Valuation of Contingent Pension Liabilities and Guarantees Under Sponsor Default Risk

This article analyzes the relationship between a pension fund with contingently indexed defined benefit liabilities and its sponsor, using contingent claims analysis. As pension funds generally choose to run a mismatch risk, future surpluses and deficits will occur. Surpluses are divided between beneficiaries and sponsor through contingent indexation of the benefits and refunding. Covering a deficit at the pension fund level is a function of the sponsor's financial ability to do so. This article suggests that this system creates an asymmetric allocation of the residual risk between sponsor and beneficiaries. The optimal investment policy for the pension fund in this context can be found by reverse engineering option valuation formulas. The main conclusion is that sponsor default risk negatively impacts the optimum risk profile and thereby the market value of contingent pension liabilities.     

Do Managers of U.S. Defined Benefit Pension Plan Sponsors Use Regulatory Freedom Strategically?

We use historical particularities of pension funding law to investigate whether managers of U.S. corporate defined benefit pension plan sponsors strategically use regulatory freedom to lower the reported value of pension liabilities, and hence required cash contributions. For some years, pension plans were required to estimate two liabilities—one with mandated discount rates and mortality assumptions, and another where these could be chosen freely. Using a sample of 11,963 plans, we find that the regulated liability exceeds the unregulated measure by 10% and the difference further increases for underfunded pension plans. Underfunded plans tend to assume substantially higher discount rates and lower life expectancy. The effect persists both in the cross‐section of plans and over time and it serves to reduce cash contributions. We further show that plan sponsor managers use the freed‐up cash for corporate investment and that credit risk is unlikely to explain the finding.     

Public Pension Promises: How Big Are They and What Are They Worth?

We calculate the present value of state employee pension liabilities using discount rates that reflect the risk of the payments from a taxpayer perspective. If benefits have the same default and recovery characteristics as state general obligation debt, the national total of promised liabilities based on current salary and service is $3.20 trillion. If pensions have higher priority than state debt, the value of liabilities is much larger. Using zero‐coupon Treasury yields, which are default‐free but contain other priced risks, promised liabilities are $4.43 trillion. Liabilities are even larger under broader concepts that account for salary growth and future service.     

Seeking safety: The relation between CEO inside debt holdings and the riskiness of firm investment and financial policies

CEO inside debt holdings (pension benefits and deferred compensation) are generally unsecured and unfunded liabilities of the firm. Because these characteristics of inside debt expose the CEO to default risk similar to that faced by outside creditors, theory predicts that CEOs with large inside debt holdings will display lower levels of risk-seeking behavior (Jensen and Meckling, 1976). Consistent with the theoretical predictions, we find a negative association between CEO inside debt holdings and the volatility of future firm stock returns, R&D expenditures, and financial leverage, and a positive association between CEO inside debt holdings and the extent of diversification and asset liquidity. Collectively, our results provide empirical evidence suggesting that CEOs with large inside debt holdings prefer investment and financial policies that are less risky.     

Pension Funding Regulations and Actuarial Gains and Losses

With pervasive pension funding deficits, Korean firms have been under pressure to improve their funding levels. We examine whether firms have incentives to set obligation‐decreasing pension assumptions when they have large pension deficits (pension obligations in excess of plan assets) and when they make insufficient contributions to external pension funds. We find that firms report larger actuarial gains (or smaller actuarial losses) associated with the remeasurement of pension liabilities when their pension funding ratio (the ratio of the fair value of plan assets to defined benefit obligations) is lower and when contributions to plan assets relative to pension service costs are smaller. Next, upon the introduction of a minimum pension funding guideline, we find that the effect of the funding ratio and contributions to pension funds on actuarial gains and losses is more pronounced for firms whose funding ratios are slightly below the minimum funding ratio than it is for firms whose funding ratios exceed or fall short of the minimum by a large margin. Our results indicate that firms opportunistically exercise discretion regarding corporate pension accounting under International Financial Reporting Standards to comply with pension funding regulations, thereby reducing perceived pension deficits.     

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.     

CEO Inside Debt Incentives and Corporate Tax Sheltering

This paper examines the relation between CEO inside debt holdings (pension benefits and deferred compensation) and corporate tax sheltering. Because inside debt holdings are generally unsecured and unfunded liabilities of the firm, CEOs are exposed to risk similar to that faced by outside creditors. As such, theory (Jensen and Meckling [1976]) suggests that inside debt holdings negatively impact CEO risk‐appetite. To the extent that corporate tax shelters are likely to result in high cash flow volatility in the future, we expect that inside debt holdings will curb CEOs from engaging in tax shelter transactions. Consistent with the prediction, we document a negative association between CEO inside debt holdings and tax sheltering. Additional analyses suggest that the effect of inside debt on tax sheltering is more (less) pronounced in the presence of high default risk and liquidity threats (cash‐out options in pension packages). Overall, our results highlight the importance of investigating the implication of CEO debt‐like compensation for corporate tax policies.     

A case of constitutional apples and oranges: a functional comparison of pension priority and benefit guarantees in U.S., U.K. and Canadian insolvency and pension law regimes

Canada's insolvency law reform increased the priority granted to employer‐sponsored pension claims. The article compares the treatment of such claims in the U.S., the U.K. and Canada. A comparison of the legislative provisions concerning pension funding shortfalls from contribution arrears or economic underperformance in relation to the assumptions used for investment income or liability valuations finds that insolvency law has been used to address contribution arrears, but risks from economic underperformance have been addressed by pension benefit insurance. Post‐insolvency priority for contribution arrears provides appropriate incentives to discourage pre‐insolvency preferences for payments to other creditors, while shortfalls from economic underperformance do not involve issues of preference between creditors. The absence of any insolvency rationale for changing priority for shortfalls from economic underperformance and the likely disparity between the assets available to satisfy clams and the much larger amounts of such shortfalls makes the use of insolvency law to address this risk much less effective than insurance. Canada, however, has not adopted the insurance policy instrument used in the U.S. and U.K. to mitigate the impact of pension funding shortfalls. The constitutional inability of Canada to legislate in respect of matters of pension regulation that would allow it to control the well‐known insurance problems of moral hazard and adverse selection may explain why it has only chosen to adopt an insolvency policy instrument. However, a change in priorities in insolvency may generate incentives for secured creditors that either undermine or reinforce this policy choice. Secured creditors could attempt to circumvent the new priority scheme through private arrangements with the debtor or to increase their monitoring activities to ensure the debtor is current in its pension contributions. Secured creditors choices will be influenced by the bankruptcy courts' interpretation of the preference provisions in the insolvency legislation. Copyright © 2009 John Wiley & Sons, Ltd.     

Back on the balance sheet: The tax effects of contingent claims in commercial banking

Contingent claims separate revenue and cost into two different time periods. Revenue comes in the initial origination process, while the cost comes upon completion of the contract in the event of default. With banks increasing contingent claims in recent years, a higher taxable income leads to a shift in a bank's balance sheet toward tax-free income and tax-shielding liabilities. This provides a valuable case-study of corporate finance theories of tax management. This paper builds a model to illustrate the income features of contingent claims. Call Reports from 1990-1996 are examined, and show significant evidence of increases in leverage associated with contingent claims.     

What determines corporate pension fund risk-taking strategy?

Corporate sponsors of defined benefit pension plans generally assume low investment risk when they have low funding ratios and high default risk, consistent with the risk management hypothesis. However, for financially distressed sponsors and sponsors that freeze, terminate, or convert defined benefit to defined contribution plans, the risk-shifting incentive (moral hazard) dominates. Pension fund risk-taking is also affected by labor unionization and sponsor incentives to maximize tax benefits, restore financial slack, and justify the accounting choices of pension assumptions. Sponsors shift toward an aggressive risk strategy when their pension plans emerge from underfunding, bankruptcy risk is reduced, or marginal tax rate decreases. Overall, we show that corporate sponsors adopt a dynamic risk-taking strategy in their pension fund investments.     

The effect of unfunded pension liabilities on corporate bond ratings,default risk,and recovery rate

Unfunded pension liabilities lower ratings of non-senior secured bonds but do not affect ratings of senior secured bonds due to their higher seniority. Pension funding improvement (deterioration) is associated with bond rating upgrade (downgrade). Moreover, large unfunded liabilities increase bond default risk and reduce the recovery rate of bondholders after controlling for credit ratings, suggesting that bond ratings do not fully capture pension underfunding risk. Overall, our results highlight the important effects of unfunded pension obligations on bond ratings, default risk, and creditors’ payoff, and suggest that investors should look beyond bond ratings in making investment decisions.     

Smart defaults: Determining the number of default funds in a pension scheme

We propose a new methodology for the smart design of the default investment fund(s) in occupational defined contribution pension schemes based on the observable characteristics of scheme members. Using a unique dataset of member risk attitudes and characteristics from a survey of a large UK pension scheme, we apply factor analysis to identify single factors for risk aversion, risk capacity and ethical investment preferences, and then apply cluster analysis to these factors to identify two distinct groups of members across age cohorts. We find membership of these clusters depends on a number of personal characteristics, with the principal differentiating feature being that one group had previously engaged with the pension scheme, while the other had not. These identified characteristics can be utilised in the design of smart default funds, including appropriate engagement strategies.     

“De‐risking” Corporate Pension Plans: Options for CFOs

Until the stock market bubble burst in 2000–2002, most CFOs viewed their defined benefit pension plans as profit centers and relatively risk‐free sources of income. Since neither pension assets nor liabilities were reported on corporate balance sheets, and expected returns on pension stocks could be substituted for actual returns when reporting net income, the risks associated with DB plans were masked by GAAP accounting and thus assumed to have no bearing on corporate capital structure. But when stock prices and corporate profits fell together, the risks associated with conventional stock‐heavy pension plans showed up first in reduced pension surpluses (or, in many cases, deficits) and then later in higher required cash contributions and lower reported earnings. As a consequence, today's investors (and rating agencies) are viewing pension and other legacy liabilities as corporate debt, and demands for transparency and increased funding have triggered accounting changes and proposed legislative reforms that will further unmask the economics. This article aims to provide both private‐sector and public‐sector CFOs with suggestions for reducing and controlling the cost of providing for the retirement of their employees. Profitable, tax‐paying companies with DB plans should consider (1) funding any unfunded liabilities (if necessary, by issuing debt) and (2) reducing pension equity and interest rate exposures by shifting some (if not all) pension assets into bonds and defeasing the pension liability (achieving a tax arbitrage in the process). And in cases where the expected costs of maintaining DB plans outweigh the benefits, companies should consider freezing or terminating their plans and switching to a defined contribution (DC) or some form of hybrid plan. The authors also propose similar changes for public pension plans, where underfunding and mismatch problems are greater, less transparent, and in some ways less tractable than those of corporate DB plans.     

Underfunding pension obligations while paying dividends: evidence of risk transfers

This research examines the differential effects of earnings, dividends, and cashflows on increases and decreases in pension liabilities. Of the 1700 firms in the Value Line Investment Survey (1997a), there were 189 firms with pension liabilities—88 (101) firms with increasing (decreasing) pension liabilities that serve as research observations. For firms with increasing pension liabilities, there is a significant correlation between the increase in pension liabilities and earnings, cashflows, and dividends. However, none of these relationships exist for firms with decreasing pension liabilities. The underfunding of pension funds is a unilateral decision by management that effectively transfers risk away from stockholders and imposes it on employees and potentially on the society at large. This risk transfer is not associated with any compensatory returns and suggests social and regulatory policies should be reconsidered.     

The Take‐Up of Multiple Means‐Tested Benefits by British Pensioners: Evidence from the Family Resources Survey

Non‐take‐up of means‐tested benefits among pensioners is of long‐standing concern. It has assumed increased importance from October 2003 with the introduction of the new means‐tested pension credit to which about half of pensioners are expected to be entitled. We use Family Resources Survey data from April 1997 to March 2000 to investigate patterns of pensioner take‐up of income support (IS) (subsequently renamed the minimum income guarantee and now subsumed in pension credit), housing benefit (HB) and council tax benefit (CTB). Although 36 per cent of pensioners in our sample failed to claim their entitlements to at least one of these benefits, only 16 per cent failed to claim amounts worth more than 10 per cent of their disposable income. Generally, take‐up is high where entitlement is high. But there are exceptions which may reflect the claims process and/or a greater degree of social stigma associated with IS than with HB or CTB.     

Does the debt market assess large banks, risk? : Time series evidence from money center CDs

Uninsured bank liabilities should offer a promised yield that compensates depositors for their expected default losses. However, the conjectural, guarantees available to large U.S. banking firms makes it questionable whether large depositors should or do feel themselves exposed to credit risk. Prior papers have evaluated the determinants of bank risk premia using cross-sectional data, with relatively inconclusive results. This paper investigates the same issue in a methodologically independent fashion: using time series data on specific banks' daily offering rates during the period May 1982 through July 1988. We find that CD rates paid by large money center banks include significant default risk premia.     

FRS17 and the Sterling Double A Corporate Yield Curve

Abstract:   We argue that the appropriate discount rate used to report defined benefit pension plan liabilities in the financial statements is a yield derived from an estimate of a double A corporate yield curve. We show that parsimonious yield curve techniques are easily applicable to the sterling double A corporate bond market. Moreover, we find that with a careful selection of the data an objective and reliable yield curve can be obtained. In all we find that using a yield from a sterling double A corporate yield curve to obtain the value of defined benefit pension plan liabilities is a feasible alternative to the current recommendations of FRS17 .     

Defeasing Legacy Costs*

The authors propose a new way to defease the legacy costs of America's defined benefit pension system that will help ensure its viability. The proposal would allow companies to exchange their legacy pension debt for another liability with more attractive terms—to the benefit of the sponsor, the Pension Benefit Guaranty Corporation (PBGC), and the plan participants. The transparency gained by separating the past from future liabilities will give better insight into sponsors' balance sheets. And it could take the PBGC out of the impossible position of insuring against events over which the insured have considerable control.     

Public Pensions and U.S. Infrastructure Investment: The Perfect Partnership?

Public pension funds have been passive investors in U.S. infrastructure projects for years, serving primarily as limited partners in designated infrastructure funds. However, the continued maturation of U.S. public‐private partnerships, combined with pension funds' need for yield to match future liabilities, has prompted the funds to take a more active role in infrastructure investment. In recent years, many pension funds have built internal teams to make direct (as opposed to indirect and for the most part passive) investments in infrastructure projects. Governments in particular should pay close attention to the emergence of pension funds as direct infrastructure investors. With OECD pension assets totaling $10.6 trillion at the end of 2010, the world's pension funds offer governments a strong value proposition. Given the fixed nature of their pension liabilities, pension funds emphasize yield and long‐term appreciation, and are likely to accept rate of returns in the neighborhood of CPI + 5%. Infrastructure investments, which generate highly stable cashflow and enjoy high barriers to entry, are ideally suited to meet these criteria. Also of particular significance to governments, pension funds have two bottom lines. First is expected yield and returns; second is their desire to invest in projects that meet a mission of social responsibility. Pension investors prefer, when possible, to invest in projects that promote government objectives such as reduced congestion and clean air. Taking account of pension funds' double mission can help governments capture opportunities to develop infrastructure through meaningful partnerships with like‐minded investors.     

Pension regulation and the market value of pension liabilities: A contingent claims analysis using Parisian options

We analyze the market-consistent valuation of pension liabilities in a contingent claim framework whereby a knock-out barrier feature is applied to capture early regulatory closure of a pension plan. We investigate two cases which we call “immediate closure procedure” and “delayed closure procedure”. In an immediate closure procedure, when the assets value hits the regulatory boundary, the pension plan is terminated immediately. Whereas in a delayed closure procedure, a grace period is given to the pension fund for reorganization and recovery before premature closure is executed. The framework is then used to construct fair pension deals. Furthermore, we provide rules for deriving the optimal recovery period in pension regulation using utility analysis and interconnect the recovery period to the regulatory liquidation probability.