Inside debt and firm risk-taking: Evidence from the UK pension reform

This paper provides new evidence on the relation between CEO inside debt and firm risk-taking by exploiting the change in the tax treatment of UK pensions following two pension amendments. The 2006 pension reform introduces the annual and lifetime allowance for UK pension schemes, significantly increasing income taxes associated with CEO inside debt. The 2011 allowance cut, which substantially reduces the annual allowance introduced in 2006, further increases income taxes on inside debt. We find that CEO inside debt, in the form of executive pensions declines after the 2006 reform while cash-in-lieu increases significantly. This effect is more severe after the 2011 allowance cut than the 2006 pension reform. UK firms appear to substitute away from pensions towards cash-in-lieu, where income taxes are less punishing. If the association between CEO inside debt and firm risk-taking is causal, we should observe a change of risk-taking after the decline of inside debt. Our results, which exploit the exogenous nature of the reforms, show that the decline of CEO pensions does not lead to any change in firm risk-taking. This result suggests that no causal relationship exists between CEO inside debt and firm risk-taking. Our results extend the inside debt literature, where empirical evidence is mainly documented in the US. Contrary to findings in the US, our evidence suggests that the use of CEO inside debt is motivated to minimise income tax rather than a tool to moderate firm risk.