How does the Funding Status of Defined Benefit Pension Plans Affect Investment Decisions of Firms in the United States?

• Author: Hue Hwa Au Yong,Neeru Chaudhry,Chris Veld
• Published date: 01 January 2017
• Date: 01 January 2017
• DOI: http://doi.org/10.1111/jbfa.12219

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 44(1) & (2), 196–235, January/February 2017, 0306-686X

doi: 10.1111/jbfa.12219

How does the Funding Status of Defined

Benefit Pension Plans Affect Investment

Decisions of Firms in the United States?

Neeru Chaudhry, Hue Hwa Au Yong and Chris Veld∗

Abstract: We investigate whether the flexibility in making contributions towards defined

benefit pension plans sponsored by firms in the United States allows managers to save cash

and increase investments. Firms invest more at higher levels of pension deficit, defined as

pension benefit obligations less pension assets, and scaled by total assets. At the median level

(90th percentile) of pension deficit, investments increase by 6.7 cents (9.4 cents) for every

dollar increase in cash. As the pension deficit increases, firms deviate more from the predicted

level of investment. These findings suggest that the incremental investments are more likely to

represent overinvestment by managers. Our results are robust to alternative model specifications

and endogeneity concerns that may arise if investments are jointly determined with the funding

policy of pension plans and the firm’s target cash level. We repeat our main analysis for the

United Kingdom and also find for that country that, at a fixed cash level, total investment

increases as pension deficit increases.

Keywords: investment, capital expenditure, R&D, acquisition, defined benefit pension plan,

pension deficit, underfunded pension plan

1. INTRODUCTION

Many large US firms consider defined benefit (DB) pension plans as an important tool

for attracting and retaining employees (Towers Watson, 2013). In a DB pension plan,

an employer promises to provide pension benefits to an employee. In order to cover

pension liabilities, firms are required to keep aside assets in a trust that is segregated

from the normal operations of a firm. A pension plan is underfunded, or is in deficit,

if pension assets are insufficient to cover pension liabilities. A pension deficit may

result from the managerial decision not to contribute sufficient funds towards their

pension plans. Underfunded pension plans may affect the investments of a firm if

managers have to divert substantial cash flows from operating activities in order to

improve the funding of the pension plan. The financial press regularly suggests that

∗All authors are affiliated to Department of Banking and Finance, Monash Business School Monash

University PO Box 197 Caulfield East VIC 3145 Australia. (Paper received December 2014, revised revision

accepted August 2016).

Address for correspondence: Hue Hwa Au Yong, Department of Banking and Finance, Monash Business

School Monash University PO Box 197 Caulfield East VIC 3145 Australia.

e-mail: huehwa.auyong@monash.edu

C

2016 John Wiley & Sons Ltd 196

FUNDING STATUS OF DEFINED BENEFIT PENSION PLANS 197

pension contributions affect the ability of a firm to invest in new capital or hire new

employees:

“Regulations require that this (pension) hole be closed within ten years, costing companies £7.4

billion a year, money that could have gone into building factories and employing new workers”

(The Economist, 15 October 2011).

“Companies cannot commit to building new plants, launching new research projects or hiring new

employees if that cash is needed to fund pensions” – Glen A. Barton, Chairman and Chief

Executive of Caterpillar Inc. (The New York Times, 22 June 2003).

The statement of the Chief Executive of Caterpillar is remarkable, because an

analysis of the annual reports of the firm for the period 2001–13 shows the opposite

relationship between pension funding status and investment. From our analysis we

observe that Caterpillar has been profitable and that total revenue has increased in

each of these years (except for 2009). However, Caterpillar Inc. has been contributing

much less funds towards its pension plans than its total pension deficit, even in the

years where it had sufficient cash to completely cover its pension liabilities. During this

period Caterpillar has been investing in new projects. On several occasions we observe

that an increase in investment was accompanied by an increase in pension deficit. For

example, from 2010 to 2011, the pension deficit increased by US$ 2.5 billion while

total investment increased by US$ 8.38 billion. In addition, Caterpillar still had US$

3.1 billion cash on its balance sheet. This anecdotal evidence suggests that firms are

likely to have underfunded pension plans even when they are financially strong.

In the academic literature, there are two strands of literature on the relationship

between pension funding status and investments. Rauh (2006) and Campbell et al.

(2012) suggest that a higher pension deficit is associated with reduced investments.

Rauh (2006) argues that mandatory pension contributions (MPC) cause a reduction

in internal funds available for investment, and therefore investment decreases as

MPC increase. Campbell et al. (2012) attribute this reduction in investment to a

higher cost of capital that increases as MPC increase. Another strand of literature

suggests that firms intentionally underfund their pension plans for various reasons

such as to negotiate with employees (Ippolito, 1985; Benmelech et al., 2012), avoid

takeovers (Asthana, 1999), and maximize tax benefits (Asthana, 1999; Shivdasani

and Stefanescu, 2010; Chaudhry et al., 2016). Shivdasani and Stefanescu (2010)

and Cocco and Volpin (2013) note that pension plan sponsoring firms in general

are large and profitable with fewer growth opportunities than firms that do not

sponsor such pension plans. Bakke and Whited (2012) demonstrate that the strong

sensitivity of investment to MPC, as observed in Rauh’s (2006) study, stems from

heavily underfunded pension plans. They further document that these results cannot

be generalized beyond those severely underfunded firms; firms that account for a very

small number of the universe of firms that sponsor DB pension plans.

It is not clear from the extant literature how the funding of pension plans affects

the investment decisions of a firm. That is, whether the requirement to make MPC and

higher cost of capital causes managers to invest less. Franzoni (2009) examines market

reactions in response to mandatory pension contributions made by firms. However,

he does not directly examine the relationship between investment and the funding

of DB pension plans. If the market reaction is positive, Franzoni (2009) infers that

managers are entrenched so making MPC helps a firm in reducing its liabilities and

managers have less cash to waste in negative NPV projects (overinvestment). If the

C

2016 John Wiley & Sons Ltd

198 CHAUDHRY, AU YONG AND VELD

market reaction is negative, his interpretation is that financially constrained firms

will have fewer funds available for investments (underinvestment). In another related

study, Chen et al. (2014) examine analysts’ earnings forecasts made within 3 months

after the announcements of the prior year’s earnings. They document that analyst

forecasts, on average, underreact to corporate pension underfunding.

One possibility that has not been explored in the literature is that managers

have considerable flexibility in making pension contributions. This flexibility allows

managers to build financial slack that can be used to invest. Managers are motivated

to underfund their pension plans as pension deficits could have a significant impact

on the firm’s cash flow. For example, in 2010, S&P 500 firms invested approximately

US$ 390 billion in capital expenditure and US$ 157 billion in R&D expenses (Zenner

and Bansal, 2010). For that year, the aggregate pension deficit for S&P 500 firms was

US$ 245 billion (Zenner et al., 2011). In a US survey conducted by Towers Watson in

2013, a human resources consultancy firm based in New York, 67% of the respondents

answered that they consider cash flow needs of the entire business in deciding how

much to contribute towards their pension plans.1The funding requirements of the

Employee Retirement Income Security Act (ERISA) of 1974 recognize that pension lia-

bilities are long-term liabilities.2Firms were allowed to amortize any unfunded liability

over a period of 30 years. The Pension Protection Act of 2006 is stricter and requires

firms to amortize any unfunded liability over a period of 7 years.3Even though these

laws require firms to cover any unfunded pension liability over a fixed number of years,

the Towers Watson survey noted that instead of fully funding DB pension plans, firms

prefer to contribute the minimum MPC towards their underfunded pension plans.4

We argue that US managers intentionally underfund their DB pension plans

in order to build financial slack that can be used to make new investments. We

particularly focus on US firms that sponsor DB pension plans, because of the size and

importance of pension plans in the US. In absolute terms, the US owns the majority

of pension funds’ assets of all the countries of the Organization for Economic Co-

operation and Development (OECD) (see OECD, 2013, 2014). For example, in 2012,

US-owned pension assets were worth US$ 11.6 trillion, and accounted for 53.4% of the

total OECD pension assets followed on a substantial distance by the United Kingdom

(11%) and Japan (6.7%).5,6

1 In this survey, executives from 180 organizations participated. Sixty-seven percent of respondent

companies have at least 10,000 employees and 37% employ 25,000 or more employees globally. Re-

trieved from https://www.towerswatson.com/en/Insights/IC-Types/Survey-Research-Results/2013/11/us-

pension-risk-management-what-comes-next.

2 Firms with severely underfunded plans, which are at risk of defaulting on their obligations, are required

to make additional contributions to reduce the deficit. Only firms with underfunded pension plans are

required to make mandatory pension contributions.

3 One of the main goals of the Pension Protection Act of 2006 was to have fully funded DB pension plans

by 2011. This Act requires firms to have 100% funded pension plans. According to the Pension Protection

Act the goal was to achieve 92% funding in 2008, 94% in 2009, 96% in 2010, and 100% in 2010. However,

the actual funding levels are far from this goal. As shown in Table 2, since 2007 the number of firms with

underfunded pension plans are more than 90%, reaching a peak at 96.2% in 2012.

4 As the pension deficit increases, firms also pay a higher insurance premium to the Pension Benefit

Guaranty Corporation (PBGC), a federal corporation that insures pensions of employees in the private

sector.

5 These figures include all private pension assets (both DB and DC plans, employer-sponsored and private

pensions).

6 In 16 of the 26 OECD countries, investments in DC plans outweigh those in DB plans. In 9 countries,

pension funds only offer DC plans. Pension markets in most of the non-OECD economies are much less

C

2016 John Wiley & Sons Ltd