A critical perspective of pension tax arbitrage
Authors: Kirkpatrick, A.K.
Pension tax arbitrage theory is controversial in that it concludes that defined benefit (DB) pension plans should shift all their assets to bonds. Pension tax arbitrage may occur when a change in asset allocation of a DB pension scheme together with a change in the financing structure of the sponsoring employer firm results in additional tax-based financial returns without increasing the overall financial risk. A share buyback may be financed by an issue of bonds, and the assets of a pension plan (PP) may be shifted from equities to bonds issued by external companies. Tax advantages arise if interest on corporate debt is tax-deductible, while risk neutrality assumes that shifting assets in a DB pension plan from equities to bonds reduces risk to an extent that exactly offsets the increased risk associated with higher corporate gearing. This article considers the practical relevance of the theory of pension tax arbitrage and how to assess the impact of reported financial information on the market capitalisation of the sponsoring companies. Concerns over large and increasing pension fund (PF) deficits have added to the sense of urgency to seek more conclusive evidence of the practical impact of PF asset allocation decisions, including those based on pension tax arbitrage strategies. The main contribution of this article is to develop an insight into pension tax arbitrage in the light of accounting standards, government policy objectives and corporate pension investment policy. Further research is recommended to explain the asset allocation of PPs and in particular the reasons why so few company boards apply pension tax arbitrage strategies, and to assess the value relevance of PP asset allocation information. © 2010 Macmillan Publishers Ltd.
Preferred by: Alan Kirkpatrick