaining the interests of pension beneficiaries as well as keeping the company board aligned to their fiduciary responsibilities.
This study highlights a number of advantages to having outside directors on the boards, for both the company and pension beneficiaries, and as such the results should give encouragement to companies to give careful consideration to their board’s composition and to the merits of having a high proportion of outside directors.
This study examines the role of board composition in dealing with the conflicting interests of shareholders and pension plan beneficiaries and establishes the value that outside directors can bring. The large number of companies studied over an extended period add considerable validation to the results. However, as the study is primarily US focused, the results should be considered with that in mind. Further similar research in other countries would likely yield valuable additional insight into this area.
Source Article: Vafeas, N. & Vlittis, A. (2016). The Association between Board Composition and Corporate Pension Policies. Financial Review, 51(4), 481–506.
Published by: John Wiley & Sons, Inc.
For further details and access to the full journal article Click Here (subscription or payment may be required).
Anantharaman, D., & Lee, Y.D. (2014). Managerial risk-taking incentives and corporate pension policy. Journal of Financial Economics, 111(2), 328–351.
Becker, B., & Stromberg, P. (2012). Fiduciary duties and equity-debtholder conflicts. Review of Financial Studies, 25(6), 1931–1969.
Cocco, J., & Volpin, P. (2007). The corporate governance of defined-benefit pension plans: Evidence from the United Kingdom. Financial Analysts Journal, 63(1), 70–83.
Pathan, S. (2009). Strong boards, CEO power and bank risk-taking. Journal of Banking and Finance,33(7), 1340–1350.
Phan, H., & Hegde, S. (2013). Corporate governance and risk-taking in pension plans: Evidence from defined benefit asset allocations. Journal of Financial and Quantitative Analysis, 48, 919–946.
Rauh, J. (2009). Risk-shifting versus risk-management: Investment policy in corporate pension plans. Review of Financial Studies, 22(7), 2687–2734.
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