Corporate Pensions and the Maturity Structure of Debt

• Author: Yijia Lin,Sheen Liu,Jifeng Yu
• DOI: http://doi.org/10.1111/jori.12215
• Date: 01 June 2019
• Published date: 01 June 2019

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©2017 The Journal of Risk and Insurance. Vol.XX, No. XX, 1–36 (2017).

DOI: 10.1111/jori.12215

Corporate Pensions and the Maturity

Structure of Debt

Yijia Lin

Sheen Liu

Jifeng Yu

Abstract

In this article, we investigate the role of pension obligations, the most sig-

nificant off-balance-sheet item, in determining corporate debt maturity and

spreads. Webegin by showing a significant and robust positive relationship

between pension liabilities and corporate short-term debt ratio. Wealso find

that more pension obligations cause a significant increase in the cost of debt,

but this effect is mitigated by short-maturity debt. Overall, our study shows

that short-term debt can reduce asymmetric information costs related to

pensions.

Introduction

In recent years, there has been an increasedinterest in those items that are not reflected

on the balance sheet but may still expose firms to risk. Insufficient transparency of

these off-balance-sheet items makes it difficult for investors to properly assess their

values and riskiness. When market participants have a greater difficulty in estimating

a firm’s off-balance-sheet risk, the firm faces a greater cost of information uncertainty.

While a strand of research has examined debt maturity choice based on asymmetric

information (Flannery,1986; Diamond, 1991; Berger et al., 2005), the role of short-term

debt in mitigating costs of informational opacity related to off-balance-sheet items

remains poorly understood. Understanding this is important because off-balance-

sheet activities are a common market phenomenon. In this article, we seek to extend

the literature by examining this issue.

Perhaps no off-balance-sheet item is more important than the corporate pension plan

(Shivdasani and Stefanescu, 2010). At the end of the second quarter of 2014, the value

Yijia Lin is at the Department of Finance, College of Business Administration, University of

Nebraska, Lincoln, NE 68588. Lin can be contacted via e-mail: yijialin@unl.edu. Sheen Liu is at

the Department of Finance and Management Science, Washington State University, Pullman,

WA 99164. Liu can be contacted via e-mail: liusx@wsu.edu. Jifeng Yu is at the Department of

Management, College of Business Administration, University of Nebraska, Lincoln, NE 68588.

Yu can be contacted via e-mail: jifeng.yu@unl.edu. We are grateful to the coeditor and one

anonymous referee for very helpful comments. Wealso thank Marc Cussatt from Washington

State University for very helpful discussions on pension accounting.

Vol. 86, No. 2, 315–350 (2019).

2The Journal of Risk and Insurance

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of total defined benefit (DB) pension assets held by private sector employers was

estimated at $3.2 trillion, an amount far greater than that of any other off-balance-

sheet items (BrightScope and Investment Company Institute, 2014). Tothe extent that

pension exposures have potential to increase information costs, they are useful instru-

ments in identifying the response of corporate short-term debt to higher information

uncertainty caused by off-balance-sheet activities. Thus, in this article, we study firms

that sponsor DB pensions, when information asymmetry associated with off-balance-

sheet items is likely to be the greatest. Specifically, we address three researchquestions.

First, is a firm’s optimal short-term debt to total debt ratio positively associated with

its pension obligations? Second, is the cost of debt positively related to pension obli-

gations? Third, will short-term debt attenuate the adverse effect of pension exposures

on the cost of debt? By answering these questions, our analysis provides insights into

the quantitative importance of informational asymmetries in debt maturity explained

by off-balance-sheet arrangements.

Pension liabilities are viewed as debt-like obligations. Under the implicit contract the-

ory of pensions, firms view workers as long-term bondholders (Ippolito, 1985). When

pension liabilities and assets are incorporated into a consolidated capital structure,

Shivdasani and Stefanescu (2010) find that the leverage ratios of firms with pension

plans are about 35 percent higher.A higher leverage ratio will increase the risk of both

pension liabilities and on-balance-sheet (or financial) debts. Financial debts, however,

are more vulnerable than are pension liabilities because a firm cannot access its pen-

sion assets to meet claims of its financial debts and most financial debts are not insured.

In contrast, pension liabilities are secured by pension assets as collateral and insured

by the Pension Benefit Guaranty Corporation (PBGC) (Pennacchi, 1999; Boyce and

Ippolito, 2002). Thus, if a firm faces bankruptcy, the workers will have limited losses

on their pensions because of the PBGC insurance, whereas the financial debtholders

will face more uncertainty of losses. Moreover, when a pension plan is underfunded,

a firm must make up the gap with cash contributions within 7 years (Employee Re-

tirement Income Security Act (ERISA) of 1974, Public Law 93-406, September 2, 1974).

The ERISA and later pension legislation established a system that mandates pension

contributions for poorly performing pension plans to ensure adequate funding of

employees’ pension benefits (Kahn, 1982). Such requirements imposed by legislation

reduce the risk that a firm will fail to fund its pension liabilities, but they also increase

the probability that the firm will incur costs of financial distress and default on its

financial debts, leading to a higher cost of capital.

Risk from corporate pensions is difficult to determine (Cocco and Volpin, 2013). The

complicated and opaque actuarial assumptions as well as accounting methods and

rules obscure pension costs and obligations, and create information asymmetry be-

tween investors and firms that sponsor DB plans. Clark and Monk (2006) state that

pension obligations and matching assets are poorly reflected in corporate balance

sheets. There are three alternative pension asset and five pension liability measures

in accounting methods, which can produce large and pervasive financial statement

effects on account balances. Barth (1991) shows that after considering pension effects,

differentpension measures cause the debt-to-equity ratio to vary between 0.82 and 3.46

on average for the sample firms. Moreover,the assumptions underlying each measure

Corporate Pensions and the Maturity Structure of Debt 3

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also affect the relevance and reliability. In particular, the valuation of pension liabili-

ties depends on multiple assumptions such as pension valuation rates, participants’

mortality rates, and employee mobility.For example, the projected benefit obligation

calculation requires a rate of future salary increases based on the assumptions of fu-

ture real wage increases and inflation rate. This suggests that the rate of expected

salary increases is also an assumption, which introduces considerable uncertainty in

estimating future pension liabilities. Due to the complexity in evaluating liabilities in

a pension plan, companies that sponsor DB plans usually have more information on

the true value of pension obligations than outsiders do. As shown in Cocco and Volpin

(2013), firms that sponsor DB pensions are less likely to be the target in an acquisi-

tion due to significant information asymmetry between them and potential acquirers.

Moreover, the opaque method of pension accounting under, for example, the Gener-

ally Accepted Accounting Principles (GAAP), clouds a firm’s financials and obscures

the true impact of pensions (Rauh, 2006). Bergstresser, Desai, and Rauh (2006) find

that firms are effectively able to manipulate their reported earnings and cover their fi-

nancial problems with pensions. As a result, investors are concerned about the value

of the liabilities associated with company-sponsored pensions. Firms with greater

pension exposures are expected to have a higher degree of information asymmetry.

To mitigate the information costs, firms often choose debt seniority, covenants, and

maturities to optimize the structure of debt contracts. In terms of debt seniority,

Park (2000) argues that we should delegate monitoring to a senior lender to man-

age the information problem. As long as the senior lender has incentives to gather

effective information about the borrower and to make the right liquidation deci-

sions, the information problem can be prevented ex ante. Pension benefits are se-

nior to financial debts because promised pension payments are generally protected

from creditor claims in bankruptcy. DB participants (employees and retirees), how-

ever, do not behave like typical senior lenders, such as banks. Employees and re-

tirees have low incentive to monitor corporate pensions because they are funded and

protected under ERISA. Without active monitoring from DB pension participants,

firms must turn to other more effective means to reduce the asymmetric information

problem.

Another means to manage the asymmetric information problem is debt covenants. In

practice, debt contracts generally do not contain extensive restrictions that are costly

to enforce (Smith and Warner, 1979). Corporate pensions are complex and opaque,

which makes it difficult and expensive to specify explicit pension covenants to lessen

informational asymmetries associated with DB plans. As evidence, creditors usually

do not include constraints on pension risk taking in debt agreements (Rauh, 2006).

Flannery (1986) predicts that firms subject to larger potential information asymme-

tries should issue more short-term debt to reduce information costs. Billett, King, and

Mauer (2007) find that short-term debt and restrictive covenants can substitute for

one another in controlling the asymmetric information problem. When pension par-

ticipants (senior creditors) have low incentives to monitor, and extensive covenants

are costly to impose for pensions, we argue that the use of short-maturity debt is im-

portant for DB pension-sponsoring firms in order to minimize their information costs.

That is, to address information asymmetries between better informed firms and less