The Expected-Rate-Of-Return Assumption Fails to Reflect Cross-Sectional Differences in Pension Asset Allocation: A Case of Financial Statements Management

Abstract

We use pension asset allocation data to examine the relation between the expected long-term rate of return (ERR) on pension assets and the amount of funds allocated by fund managers to equity securities. If firms use their best estimate of the ERR, then cross-sectional differences in the ERR should reflect cross-sectional differences in the riskiness of the underlying portfolio of plan assets. We find a weak association between the assumed ERR and the percentage of equity investments. However, we find that the ERR is negatively associated with the funding status of the plan, positively associated with leverage and negatively associated with pension-related labor renegotiation costs. These findings lead us to conclude that firms do not use their best estimate of the ERR; rather, they choose this parameter to reduce the reported pension expense, to reduce the probability of violating debt covenants, and to minimize labor negotiations costs.

JEL Classification: M41, G23