The Role of Risk in a Tax-Arbitrage Pension Portfolio

Previous research has suggested that, prior to the 1986 Tax Reform Act, the optimal strategy for tax-paying investors was to hold bonds in their pension fund and stock outside the fund. Given pension funding rules, however, it is likely that a better strategy would have been to employ some combinati...

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Bibliographic Details
Published in:Financial analysts journal 1990-01, Vol.46 (1), p.24-32
Main Author: Ippolito, Richard A.
Format: Article
Language:English
Subjects:
Actuarial science
Arbitrage
Bond portfolios
Defined benefit pension plan
Financial portfolios
Funding
Investment return rates
Pension funds
Pension liabilities
Pension plan funding
Pension plans
Pensions
Portfolio management
Portfolio selection
Risk
Tax advantages
Tax benefits
Tax Reform Act 1986-US
Tax regulations
Taxable bonds
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Summary:Previous research has suggested that, prior to the 1986 Tax Reform Act, the optimal strategy for tax-paying investors was to hold bonds in their pension fund and stock outside the fund. Given pension funding rules, however, it is likely that a better strategy would have been to employ some combination of risky assets and bonds. This is because risky assets expand the tax-exempt base beyond the full-funding limits defined in the Internal Revenue Code. A steady-state pension plan with either a balanced portfolio of bonds and stock or an all-stock portfolio would have generated tax benefits only about two-thirds as high as the tax benefits to an all-bond alternative prior to 1986. But a dynamic strategy that called for an all-stock portfolio until substantial funding was achieved, followed by a switch to an all-bond portfolio, would have far outstripped the tax gains from a static all-bond portfolio. The incentive to hold bonds in pension portfolios was substantially reduced by the Tax Reform Act of 1986. Elimination of the special capital gains tax substantially reduced the previous inequality between pre-personal-tax bond and equity returns. The new legislation left unaffected, however, the trust-expanding benefits of risky assets. Asset allocation strategies calling for substantial stockholdings thus become optimal under current tax laws.
ISSN:0015-198X
1938-3312
DOI:10.2469/faj.v46.n1.24