Pension Fund Governance in the US and Europe

CEPR Discussion Paper No. 3955

Pension Fund Governance and the Choice between Defined Benefit and Defined Contribution Plans

Authors: Timothy Besley (London School of Economics and CEPR) and Andrea Prat (London School of Economics and CEPR)

Over the last decade, the policy debate on pensions – especially in Europe – has focused mainly on public pensions but recent events in several countries have now generated an equally strong interest in private pensions. Falling stock prices have created a gap between promised benefits and available funds and have led to questions about the investment strategy of private pension funds. In CEPR Discussion Paper No. 3955, Timothy Besley and Andrea Prat analyse the interplay of residual claims and control rights in private pensions to show how they relate to decisions on funding, asset allocation, and asset management. Besley and Prat’s Paper offers the following observations and recommendations:

• The recent failure of the Enron Corporation has highlighted the danger of employees investing in the company’s own stock in their pension plans. When Enron failed, its employees lost not only their jobs but also most of their pension assets. In the US, 5 million employees have over 60% of their pension assets invested in their own firm’s stock.

• A recent trend, in both the US and the UK is the dramatic shift from Defined Benefit (DB) to Defined Contribution (DC) plans. In DB plans, payments to retirees are defined in advance, with employers bearing the investment risk. DC plans effectively transfer the risk onto employees, by specifying only the contribution to the plan, and making no guarantee about eventual payout in retirement.

• The core contribution of Besley and Prat’s work is to establish a connection between the residual claim structure of a pension fund and its optimal control right structure.

• Besley and Prat identify the problem of pension fund governance: pension arrangements are highly incomplete contracts extending over many years. Under DC plans sponsors tend to be a dispersed and disorganized group, making monitoring the management of their pension fund difficult. 

• A solution is for a strong board of trustees to monitor the performance of the pension fund. The effectiveness of such a board depends on the existence of a well-defined job market for trustees and of the independence between the trustees’ decisions and fund performance. 

• If the pension sponsor is responsible for asset allocation, the risk of misallocation is a particular issue for DC plans because the sponsor’s allocation objectives may not be aligned with the goal of efficient allocation. 

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