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Review of Accounting Studies

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01-09-2015

CEO incentives and the health of defined benefit pension plans

Authors: Joy Begley, Sandra Chamberlain, Shuo Yang, Jenny Li Zhang

Published in: Review of Accounting Studies | Issue 3/2015

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Abstract

We examine the relation between CEO pay-related wealth and the funding levels, and freezing decisions, of defined benefit pension plans. Results show that higher funding levels occur when CEOs are most endowed in employee pension plans, but that spillover endowments in supplemental executive plans coincide with the lowest funding levels. CEO equity-wealth correlates with funding health in between the extremes. Further, “hard freezes” of employee plans are less likely, the larger the CEO’s total pension interest (in executive and employee plans together). This suggests that CEOs fear repercussions to their own pension plan when employee plans are frozen.

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In bankruptcy, some unfunded defined benefit entitlements may be protected by the Pension Benefit Guaranty Corporation (PBGC), a self-funded insurance plan for defined benefit plans. But the upper limit on this protection is modest. In 2013, the maximum pension benefit is set at $4790 per month for employees retiring at age 65.

We assume the CEO influences these decisions. Cocco and Volpin (2007) use UK data to show that insiders such as the CEO influence the riskiness of instruments that secure the plan obligation, providing some support for this assumption. Anantharaman and Lee (2014) assume that oversight of the pension trust tends to be entirely in the hands of insiders (p. 330) but find more support for the CFO’s influence relative to the CEO.

In other words, our strongest results hold for the measure of funding which is most commonly used by regulators and by prior studies such as Anantharaman and Lee (2014).

Another related paper is by Asthana (2009), who finds that tax qualified plans are better funded if plan participants are highly compensated (e.g., CEOs). Asthana’s evidence is consistent with our findings.

See also Perun and Valenti (2008), who link defined benefit plan popularity to market movements. Campbell et al. (2010) document that the PPA event is associated with negative excess returns to corporate sponsors with underfunded plans. Butricia et al. (2009) conjecture that the PPA will further reduce the number of defined benefit plans.

Firms also report ABO (accumulated benefit obligation), the present value of their current defined benefit pension obligations, assuming no increase in future salaries. If a firm decides not to continue offering its workers a defined benefit plan for their future services (i.e., a plan freeze), future pension payouts will be based on current, but not future, salary levels. Freezing therefore typically improves plan funding, by reducing PBO to be equal ABO.

Current service costs are the benefits workers accrue under the defined benefit plan each year they work for the firm.

Specific funding rules have varied over time. Following ERISA, updated legislation governing minimum funding levels is contained in the Pension Protection Act (PPA) of 1987 and 2006, the Retirement Protection Act of 1994 and the Worker, Retiree and Employer Recovery Act of 2008 (Chen et al. 2013).

Recent work by Cheng and Swenson (2014) also studies determinants of pension contributions, using data that pre-dates the 2006 PPA and our sample period. The authors find that total CEO compensation is negatively related to defined benefit plan contributions, and they attribute this finding to incentives by executives to report high cash flow from operations. The research design does not rely on minimum contributions.

Empirically, we will use control variables to help isolate the effect of voluntary contributions on defined benefit plan health.

Exceptions to this view are Anantharaman et al. (2014) and Cadman and Vincent (2014).

Our intuition for shareholders is consistent with that of Tepper (1981) and Black (1980), who argue that tax arbitrage should lead to overfunding of qualified defined benefit pension plans. Thomas (1988) notes that the arguments in the above studies are weakened under the actual practice that over-funding cannot be withdrawn. The fact that assets are held in trust is a further reason that contributions to the defined benefit pension plan intensify conflicts between unsecured debt-holders and shareholders.

Firms often introduce other retirement benefits, such as a defined contribution pension plan, when defined benefit plans are frozen. Rauh et al. (2013) find that, when defined benefit pensions are frozen, companies see a net decline in payroll costs of 2.7–3.6 %, suggesting employees are not fully compensated for their lost pensions.

While employees who are early in their careers with the firm can be relatively indifferent between the expected outcomes of a defined benefit or a defined contribution plan, as they approach retirement, the value of defined benefit pension benefits increases at a faster rate, making switching to a defined contribution plan much more costly for employees late in their career (Fig. 5). See also Munnell et al. (2007).

Cadman and Vincent (2014) point out that there are two types of executive pension arrangements: nonqualified plans linked directly to the terms offered to rank-and-file employees and widely available to many executives and special plans that are tailored to individual executives. We refer to these special plans as top-hat plans. Freezing the executives’ nonqualified pension can be tied to freezing employee defined benefit plan, whereas the top-hat plans are not automatically frozen. We do not separate these two types of plans. Therefore, in H2B, we assume that the majority of CEOs in our sample with EXEC_PLAN wealth have nonqualified excess defined benefit plan pensions.

We randomly sampled 15 plan freezes and found that 10 executive plans froze at the same time as employee plans.

Compustat records PBO from the 10-K pension footnote. This is total PBO of all defined benefit plans, including supplemental and foreign plans. To focus on decisions for U.S. tax-qualified plans only, we attempt to remove supplemental and non-U.S. plans from our pension measures by hand-collecting voluntarily disclosed detail on these plans from 10-K footnotes. In cases where supplemental plans are not disclosed separately in the 10-K, we use EXEC_PLAN of the top five officers from Execucomp.

As mentioned in our theory section, a decision to switch to a cash balance plan or to freeze existing defined benefit plans are alternative ways of managing the funding status of defined benefit plans, and these choices can be influenced by the incentive alignment of the CEO with firm employees.

Firms with multiple plans do not necessarily freeze all of their plans at the same time. In particular, unionized plans are sometimes the last plans to freeze. We attempt to identify the final date on which all U.S tax-qualified defined benefit plans become frozen.

Beginning in 2006, the SEC required, for the first time, the finer details on the pension plans and deferred compensation of their CEO, CFO, and the three other highest paid executives.

To identify the qualified defined benefit plan, we manually read the description of each plan in the proxy statements, 10-K filings, or both.

In the final year of the CEO’s tenure, this measure falls to zero if the CEO is paid out upon retirement, even though, during the year up until their retirement, the CEO may have had wealth in the firm’s pension plans.

The exception is 2006. In 2006 the sample is smaller because firms with a fiscal year end prior to December 15, 2006, were not required to disclose the breakdown of executive pensions in their proxy statements.

The sample with adjusted ABO available is smaller because 10-K footnotes that disclosure supplemental and foreign plans separately report a breakdown for PBO and plan assets but they do not always report a breakdown for ABO. As we analyze PBO, not ABO, this is not a problem.

These amounts are higher if we exclude cases where the CEO is not part of the employee plan. (The untabulated mean is 25 %, and the median is 12 %.) For those CEOs with a positive interest in the employee plan (denoted EMP_PLAN_VALUE_A), their average (median) dollar entitlement is $580,000 ($421,000).

In addition, failing to find evidence consistent with H1C when funding status is measured relative to total assets could be due to controlling for plan size. In untabulated analysis, we find that, when we take plan size out of the regressions using funding status to total assets, the F-tests become significant at the 10 % level or better across all 8 subsamples.

We report results for a smaller set of instrumental variables for brevity. We looked to other studies such as Anantharaman and Lee (2014) and Liu and Mauer (2011) for additional IVs. We checked the robustness of our two-stage least squares results by using a variety of additional instruments, e.g., CEO age, CEO tenure, firm age, idiosyncratic risk of the firm. In all cases, the results are similar to those reported in Panel A of Table 7 when the instrument variable passes the over-identification tests. The instrumental variables we report behave the best in over-identification tests.

An additional 159 firms enter our sample already frozen.

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Title: CEO incentives and the health of defined benefit pension plans
Authors: Joy Begley
Sandra Chamberlain
Shuo Yang
Jenny Li Zhang
Publication date: 01-09-2015
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 3/2015
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-015-9332-0

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