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Should risky firms offer risk-free DB pensions?

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

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
Date of revision:
Handle: RePEc:fip:fedgfe:2009-20
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  1. 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.
  2. 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.
  3. 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.
  4. Irwin Tepper, 1981. "Taxation and Corporate Pension Policy," NBER Working Papers 0661, National Bureau of Economic Research, Inc.
  5. Brian J. Hall & Kevin J. Murphy, 2000. "Stock Options for Undiversified Executives," NBER Working Papers 8052, National Bureau of Economic Research, Inc.
  6. 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.
  7. 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.
  8. 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.
  9. Julia Coronado & Olivia S. Mitchell & Steven A. Sharpe & S. Blake Nesbitt, 2008. "Footnotes Aren't Enough: The Impact of Pension Accounting on Stock Values," NBER Working Papers 13726, National Bureau of Economic Research, Inc.
  10. 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.
  11. Tepper, Irwin, 1981. "Taxation and Corporate Pension Policy," Journal of Finance, American Finance Association, vol. 36(1), pages 1-13, March.
  12. David Love & Paul Smith & David Wilcox, 2007. "Why Do Firms Offer Risky Defined Benefit Pension Plans?," Department of Economics Working Papers 2007-04, Department of Economics, Williams College.
  13. Zvi Bodie, 1988. "Pension Fund Investment Policy," NBER Working Papers 2752, National Bureau of Economic Research, Inc.
  14. repec:oup:qjecon:v:97:y:1982:i:3:p:435-52 is not listed on IDEAS
  15. 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.
  16. Gary S. Becker, 1962. "Investment in Human Capital: A Theoretical Analysis," Journal of Political Economy, University of Chicago Press, vol. 70, pages 9.
  17. Daron Acemoglu & Jorn-Steffen Pischke, 1998. "The Structure of Wages and Investment in General Training," NBER Working Papers 6357, National Bureau of Economic Research, Inc.
  18. 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.
  19. Sharpe, William F., 1976. "Corporate pension funding policy," Journal of Financial Economics, Elsevier, vol. 3(3), pages 183-193, June.
  20. Treynor, Jack L, 1977. "The Principles of Corporate Pension Finance," Journal of Finance, American Finance Association, vol. 32(2), pages 627-38, May.
  21. Hashimoto, Masanori, 1981. "Firm-Specific Human Capital as a Shared Investment," American Economic Review, American Economic Association, vol. 71(3), pages 475-82, June.
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