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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

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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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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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Keywords: Defined benefit pension plans;

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  2. Irwin Tepper, 1981. "Taxation and Corporate Pension Policy," NBER Working Papers 0661, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. George G. Pennacchi & Christopher M. Lewis, 1994. "The value of Pension Benefit Guaranty Corporation insurance," Proceedings, Federal Reserve Bank of Cleveland, pages 735-756.
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  6. Zvi Bodie, 1988. "Pension Fund Investment Policy," NBER Working Papers 2752, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Tepper, Irwin, 1981. "Taxation and Corporate Pension Policy," Journal of Finance, American Finance Association, vol. 36(1), pages 1-13, March. [Downloadable!] (restricted)
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  9. 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(2003-1), pages 323-371. [Downloadable!]
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  10. David Love & Paul Smith & David Wilcox, 2007. "Why Do Firms Offer Risky Defined Benefit Pension Plans?," Department of Economics Working Papers 2007-4, Department of Economics, Williams College. [Downloadable!]
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  11. 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. [Downloadable!] (restricted)
  12. Pennacchi, George G & Lewis, Christopher M, 1994. "The Value of Pension Benefit Guaranty Corporation Insurance," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(3), pages 735-53, August. [Downloadable!] (restricted)
  13. Gary S. Becker, 1962. "Investment in Human Capital: A Theoretical Analysis," Journal of Political Economy, University of Chicago Press, vol. 70, pages 9. [Downloadable!] (restricted)
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  15. Bulow, Jeremy I, 1982. "What Are Corporate Pension Liabilities?," The Quarterly Journal of Economics, MIT Press, vol. 97(3), pages 435-52, August. [Downloadable!] (restricted)
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  17. Francesco Franzoni & José M. Marín, 2006. "Pension Plan Funding and Stock Market Efficiency," Journal of Finance, American Finance Association, vol. 61(2), pages 921-956, 04. [Downloadable!] (restricted)
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  18. Jeffrey R. Brown, 2008. "Guaranteed Trouble: The Economic Effects of the Pension Benefit Guaranty Corporation," Journal of Economic Perspectives, American Economic Association, vol. 22(1), pages 177-198, Winter.
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  19. 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. [Downloadable!] (restricted)
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  20. J. Michael Harrison & William F. Sharpe, 1983. "Optimal Funding and Asset Allocation Rules for Defined-Benefit Pension Plans," NBER Chapters, in: Financial Aspects of the United States Pension System, pages 91-106 National Bureau of Economic Research, Inc. [Downloadable!]
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