"Efficient Gain and Loss Amortization and Optimal Funding in Pension Plans," M. Iqbal Owadally and Steven Haberman, January 2004

North American Actuarial Journal, Apr 2004 by Gold, Jeremy, Cowling, Charles, Exley, Jon, Hudson, Nick, Et al

Turning to the members of the pension plan, it is clear that the Modigliani-Miller conditions are not satisfied. These individuals have large amounts of their wealth tied up in defined-benefit pension assets that cannot be traded, so they cannot change their private portfolios in ways that could nullify changes to their pension benefits - thus, assumption (iv) does not hold. We argue that the financial strategy adopted by the pension plan affects the balance between the security of the termination benefit and the security of the retirement benefit. There are no market transactions members can perform that would alter the balance between these risks. Consequently, changes to the financial strategy of the pension plan will have real "first-order" consequences for the diversification of risk within each member's private portfolio.

Our view is that the assumption of independence between the sponsor and the plan is crucial and the erosion of this assumption is partly the cause of the decline in defined-benefit pension provision. It must be recognized that defined-benefit pension risk is not born by stockholders alone, but is also borne by plan beneficiaries because of uncertain discretionary benefit enhancement and job mobility. In our view, a "consumer-centric" approach must be restored, whereby the defined-benefit promise is simplified and made explicit so that both employees and stockholders can cost it under standardized valuation models and identify the risks they take. This should then improve the quality of information available to investors and employees when they value company stock and employee contracts, respectively. This may involve the introduction of novel designs for defined benefit pension plans, such as variable benefit accrual rates (Khorasanee and Ng 2000).

REFERENCES

KHORASANEE, M. ZAKI, AND ho KUNG Nu. 2000. "A Retirement Plan Based on Fixed Accumulation and Variable Accrual," North American Actuarial Journal 4(1 ): 63-79.

MODIGLIANI, F., AND M. II. MILLER. 1958. "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review 48: 261-97.

OWADALLY, M.I. 2003. "Pension Funding and the Actuarial Assumption Concerning Investment Returns," ASTIN Bulletin 33(2): 289-312.