Pension Policy and the Value of Corporate‐Level Investment

• Published date: 01 June 2013
• DOI: http://doi.org/10.1111/fima.12008
• Author: Neil L. Seitz,Michael J. Alderson
• Date: 01 June 2013

Pension Policy and the Value of

Corporate-Level Investment

Michael J. Alderson and Neil L. Seitz∗

Weexamine how pension policy affects the value of corporate-level investment to the firm and its

various claimants using Monte Carlo simulation. Shareholderslose the greatest amount of project

value to the pension plan when it is undiversified across asset classes. Improved funding levels

mandated by the provisions of the Pension Protection Act of 2006 generally reduce those wealth

transfers. Thus, mitigation of the overhangeffect joins the reduction of financial distress costs as

a motivation for holding both stocks and bonds in the pension fund.

Corporate pension policy describes decisions that determine the funded status of the pension

plan (the ratio of plan assets to plan liabilities) and the allocation of the pension fund among

different asset classes. When financing constraints exist, corporate pension policy will be rel-

evant to shareholder wealth if it influences the amount of internal finance available for capital

expenditures. Pension policy also has the potential to determine the extent to which gains from

corporate-level investment are shared with the bondholders and the pension fund.

This article employs Monte Carlo simulation to explore the extent to which the investment

policy and funded status of a defined benefit pension plan affects the value of corporate-level

investment to the firm, its senior claimants, and the shareholders. We also investigate whether

changes in the speed of funding mandated by the Pension Protection Act of 2006 have an

incremental effect on investment efficiency. To the best of our knowledge, the results presented

here are new, and provide an additional motivation for balanced asset allocations in defined

benefit plans. The insight they provide cannot be obtained from a large sample empirical study

due to the endogenous relationship between pension policy and the financial strength of the plan

sponsor.

The simulation results indicate that shareholder project values are indeed sensitive to the

selection of corporate pension policy. Shareholder gains from investing are influenced by the

asset allocation of the pension assets, the funded status of the plan, and the degree of financial

leverage employed by the plan sponsor. That happens because the pension fund is both a profit

center (generating volatile investment earnings) and a senior claimant (requiring a fluctuating

contribution stream that is senior to debt service).

Our work is closely related in spirit to Parrino and Weisbach (1999), who employ simulation

to study the impact of bondholder wealth transfers on the incremental shareholder wealth created

by the acceptance of a project. The model here introduces the funding level and asset allocation

of the pension fund as added influences on the shareholder value of corporate-level investment.

Wethank John T. Aldersonof Towers Watson,Brian Betker, Bidisha Chakrabarty,Bill Christie (Editor) and an anonymous

reviewer forhelpful comments and suggestions. We are also grateful to John Grahamfor providing us with the marginal

income tax rates used in the study.An earlier version of this paper was presented at the 2011 FMA Conference (Denver).

All errors remain our own.

∗Michael J. Aldersonis a Professor of Finance in the Department of Finance at Saint Louis University in St. Louis, MO.

Neil L. Seitz is a Professor of Financein the Department of Finance at Saint Louis University in St. Louis, MO.

Financial Management •Summer 2013 •pages 413 - 440

414 Financial Management rSummer 2013

That modification leads to another form of overhang; one that occurs because the pension fund

benefits from incremental project income.

All other things equal, a higher level of funding reduces the shortfall that can be transferred to

the Pension Benefit Guaranty Corporation (PBGC) in the event of a distressed plan termination.

Therefore, for a given level of underfunding, some of the gain from incremental capital expendi-

tures accrues to the pension fund in the form of additional contributions, making those investment

opportunities less attractive to the bondholders and the stockholders. The investment policy of

the pension fund matters here, too. A streak of poor investment performance can increase the

unfunded portion of the liability making the overhang problem more severe.

Parrino and Weisbach(1999) report that low risk projects augment the wealth of the bondholders

and high risk projects reduce it. Our analysis begins with an examination of a levered firm that

sponsors a defined benefit pension plan that is: 1) initially fully funded and 2) holds only

bonds. The results indicate that the pension fund experiences the same coinsurance effect as the

bondholders. The plan gains in the form of greater contributions when the firm accepts low risk

projects, and those gains decline as the level of project risk increases.

If the plan is severely underfunded,the overhang problem worsens. Corporate-level investment

produces even greater gains for the pension fund. As the financial leverage of the plan sponsor

increases, both the bondholders and the pension fund receive a greater share of the value of a

new project. The same effect occurs when, holding the debt level of the plan sponsor constant,

the projected benefit obligation is larger.

The asset allocation of the pension fund also affects the stream of payments it receives from

the plan sponsor. Corporate-level investment is most beneficial to the pension plan when the

pension fund is undiversified across asset classes as the cash flow stream from the project offsets

the more frequent downside performance generated by an unbalanced asset allocation. A 40/60

stock/bond mix minimizes the extent to which the pension fund gains from capital expenditures,

regardless as to how risky the project is. In contrast, the bondholders generally lose as the equity

exposure of the pension fund increases. That is because the added stock market risk impairs the

coinsurance benefit of the project to the f ixed claimants.

The influence of equity exposure on the value of the project to the shareholders is determined

by a combination of the incremental effect on the valueof the project to the firm, the bondholders,

and the pension fund. Our simulation results indicate that balanced asset allocations lead to the

highest shareholder net present values (NPVs) by a small margin. That outcome occurs because a

mix of stocks and bonds in the pension fund produces the greatest shareholder gain to corporate-

level investment after accounting for the impact of wealth transfers, tax shields, distress costs,

and pension fund investment returns. We conclude that overhang from the pension fund affects

the value of corporate-level investment to the shareholders of a defined benefit pension plan and

that the magnitude of the effect is shaped, in part, by the investment risk of the pension fund.

The Pension Protection Act of 2006 implemented a series of changes in the minimum funding

requirements for defined benefit plan sponsors. We also examine the incremental effect of those

changes on the value of corporate-level investment. The impact varies with the funded status of

the plan and the investment policy of the pension fund. Our results indicate that the share of

project value expropriated by the pension fund is reduced under the new law. That change occurs

because the improved level of funding mandated by the Act makes the income from the project

less critical to the ability of the plan sponsor to meet future required pension contributions.

This study contributes to the literature on corporate pension policy in three distinct ways. We

demonstrate that pension policy is relevant to firm valuation due to its impact on the incremental

value of corporate-level investment. Much of the traditional viewof cor porate pension policyhas

focused on how the investment risk of the pension fund should be employed in order to exploit