Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan?

Abstract

This paper examines the empirical question of whether systematic equity risk of U.S. firms as measured by beta from the Capital Asset Pricing Model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet, and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of Pension Benefit Guaranty Corporation further clouds the real relation between pension plan risk and firm equity risk.The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the deleveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment will typically bias upwards estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known U.S. companies. This bias can result in positive net-present-value projects being rejected.

Does Freezing a Defined-Benefit Pension Plan Increase Company Value? Empirical Evidence

“…Jin, Merton, and Bodie (2006) further verified the informational efficiency in the capital market by showing that, besides the value of a pension surplus or deficit, pension plan risk is closely reflected in company equity risk. Coronado, Mitchell, Sharpe, and Nesbitt (2008), however, found that investors pay more attention to the face values in the financial statements and less attention to the more pertinent footnotes regarding pension assets and liabilities.…”

An Analysis of Risk-Taking Behavior for Public Defined Benefit Pension Plans

“…Our measures of investment risk include the percentage of total plan assets invested in the equity markets and the pension plan asset beta (Jin, Merton, and Bodie 2006). We offer evidence that government accounting standards strongly affect risk-taking behavior, as most pension plans use higher return assumptions to discount their pension liabilities.…”

Untitled

“…Pension asset beta captures the risk of a pension plan's exposure to alternative investments, including private equity, venture capital, hedge funds, and other alternative assets. It was fi rst proposed by Jin, Merton, and Bodie (2006).…”