Corporate Governance of Pension Plans: The U.K. Evidence

For this study of the governance of defined-benefit pension plans in the United Kingdom, the governance measure was equal to the proportion of trustees of the pension plan in 2002 who were also executive directors of the sponsoring company. The findings indicate that pension plans of indebted companies with a higher proportion of insider than independent trustees invest a higher proportion of pension plan assets in equities and that the sponsors contribute less to the plan and have a larger dividend payout ratio. This evidence supports the agency view that insider trustees act in the interests of shareholders of the sponsor, not necessarily in the interests of pension plan members.Many companies have promised their employees defined-benefit (DB) pensions. The large increases in life expectancy that have occurred since the 1970s and the decline in interest rates that are used to calculate the present value of pension liabilities have led to significant increases in corporate pension liabilities. As a result, many DB corporate pension plans now show substantial deficits.In the United Kingdom, which is the focus of this article, DB pension plans are set up in trusts with trustees responsible for the trust assets and management. More precisely, the trustees must decide how to invest the assets of the pension plan and must put in place a schedule of contributions for the sponsoring companies. These powers, combined with the size and deficit of the pension plans, mean that the actions of pension plan trustees have important implications not only for pension plan members (or beneficiaries) but also for the value and behavior of sponsors.The law specifies that the trustees of the pension plan may be directors of sponsoring companies, which may lead to conflicts of interest between the executive and trustee roles. In this article, we study such conflicts of interest.We focus on two alternative hypotheses. The first is that the presence of insiders is a source of agency problems because it allows insider trustees to favor shareholders of the company over members of the pension plan. A company with a DB pension plan can be considered to own a put option: If the assets (the company and DB assets) fall short of the pension fund liabilities, the company has the option of giving those assets to the DB beneficiaries as payment. Because the value of a put option increases with the risk of the underlying assets, insider trustees may have an incentive to increase the riskiness of the assets (the company and the DB plan assets) beyond what is optimal for the members of the pension plan by, for example, investing the pension plan assets in equities.Agency problems may also be reflected in the contributions paid into the pension plan. Pension plan liabilities are similar to long-term debt, and pension plan members are debtholders of the company. Insider trustees who favor shareholders of the company over debtholders (i.e., pension plan members), however, may have an incentive to reduce company contributions to the plan.The second hypothesis is that insider trustees facilitate an efficient management of tax liabilities, which may be positive for both shareholdersand pension plan members. More precisely, companies may be able to generate tax savings if they integrate their financial and pension investment policies: If a company increases leverage, uses the proceeds to fund the pension plan, and invests those funds in bonds, it may generate tax savings without affecting financial risk. The reason is that the increase in leverage generates a debt tax shield while the return on bonds held in the pension plan is tax exempt.To test these hypotheses, we collected information for 2002 and 2003 on U.K. companies that had DB pension plans. We found evidence that supports the agency hypothesis that insider trustees act in the interests of shareholders of the sponsoring company, not necessarily in the interests of pension plan members. More precisely, we found that pension plans of the more-leveraged companies with a higher proportion of insider trustees invest a higher proportion of the pension plan assets in equities than do other plans and, in this way, make riskier investments. Also, we provide evidence, consistent with the risk-shifting effect, that the presence of insider trustees allows companies to reduce contributions to the plan.