Pension Contributions and Firm Performance: Evidence from Frozen Defined Benefit Plans

• Author: Hieu V. Phan,Shantaram P. Hegde
• Date: 01 June 2013
• Published date: 01 June 2013
• DOI: http://doi.org/10.1111/j.1755-053X.2012.01218.x

Pension Contributions and Firm

Performance: Evidence from Frozen

Defined Benefit Plans

Hieu V. Phan and Shantaram P. Hegde*

We study the impact of freezing defined benefit (DB) pension plans and replacing them with

defined contribution (DC) plans on liquidity, financial leverage, investment,and market value of

a sample of firms over 2001-2008. Wef ind evidencethat the pension freeze tends to attenuate the

drain on corporateliquidity and relieve the pressure to borrowto pay for mandatory contributions

(MCs) associated with underfunded DB plans. Although investors seem to favor the pension freeze

as evidenced by positive announcement abnormal stock returns, there is little reliable evidence

that the freeze increases investmenteff iciency and long-term stock performance.

In recent years, an increasing number of corporations have resorted to altering the structure of

employee retirement plans from defined benefit (DB) to defined contribution (DC) in response to

escalating pension costs. For example, in 2008, the dramatic decline in the stock market resulted

in a sharp drop in DB pension plan assets, whereas the fall in interest rates raised the value of

pension liabilities. Consequently, pension plans of S&P 1,500 companies showed an aggregate

deficit of $409 billion with overall funding at 75% of pension obligations. Press reports suggest

that the shortfall forced companies to divert funds from growing their businesses to pay for

pension obligations, to freeze DB plans, and to replace them with DC plans.

A DB plan promises employees a stream of monthly retirement benefits that are determined

based on their age, earnings, and years of service. Typically, only the employer makes regular

and consistent contributions to the DB plan and bears the full investment risk and beneficiaries’

longevity risk. In contrast, a DC plan specifies the contributions that the employee and the

employer choose to make and promises no specific retirement benefits, except that the employee

is entitled to the investment results derived from those contributions. DB plan contributions are

higher, on average, and less predictable than DC plan contributions (Munnell et al., 2006). The

former tends to depress corporate liquidity and capital expenditures as a firm with underfunded

pension obligations is required, under pension laws,to make annual contributions by applying an

arbitrary nonlinear formula based on its pension funding status (Rauh, 2006). In comparison, DC

We appreciate the helpful comments from Bill Christie (Editor), three anonymous referees, Assaf Eisdorfer, Carmelo

Giaccotto, Joseph Golec, John Harding, Sigitas Karpavicius, Jung-Min Kim, Sanjay Kudrimoti, Alfred Liu, Marcel

Prokopczuk, Susan Thorp, as well as session participants at the 2009 International Conferenceat Iqfai Business School

(Bangalore), 2009 and 2010 Financial ManagementAssociation International Annual Meetings, 2009 Eastern Finance

Association Annual Meeting, 2009 Southwestern Finance Association Annual Meeting, 2011 FINCON at Management

Development Institute (Gurgaon), and seminar participants at the University of Connecticut, MasseyUniversity, Univer-

sity of Adelaide, and Victoria University of Wellington. A previous version of this paper was titled “Impact of Change in

Retirement Benefit Plans on Firm’s Investment, Value, and Risk.” All errors remainthe sole responsibility of the authors.

∗Hieu V. Phan is an Assistant Professorof Finance at the University of Massachusetts at Lowell, MA. Shantaram P. Hegde

is a Professor of Financeat the University of Connecticut in Storrs, CT.

Financial Management •Summer 2013 •pages 373 - 411

374 Financial Management rSummer 2013

plans are viewed as more flexible because they allow firms to vary contributions according to

their cash flow and lower their operating leverage (Petersen, 1992). Retirement analysts observe

that though DB plans tend to place too much burden on employers, DC plans swingto the opposite

end of the spectrum by dumping much of the burden on the individual.

In this paper, we investigate the response of corporate liquidity, financial leverage, investment,

and firm value to potential reductions in legally required pension contributions caused by the

strategic decision of sponsoring firms to freeze DB plans and replace them with DC plans.

Our research is closely related to some recent papers. First, Shivdasani and Stefanescu (2010)

observe that the magnitude of the liabilities arising from DB pension plans is substantial and

firms incorporate the magnitude of their pension assets and liabilities into their capital str ucture

decisions. Additionally, examining the impact of negative shocks to internal resources caused by

required pension outlays based on sharply nonlinear funding rules under pension laws governing

DB plans, Rauh (2006) reports that capital expenditures decline with mandatory contributions

(MCs), particularly so for financially constrained firms. Moreover, Franzoni and Marin (2006)

find that the emergence of large pension deficits for sponsors is followed by negative stock

returns. Finally,Franzoni (2009) concludes that MCs associated with underfunded DB plans lead

to negative stock returns and are more pronounced for firms exposed to financial constraints

and strong governance structures. In light of this evidence, one would expect that a strategic

decision to close existing DB pension plans (eliminating future mandatory pension outlays) and

substitute DC plans would relieve the debt pressure and attenuate the negative effects of DB

plans on corporate liquidity, investment,and value, particularly for f inanciallyconstrained f irms.

However, if the decision to switch from DB to DC plans is prompted primarilyby a severe liquidity

crunch or financial distress, then the near-term net benef its from switching in terms of investment

efficiency and shareholder value wouldbe small. Fur ther,because capital investment requires both

immediate outlays, high adjustment costs, and future capital commitment, financially constrained

firms would give priority to building up liquidity and recapitalizing in the short-term before

embarking on new investment(Pulvino and Tarhan, 2006; Almeida and Campello, 2010; Marchica

and Mura, 2010; Dasgupta, Noe, and Wang, 2011; among others). These arguments suggest that

we need to perform empirical tests to sort out the liquidity, financing, investment, and net firm

value effects of the decision to freeze existing DB pension plans and replace them with DC plans.

Studies by Rauh (2006) and Franzoni (2009) depend on the level of MCs associated with the

DB plans to identify exogenous shocks to internal liquidity and the resulting effect on investment

and firm value. Re-examining Rauh’s(2006) f indings that mandatory pension contributions cause

a sharp drop in capital expenditures, Bakke and Whited (2012) find little evidence that firms

cut back on investment and conclude that Rauh’s (2006) results are likely due to the endogeneity

of benefit contributions. This research is complimentary to Rauh’s (2006) study of exogenous

drops in internal liquidity due to mandatory pension contributions. We focus our analysis on the

potential financial, investment, and value effects of changes in internal liquidity due to a regime

shift in pensions, that is, a deliberate change from required contributions under DB plans to

discretionary contributions under DC plans. Regime shifts in pensions provide a unique setting

that is particularly advantageous in identifying the financial and real effects of improvements in

internal resources because the change in the pension plans has the potential to increase the share

of free cash flows allocated to equity investors as compared to employees given the evidence

that DC plans are less costly, on average. It is true that this shift in the pension regime is itself

endogenous to the sponsoring firm. Yet it mitigates the mandatory nature of DB plan pension

outlays that the firm faces when experiencing adverse economic conditions. Moreover,we employ

different techniques to explicitly address the potential endogeneity bias caused by the shift to

ensure the robustness of our results.

Phan & Hegde rFrozen Pension Plans 375

Westudy a sample of 1,071 firms that sponsor DB pensions, of which 179 firms freeze at least

one DB plan, from 2001 to 2008. Our results indicate that though MCs under DB plans continue

to drain liquidity and increase financial leverage, the freeze tends to mitigate the negative impact

of MCs on corporate liquidity and relieve the pension-induced debt burden. Further, consistent

with Rauh (2006), we find evidence in support of the argument that MCs depress investment,

but there is little evidence that the shift from DB to DC plans improves corporate investment

in a significant way over the following three years. These findings are robust to alternative

corrections for endogeneity of the freeze decision. The regime shift from DB to DC plans appears

to generate stronger liquidity and leverage benefits to sponsors facing financial constraints.

Finally, our analysis of a subsample indicates positive abnormal stock returns during the DB-DC

shift announcement window. However, we find little significant change in the effects of MCs on

long run stock returns up to three years following the DB-DC shift.

This study makes several important contributions to the literature. First, our research offersnew

evidence taken from recent data (2001-2008) relative to thef indings of Rauh (2006) and Franzoni

(2009) (based on the 1990-1998 period) that a negative shock to internal cash flow, caused by

the legally required DB pension contributions, tends to hurt corporate investment and firm value,

particularly that of financially constrained firms. In our full sample, covering both frozen and

nonfrozen DB plans, we document a substantial decline in the marginal negative investment and

value effects of MCs despite the sharp market declines in recent years. Our point estimates are on

the order of $0.05-$0.21 reduction in capital expenditures per dollar of required contributions, as

compared to the $0.60 drop in investment reported by Rauh (2006). Nonetheless, these adverse

investment effects are not inconsequential in light of the average positive investment cash flow

coefficient of 6% in our sample. Further, we find that a one dollar increase in MCs depresses

shareholder value by $0.17-$0.21, as compared with a $0.99 drop in value reported by Franzoni

(2009) based on a 1990-1998 sample.

Additionally, prior research has underscored the serious identification problem arising from

omitted investment opportunities in the investment-cash flow sensitivity tests. We believe that a

study of regime shifts that fundamentally alter MCs, with suitable controls for the endogeneity

of the freeze decision itself, improves our understanding of the linkages among corporate pen-

sions, investment, liquidity, capital structure, and firm value. Specif ically, consistent with recent

evidence documented in the literature (Dasgupta et al., 2011), we find that a positive change in

internal cash flow of constrained firms, induced by the shift from DB to DC plans, has a first

order impact on liquidity and financing, but the real effect (i.e., investment effect), if any, appears

to be secondary. Moreover, previous research on the immediate market reaction to changes in

corporate pension plans does not find a signif icant impact of the change announcement on firm

value (McFarland, Pang, and Warshawsky, 2009; Milevsky and Song, 2010).1In addition, when

examining the effects of MCs on stock performance in a long run event study, Franzoni (2009)

documents that required contributions have a negativeimpact on stock perfor mance. Our investi-

gation provides new evidence regardingthe shor t-term and long-term effects of the DB-DC shift

on firm value. Finally, because adverse capital market conditions aggravate the funded status of

DB pension plans and can pose a real threat to their viability and sustainability, our comprehen-

sive analysis of the financial and the real (investment) effects of regime switches in pensions is

expected to be of value in crafting corporate policy on pension plans and regulatory policy on

employee retirement income security and welfare.

1Although Milevsky and Song (2010) report positive pooled cumulative announcement abnormal returns, none of these

abnormal returns are statistically significant (see Panel A of Table III).