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Why Do Firms Offer Risky Defined–Benefit Pension Plans?

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  • Love, David
  • Smith, Paul A.
  • Wilcox, David

Abstract

Even risky pension sponsors could offer essentially riskless pension promises by contributing a sufficient level of resources to their pension trust funds and by investing those resources in fixed–income securities designed to deliver their payoffs just as pension obligations are coming due. However, almost no firm has chosen to fund its plan in this manner. We study the optimal funding choice for plan sponsors by developing a simple model of pension financing in which the total compensation offered to workers must clear the labor market. We find that if workers understand the implications of pension risk, they will demand greater compensation for riskier pension promises than for safer ones, all else equal. Indeed, in our model, pension sponsors maximize their value by making their pension promises free of risk. We close by positing some explanations for why no real–world firm follows the prescription of our model.

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Bibliographic Info

Article provided by National Tax Association in its journal National Tax Journal.

Volume (Year): 60 (2007)
Issue (Month): 3 (September)
Pages: 507-19

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Handle: RePEc:ntj:journl:v:60:y:2007:i:3:p:507-19

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  1. Zvi Bodie, 1988. "Pension Fund Investment Policy," NBER Working Papers 2752, National Bureau of Economic Research, Inc.
  2. Julia Lynn Coronado & Steven A. Sharpe, 2003. "Did Pension Plan Accounting Contribute to a Stock Market Bubble?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 323-371.
  3. Irwin Tepper, 1981. "Taxation and Corporate Pension Policy," NBER Working Papers 0661, National Bureau of Economic Research, Inc.
  4. Jeremy Gold & Nick Hudson, 2003. "Creating Value In Pension Plans (Or, Gentlemen Prefer Bonds)," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 15(4), pages 51-57.
  5. Deborah Lucas, 2007. "Valuing & Hedging: Defined Benefit Pension Obligations - The Role of Stocks Revisited," Money Macro and Finance (MMF) Research Group Conference 2006, Money Macro and Finance Research Group 169, Money Macro and Finance Research Group.
  6. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, Econometric Society, vol. 58(1), pages 53-73, January.
  7. Sharpe, William F., 1976. "Corporate pension funding policy," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(3), pages 183-193, June.
  8. J. Michael Harrison & William F. Sharpe, 1983. "Optimal Funding and Asset Allocation Rules for Defined-Benefit Pension Plans," NBER Chapters, National Bureau of Economic Research, Inc, in: Financial Aspects of the United States Pension System, pages 91-106 National Bureau of Economic Research, Inc.
  9. Bulow, Jeremy I, 1982. "What Are Corporate Pension Liabilities?," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 97(3), pages 435-52, August.
  10. Pennacchi, George, 2006. "Deposit insurance, bank regulation, and financial system risks," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(1), pages 1-30, January.
  11. Tepper, Irwin, 1981. "Taxation and Corporate Pension Policy," Journal of Finance, American Finance Association, American Finance Association, vol. 36(1), pages 1-13, March.
  12. Treynor, Jack L, 1977. "The Principles of Corporate Pension Finance," Journal of Finance, American Finance Association, American Finance Association, vol. 32(2), pages 627-38, May.
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Cited by:
  1. Eichhorst, Werner & Gerard, Maarten & Kendzia, Michael J. & Mayrhuber, Christine & Nielsen, Conny & Rünstler, Gerhard & Url, Thomas, 2011. "Report No. 42: Pension Systems in the EU – Contingent Liabilities and Assets in the Public and Private Sector," IZA Research Reports, Institute for the Study of Labor (IZA) 42, Institute for the Study of Labor (IZA).
  2. David A. Love & Paul A. Smith & David Wilcox, 2009. "Should risky firms offer risk-free DB pensions?," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2009-20, Board of Governors of the Federal Reserve System (U.S.).
  3. Love, David A. & Smith, Paul A. & Wilcox, David W., 2011. "The effect of regulation on optimal corporate pension risk," Journal of Financial Economics, Elsevier, Elsevier, vol. 101(1), pages 18-35, July.

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