DB dilemma: How do investment decisions affect stock returns?

Corporate plans that adopt an LDI framework intend to derisk over time, which can help stabilize the company’s balance sheet but also result in a negative earnings adjustment. In this paper, we share research on the effect derisking can have on the value of a company’s stock, including the relationship between valuations and the pension balance sheet/pension earnings, the impact of changes in ROA assumptions, and the effect of pension buyouts.

ANY VIEWS EXPRESSED HERE ARE THOSE OF THE AUTHOR AS OF THE DATE OF PUBLICATION, ARE BASED ON AVAILABLE INFORMATION, AND ARE SUBJECT TO CHANGE WITHOUT NOTICE. INDIVIDUAL PORTFOLIO MANAGEMENT TEAMS MAY HOLD DIFFERENT VIEWS AND MAY MAKE DIFFERENT INVESTMENT DECISIONS FOR DIFFERENT CLIENTS.

SETTING INVESTMENT POLICY IS ALL ABOUT UNDERSTANDING TRADEOFFS BETWEEN RISK AND RETURN. In our discussions with US corporate defined benefit (DB) plan sponsors, we have found that one of the tradeoffs that is top of mind for investment committees and senior company management is an accounting trade-off: Plans that have adopted an LDI framework intend to gradually derisk over time (shifting assets from return-seeking assets to liability-hedging assets),  a move that can help stabilize the company’s balance sheet but can also result in a negative earnings adjustment.

In this paper, we share our research on this dilemma and the effect derisking can ultimately have on the value of a company’s stock. We address three questions in particular:

  1. What matters for stock valuations — the pension balance sheet or pension earnings?
  2. Does reducing a plan’s return on assets (ROA) assumption hurt stock returns?
  3. How do pension buyouts affect stock returns?

Importantly, as we discuss in the paper, the derisking dilemma is a result of US accounting rules relating to the ROA assumption, and therefore is relevant only to US plans…

To read more, please click the download link below.

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