Some financial implications of United States pension actuarial methods and assumptions

This dissertation consists of a preface and three chapters each examining how pension actuarial principles distort the financial management of U.S. defined benefit pension plans. Pension actuarial methods were originally developed to assess the relationship between plan assets and liabilities and to manage the flow of cash contributions made by sponsors. Subsequent extensions of actuarial principles to pension accounting and law influenced all aspects of corporate pension plan financial management while ignoring and contradicting contemporaneous developments in finance. This has distorted the accounting, tax and investing environment for U.S. pensions. The first chapter, Assumed Rates of Discount for Valuations of Publicly Sponsored Defined Benefit Plans, illustrates how the use of expected returns on plan assets, unadjusted for risk, misrepresents intergenerational costs in the public sector. Second, The Shareholder-Optimal Design of Cash Balance Pension Plans applies the corporate finance lessons of Black (1980) and Tepper (1981) to “cash balance” pension plans, concluding that these plans can best serve shareholders by investing in fixed income assets while offering equity-based returns to plan participants. Third, Biased Methodology Enables Defined Benefit Pension Plan Equity Investments shows that actuarial distortion can overrule the lessons of financial economics. Actuarial principles erroneously presume that defined benefit plans may anticipate the rewards of risky investing and smooth away the risks incurred without causing bias. Modern finance may correct this and inform future actuarial theory in three ways: (i) market risk cannot be diversified without limit; (ii) Independent risks compounded over time increase absolutely even though the risk per unit of time decreases; (iii) pricing by arbitrage is intellectually compelling when its necessary conditions are met and systems that offer arbitrage opportunities are inherently fragile. Actuaries trained in modern finance are equipped to participate in correcting the biases embedded in present actuarial principles. Recent actuarial writings have moved to integrate actuarial and financial principles. This dissertation is designed to abet that integration in the pension sector