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Should risky firms offer risk-free DB pensions?

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Author Info

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

Abstract

We develop a simple model of pension financing to study the effects of pension risk on shareholder value. In the model, firms minimize costs, total compensation must clear the labor market, and a government pension insurer guarantees a portion of promised benefits. We find that in the absence of mispriced pension insurance, the optimal pension strategy under most specifications is to immunize all sources of market risk. Mispriced pension insurance, however, gives firms the incentive to introduce risk into their pension promises, offering an explanation for some of the observed prevalence of risky pensions in the real world.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2009-20.

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Date of creation: 2009
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Handle: RePEc:fip:fedgfe:2009-20

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Related research

Keywords: Defined benefit pension plans;

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References

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  1. Julia Lynn Coronado & Steven A. Sharpe, 2003. "Did pension plan accounting contribute to a stock market bubble?," Finance and Economics Discussion Series 2003-38, Board of Governors of the Federal Reserve System (U.S.).
  2. George G. Pennacchi & Christopher M. Lewis, 1994. "The value of Pension Benefit Guaranty Corporation insurance," Proceedings, Federal Reserve Bank of Cleveland, pages 735-756.
  3. Coronado, Julia & Mitchell, Olivia S. & Sharpe, Steven A. & Blake Nesbitt, S., 2008. "Footnotes aren't enough: the impact of pension accounting on stock values," Journal of Pension Economics and Finance, Cambridge University Press, vol. 7(03), pages 257-276, November.
  4. Hashimoto, Masanori, 1981. "Firm-Specific Human Capital as a Shared Investment," American Economic Review, American Economic Association, vol. 71(3), pages 475-82, June.
  5. Francesco Franzoni & José M. Marín, 2005. "Pension plan funding and stock market efficiency," Economics Working Papers 871, Department of Economics and Business, Universitat Pompeu Fabra.
  6. Brian J. Hall & Kevin J. Murphy, 2000. "Stock Options for Undiversified Executives," NBER Working Papers 8052, National Bureau of Economic Research, Inc.
  7. Treynor, Jack L, 1977. "The Principles of Corporate Pension Finance," Journal of Finance, American Finance Association, vol. 32(2), pages 627-38, May.
  8. Deborah Lucas, 2007. "Valuing & Hedging: Defined Benefit Pension Obligations - The Role of Stocks Revisited," Money Macro and Finance (MMF) Research Group Conference 2006 169, Money Macro and Finance Research Group.
  9. Ippolito, Richard A, 1985. "The Labor Contract and True Economic Pension Liabilities," American Economic Review, American Economic Association, vol. 75(5), pages 1031-43, December.
  10. Daron Acemoglu & Jorn-Steffen Pischke, 1999. "The Structure of Wages and Investment in General Training," Journal of Political Economy, University of Chicago Press, vol. 107(3), pages 539-572, June.
  11. Jeremy Gold & Nick Hudson, 2003. "Creating Value In Pension Plans (Or, Gentlemen Prefer Bonds)," Journal of Applied Corporate Finance, Morgan Stanley, vol. 15(4), pages 51-57.
  12. Zvi Bodie, 1988. "Pension Fund Investment Policy," NBER Working Papers 2752, National Bureau of Economic Research, Inc.
  13. David A. Love & Paul A. Smith & David Wilcox, 2007. "Why do firms offer risky defined benefit pension plans?," Finance and Economics Discussion Series 2007-36, Board of Governors of the Federal Reserve System (U.S.).
  14. Bulow, Jeremy I, 1982. "What Are Corporate Pension Liabilities?," The Quarterly Journal of Economics, MIT Press, vol. 97(3), pages 435-52, August.
  15. Gary S. Becker, 1962. "Investment in Human Capital: A Theoretical Analysis," Journal of Political Economy, University of Chicago Press, vol. 70, pages 9.
  16. J. Michael Harrison & William F. Sharpe, 1982. "Optimal Funding and Asset Allocation Rules for Defined-Benefit Pension Plans," NBER Working Papers 0935, National Bureau of Economic Research, Inc.
  17. Tepper, Irwin, 1981. "Taxation and Corporate Pension Policy," Journal of Finance, American Finance Association, vol. 36(1), pages 1-13, March.
  18. Irwin Tepper, 1981. "Taxation and Corporate Pension Policy," NBER Working Papers 0661, National Bureau of Economic Research, Inc.
  19. Jeffrey R. Brown, 2007. "Guaranteed Trouble: The Economic Effects of the Pension Benefit Guaranty Corporation," NBER Working Papers 13438, National Bureau of Economic Research, Inc.
  20. Joshua D. Rauh, 2006. "Investment and Financing Constraints: Evidence from the Funding of Corporate Pension Plans," Journal of Finance, American Finance Association, vol. 61(1), pages 33-71, 02.
  21. Sharpe, William F., 1976. "Corporate pension funding policy," Journal of Financial Economics, Elsevier, vol. 3(3), pages 183-193, June.
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Cited by:
  1. Chen, An & Uzelac, Filip, 2014. "A risk-based premium: What does it mean for DB plan sponsors?," Insurance: Mathematics and Economics, Elsevier, vol. 54(C), pages 1-11.

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