Overfunded Pension Plans, Early Termination, and Asset Allocation Strategies: an Option Theoretic Approach

The objective of this paper is to explain the reluctance of pension fund sponsors to terminate overfunded defined benefit pension plans (hereafter, pension plans). The paper extends the “pension put” option-theoretic approach of Sharpe [1976] and Bicksler and Chen [1985] to a “pension call” model to describe a general phenomenon of the unwillingness to terminate overfunded plans by their sponsors. Recently, Turner and Beller [1989] estimate that by 1987 aggregate pension assets were 125.7% of aggregate pension liabilities. This indicates that pension funds are overfunded. In addition, Alderson and Chen [1986], Haw, Ruland, and Hamdallah [1987], VanDerhei [1987], and Mitchell and Mulherin [1989] provide evidence that the terminations of overfunded pension plans can, indeed, produce positive statistically significant abnormal returns. Nonetheless, only 0.7% of all plans had been terminated as of 1987-accounting for a mere 9% of the excess plan assets (Mitchell and Mulherin [1989 p.43]). A question that naturally arises, then, is, “Why haven't more sponsors terminated their overfunded plans?” Some research has been done in this area with the focus on factors such as implicit labor agreements (Ippolito and Turner [1987]), tax abuse (Ippolito [1986]), financial distress (Mittelstaedt [1989] and Thomas [1989]), and efficient market (Ippolito and James [1992]). This paper offers an alternative explanation that does not base on neither external factors nor on termination costs. Instead, our “pension call” option-theoretic approach shows that it is economically sub-optimal to divest overfunded portfolios of risky assets. Besides, our model also provides implications on the allocation strategies of pension plans. This paper is organized as follows. Section II analyzes the “pension call” option model and summarizes the general implications of the model. Section III discusses the asset allocation decisions and section IV concludes the paper.