Previous research has suggested that, prior to the 1986 Tax Reform Act, the optimal strategy for tax-paying investors was to hold bonds in their pension fund and stock outside the fund. Given pension funding rules, however, it is likely that a better strategy would have been to employ some combination of risky assets and bonds. This is because risky assets expand the tax-exempt base beyond the full-funding limits defined in the Internal Revenue Code.

A steady-state pension plan with either a balanced portfolio of bonds and stock or an all-stock portfolio would have generated tax benefits only about two-thirds as high as the tax benefits to an all-bond alternative prior to 1986. But a dynamic strategy that called for an all-stock portfolio until substantial funding was achieved, followed by a switch to an all-bond portfolio, would have far outstripped the tax gains from a static all-bond portfolio.

The incentive to hold bonds in pension portfolios was substantially reduced by the Tax Reform Act of 1986. Elimination of the special capital gains tax substantially reduced the previous inequality between pre-personal-tax bond and equity returns. The new legislation left unaffected, however, the trust-expanding benefits of risky assets. Asset allocation strategies calling for substantial stockholdings thus become optimal under current tax laws.