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Should risky firms offer risk-free DB pensions?

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  • David A. Love
  • Paul A. Smith
  • David W. 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.

Suggested Citation

  • David A. Love & Paul A. Smith & David W. Wilcox, 2009. "Should risky firms offer risk-free DB pensions?," Finance and Economics Discussion Series 2009-20, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2009-20
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    References listed on IDEAS

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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.
    2. Qian, Linyi & Shen, Yang & Wang, Wei & Yang, Zhixin, 2019. "Valuation of risk-based premium of DB pension plan with terminations," Insurance: Mathematics and Economics, Elsevier, vol. 86(C), pages 51-63.

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    Keywords

    Defined benefit pension plans;

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