The sponsor of a defined benefit pension plan is obliged to pay some minimum level of benefits, regardless of the performance of the pension fund’s investment portfolio. To minimize the cost to the corporation of providing this guarantee, the plan sponsor should hedge it by investing in fixed income securities or by pursuing a strategy of portfolio insurance.
Investing in equities will increase the volatility of plan assets. While this may also increase their return, any advantage to corporate shareholders will in general be limited. The cost of insuring against shortfall risk (i.e., guaranteeing the minimum benefit) will increase with increased volatility and with the duration of the plan’s liabilities. If management does not possess superior investment skills, this increased cost will not be covered by increased returns unless the corporation can be considered to own 100 per cent of any pension surplus. This is rarely the case.
If the goal is to hedge the guaranteed benefit, equities are not the answer (even in inflationary periods). Equity investments may be justifiable for funds being managed as if they were defined contribution plans and for some funds with active managers who possess superior investment skills. Also, for underfunded plans of financially distressed sponsors, investment in equities may be used to exploit the pension insurance provided by the Pension Benefit Guaranty Corporation.