Does Smoothing in Pension Accounting Encourage Equity Investment in Corporate Pension Plans? Evidence from the U.K.

Abstract

I test whether the introduction of a new pension standard (FRS 17) in the U.K., which virtually eliminated the smoothing mechanisms in pension accounting, is associated with a reallocation of assets from equities to bonds in defined benefit pension plans. My findings indicate that sample firms reduced their equity allocation by about 8 percentage points, on average, after the passage of FRS 17. Further, the magnitude of the asset reallocation depends on the financial reporting effect of FRS 17, and is positively associated with: (i) the increase in reported pension underfunding, (ii) the expected future volatility of reported actuarial gains/losses, and (iii) the increase in reported pension expense. The systematic shift away from equities after FRS 17 indicates that the smoothing mechanisms in pension accounting encourage equity investment in pension plans by enabling firms to avoid the financial reporting costs of equity volatility. This paper contributes to the ongoing debate among standard setters about the economic consequences of smoothing in pension accounting.