Pensions and Capital Structure

Abstract

This paper considers the pension plan as part of the capital structure of the sponsoring employer. This enables lessons from financial theory concerning capital structure to be used to answer the question, "What assets should a pension fund hold?" The standard Modigliani-Miller framework is expanded on to consider the implications of corporate tax. This leads to the conclusion that bond investment for pension plans has tangible advantages over holding risky assets (e.g., equities). The paper considers a case study of the pension plan of the Boots Company, a U.K. pharmacy retailer with a pension fund of around £2.3 billion ($3.5 billion), where these ideas were put into practice. Finally, the paper discusses the value released to shareholders and the extra security members of the pension fund have derived from putting theory into practice.

What determines the asset allocation of defined benefit pension funds?

“…Thomas (1988) and Frank (2002) found some modest US evidence in favour of the tax arbitrage strategy, while, Bartram (2018) found no evidence for the tax arbitrage strategy for the US. In the UK Boots moved to 100% bonds in 2000 (Ralfe, Speed, and Palin 2004) in accordance with tax arbitrage motive.…”