1. Impact of Pension Accounting Rule Change on UK Pension Plan Terminations Paul Klumpes, Imperial College Liyan Tang, University of Stirling Mark Whittington, Aberdeen University

2. ARIA Quebec, Aug 72 Motivation  Recent demise of employer-sponsored defined benefit pension arrangements in the UK  FRS17 controversy- real or scapegoat?  UK firms’ response to uncertainty over pension accounting and funding regulatory environment  Actuarial switching-does it bear on subsequent terminations?  Pension plans terminations- competing theoretical explanations?

3. ARIA Quebec, Aug 73 Objectives  Examine determinants of plan terminations in an economic environment of under- funding, where pension surplus reversion does not apply  Investigate competing hypotheses from finance, insurance and labour economic literature on managerial termination decisions  Examine whether terminations are inter- related with firms’ prior accounting policy choice (actuarial valuation method switch)

4. ARIA Quebec, Aug 74 Outline Background Literature review Competing hypotheses for termination Sample and data Empirical results Conclusion and further research

5. ARIA Quebec, Aug 75 Background- Pension Terminations Legality of pension funds as equitable trusts – ‘property rights’ or trustee responsibility? US evidence:  Early 1980s – excess surplus motivates takeovers UK evidence:  Pre-1998 – firms take contribution ‘holidays’  1999- equity crash; many funds in deficit  Post FRS 17 – many terminations: why?

6. ARIA Quebec, Aug 76 Background (cont.)- Recent Demise of UK DB Plans  84 ‘Final Salary’ Schemes were closed in 2002, increased by 50 percent from 2001  Creation of the Pension Protection Board  Over 30% of private employer schemes are now closed to new entrants, compared with 17% in 2001  Employer contributions into replacement ‘money purchase’ schemes are only at half of the level of final salary schemes  So not just a risk transfer but a cost reduction exercise -source: NAPF( National Association of Pension Funds) 2002 Annual Survey

7. ARIA Quebec, Aug 77 Prior Research (US) Early 1980s (excess surpluses, managerial discretion over spreading of pension costs):  Put option voluntary termination to PBGC (Marcus, 1985)  Studies identified association between corporate financial characteristics and managerial decision to terminate over-funded pension plans (Thomas,1989; Mittelstaedt,1989; Stone,1987;Hamdallah and Ruland, 1986)  Other studies documented managerial actuarial switching decisions could be motivated by corporate financial characteristics (Ghicas, 1990; Godwin et al, 1996)

8. ARIA Quebec, Aug 78 Prior Research (UK)  Klumpes and Whittington (2003)  FRS 17: switch to actuarial fair valuation method  Examine corporate vs pension related determinants of UK actuarial switching  results support pension plan characteristics driving switching decision hence supporting the separation hypothesis

9. ARIA Quebec, Aug 79 Competing Ownership Hypotheses on Terminations  Integration hypothesis from corporate finance literature (Sharpe,1977;Treynor,1977)  Pension fund entirely belong to sponsoring firm  Separation hypothesis from labour economics literature (Ippolito,1985;Cooper and Ross, 2002)  Pension fund separate from sponsoring firm  Risk Management hypothesis  Actuarial switching is inter-related with terminations

10. ARIA Quebec, Aug 710 Research Hypotheses  a: Integration Perspective  1) Firms with pension deficits are more likely to terminate  2) Firms with lower debt covenant slack are more likely to terminate  b: Risk Management Perspective  3) ERR switch firms are less likely to terminate than their non- switch firms  b: Separation Perspective (Null Hypothesis)  Terminations are determined by pension fund characteristics

11. ARIA Quebec, Aug 711 Sample and Data  Sample: 80 industry matched pair firms (KW)  Data: Accounting, actuarial data related to sponsoring firm and pension fund  Integration hypothesis H1,H2: LEV, SFUND, PRET, FFUND (RUNI control)  Risk Management hypothesis H3: SWITCH, PUT

12. ARIA Quebec, Aug 712

13. ARIA Quebec, Aug 713 Findings Pension asset / pension liability and leverage ratios.  Terminating firms have lower pension funding and higher leverage  Firms that frequently adjust their ERR are less likely to terminate  The put option is just significant

14. ARIA Quebec, Aug 714

15. ARIA Quebec, Aug 715

16. ARIA Quebec, Aug 716 Sensitivity analysis Effect of change in rules on reported funding ratio (table 5) Incorporating effects of firms withdrawing from the stock market (table 6) Effect of termination on switching behavior of surviving firms (table 7)

17. ARIA Quebec, Aug 717

18. ARIA Quebec, Aug 718

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20. ARIA Quebec, Aug 720 Conclusion  Empirical findings suggest:  The need to curtail pension liabilities appear to be the primary motivation associated with termination decisions (integration hypothesis)  Link accounting policy choices and termination decisions: consistent with risk management hypothesis  At least some UK firms have exploited the PUT Option value to default on their pension promises via terminations