Short-Termism and the Asset Allocation Decisions of Defined Benefit Pension Plans

We examine the presence of short-termism in the asset allocation decisions of U.S. private defined benefit pension plans. We document an inverse U-shaped relationship between a plan's allocation to fixed income securities and its funding ratio, centered on a 80% funding ratio, and show that the relationship is stronger among plans sponsored by companies in financial distress, and whose CFOs have accumulated a substantial amount of risky pension benefits. We then theoretically demonstrate that this relationship emerges from loss-averse preferences of the plan's investment committee (supervised by the CFO), with respect to a 80% funding ratio. We additionally show that these preferences encompass both risk-shifting and risk-management behaviors, and as such allow us to explain two empirical features of U.S. defined benefit plans: a collapse in their average funding ratios over the past three decades, and the more recent shift toward fixed income securities in their allocation decisions. Assimilating these loss-averse preferences with short-termism, we conclude that plans without such preferences achieve a significant improvement in their funding ratios over the long-run