Using Prospect Theory To Explain The Setting Of The Expected Rate Of Return On Pension Assets

Abstract

Studies often use earnings management to explain the setting of assumed expected rate of return (ERRs) on pension assets in the defined benefit plans. In this paper, we argue that a manager’s risk attitude toward investment may have an impact on setting ERRs on pension assets. Prospect theory is a theory of decision making under risk and is used to explain firms’ behavior with regard to earnings management. We believe that prospect theory also can be used to explain firms’ setting of ERRs, which critically depends on managers’ expectations regarding risky investment. Empirical evidence shows that prospect theory can explain how firms set their ERRs on pension assets. We find that firms in the high-ERR group are risk-averters; that is, there is a positive relationship between risk and return. On the other hand, firms in the low-ERR group are risk-lovers and have an inverse risk-return relationship. Our findings contribute to the literature by suggesting that managers’ risk attitudes also affect the choice of ERR.