The Association between Board Composition and Corporate Pension Policies

• Published date: 01 November 2016
• Author: Adamos Vlittis,Nikos Vafeas
• DOI: http://doi.org/10.1111/fire.12113
• Date: 01 November 2016

The Financial Review 51 (2016) 481–506

The Association between Board

Composition and Corporate Pension

Policies

Nikos Vafeas∗

University of Cyprus

Adamos Vlittis

Cyprus Institute of Marketing

Abstract

This study examines the role of board composition in the determination of pension

policies. The results suggest that the proportion of outside directors serving on the board

is positively related with pension plan funding levels. In addition, the proportion of outside

directors mitigates the relation between financial distress risk and plan underfunding. Last, as

firms approach distress, boards with a greater proportion of outside directors tend to allocate

a lower fraction of plan assets to riskier securities. Together, our findings suggest that outside

directors are mindful of their obligations toward pension plan beneficiaries.

Keywords: board of directors, pension policies, defined benefit pension plans

JEL Classifications: G32, G34

∗Corresponding author: School of Economics and Management, University of Cyprus, Kallipoleos 75,

Nicosia 20537, Cyprus; Phone: +357-22893601; Fax: +357-22895475; E-mail: bavafeas@ucy.ac.cy.

We have benefited from comments and suggestions by two anonymous reviewers, seminar participants

at the University of Edinburgh and the Cyprus University of Technology, and in particular from input

by Stergios Leventis, Alex Michaelides, Andreas Milidonis, Lenos Trigeorgis, Martin Walker and Dave

Yermack. We thank John Graham for providing the corporate marginal tax rates data and Beryl Pittman

for editorial input. Nikos Vafeasacknowledges research support from the University of Cyprus. Theodora

Papanastasiou provided competent research assistance.

C2016 The Eastern Finance Association 481

482 N. Vafeasand A. Vlittis/ The Financial Review51 (2016) 481–506

1. Introduction

This study extends prior research on the relation between corporate governance

mechanisms and pension policies (e.g., Cocco and Volpin, 2007; Phan and Hegde,

2013; Anantharaman and Lee, 2014) by examining the role of board composition in

pension plan funding and asset allocation decisions. The board of directors, and in

particular its outside directors, has a potentially important monitoring role to play in

the determination of pension policies given that shareholders and plan beneficiaries,

who are a pension plan’s primary stakeholders, are not well positioned to impose

effective governance. Drawing from the board literature (e.g., Adams, Hermalin and

Weisbach, 2010), we study how outside directors help to shape corporate pension

policies. The primary tension motivating our investigationis provided by the conflict-

ing interests of shareholders and pension plan beneficiaries, and the pension-related

fiduciary responsibility bestowed on directors by regulators. It is a priori unclear how

outside directors behave toward these different constituents in the contextof pension

plans. The present study addresses this issue empirically.

Before we proceed to assess the importance of board composition, we should

review the nature of competing interests in the determination of pension policies

necessitating the enforcement of proper monitoring mechanisms. The institutional

structure of defined benefit (DB) plans in the United States creates an agency conflict

that is similar to the conflict between equity- and debtholders as a firm approaches

financial distress (Jensen and Meckling, 1976; Myers, 1977). If we view the DB

plan as corporate debt, limited downside risk constrains shareholder losses in the

case of failure but awards shareholders the full benefits when the fund performs

well. Therefore, shareholders of firms approaching distress have risk-shifting in-

centives that manifest in incentives to underfund their pension plans and to invest

plan assets in risky securities (Sharpe, 1976; Treynor, 1977).1The empirical evi-

dence on the risk-shifting hypothesis, however, is weak. While some studies find

evidence of risk shifting with regard to the funding decision (e.g., Bodie, Light,

Morck and Taggard, 1985; Coronado and Liang, 2005; Bereskin, 2011), the ma-

jority of prior studies find evidence consistent with a competing risk-management

explanation especially when it comes to the asset allocation decisions (e.g., Fried-

man, 1983; Francis and Reiter, 1987; Petersen, 1996; Amir and Benartzi, 1999).

The risk-management explanation suggests that incentives stemming from manda-

tory pension contributions increase liquidity constraints and financial distress costs,

leading financially weaker firms to select more conservative investment strategies

(Rauh, 2009).

Anatharamam and Lee (2014) propose the shareholder–manager conflict on risk

as an additional explanation to the weak empirical evidence on risk shifting. While

1This conflict is exacerbated by the insurance provided by the Pension Benefit Guaranty Corporation

(PBGC). The PBGC insurance shifts the loss away from plan beneficiaries to the PBGC and reduces the

incentives of plan beneficiaries to monitor management of their plan.