Pension Risk Management in the Enterprise Risk Management Framework

• DOI: http://doi.org/10.1111/jori.12196
• Author: Richard D. MacMinn,Jifeng Yu,Yijia Lin,Ruilin Tian
• Date: 01 April 2017
• Published date: 01 April 2017

©2017 The Journal of Risk and Insurance. Vol.84, No. S1, 345–365 (2017).

DOI: 10.1111/jori.12196

Pension Risk Management in the Enterprise Risk

Management Framework

Yijia Lin

Richard D. MacMinn

Ruilin Tian

Jifeng Yu

Abstract

This article presents an enterprise risk management (ERM) model for a firm

that is composed of a portfolio of capital investment projects and a defined

benefit (DB) plan for its workforce. The firm faces the project, operational,

and hazard risks from its investment projects as well as the financial and

longevity risks from its DB plan. The firm maximizes its capital market value

net of pension contributions subject to constraints that control project, oper-

ational, hazard, financial, and longevity risks as well as an overall risk. The

analysis illustrates the importance of integrating pension risk into the firm’s

ERM program by comparing firm value with and without managing pension

risk with other risks in an ERM program. An ERM program considering pen-

sion effect integrates the risks of the operation and pension divisions and,

thus, achieves diversification benefits between and within these two divi-

sions. We also show how pension hedging strategies can impact the firm’s

net value under the ERM framework. While the existing literature suggests

that a longevity swap is less expensive than a pension buy-out because the

latter is more capital intensive, this analysis shows that the buy-out is more

effective in increasing firm value.

Introduction

Enterprise risk management (ERM), a new development in the field of risk manage-

ment, has received unprecedented international attention from both industry and

academia in recent years (Lin, Wen,and Yu, 2012). ERM represents an integrated risk

management method that assesses all enterprise risks and coordinates various risk

Yijia Lin is in the Department of Finance, University of Nebraska, P.O. Box 880488, Lincoln,

NE 68588. Lin can be contacted via e-mail: yijialin@unl.edu. Richard D. MacMinn is a Senior

Research Fellow at the University of Texasand National Chengchi University. Ruilin Tian is in

the Department of Accounting, Finance and Information System, College of Business, North

Dakota State University.Jifeng Yuis in the Department of Management, College of Business Ad-

ministration, University of Nebraska–Lincoln. We are grateful to the two anonymous referees

for very helpful comments.

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346 The Journal of Risk and Insurance

management strategies in a holistic fashion, as opposed to a silo-based traditional

risk management (SRM) approach. In the SRM framework where risk classes

are treated in isolation, individual decisions handling idiosyncratic risks can be

incompatible with the firm’s overall risk appetite and global corporate agenda

(Ai et al., 2012). A separate management of individual risk categories can also create

inefficiencies due to lack of coordination between various risk management units

(Hoyt and Liebenberg, 2011).

Departing from SRM, ERM considers all risk factors, at a holistic level, that ostensibly

overcome the limitations of SRM; hence, ERM is likely to create value in multiple di-

mensions. For example, managing risks in the aggregate facilitates risk control on key

drivers of earnings volatility arising from business, operational, credit, and market

risks (Lam, 2001). Liebenberg and Hoyt (2003) find that firms with greater financial

leverage are more likely to establish ERM programs as ERM can mitigate information

asymmetry regarding the firm’s current and expected risk profile. As noted by Lin,

Wen, and Yu (2012), ERM can generate synergies between different risk management

activities by coordinating a set of complementary risk management strategies. Fur-

thermore, ERM optimizes the trade-off between risk and return at the enterprise level

and, thus, allows the firm to select investments based on a more accurate risk-adjusted

rate (Nocco and Stulz, 2006).

Toachieve its proposed benefits and facilitate better operational and strategic decision

making, ERM requires firms to encompass all risks that affect firm value. Despite this

widely accepted notion, surprisingly,the current ERM practice and literature primar-

ily targets risks that affect the basic balance sheet and disregards the off-balance-sheet

items that could impose a significant impact on a firm. Among different off-balance-

sheet items, perhaps no other items are more important than corporate pension plans

(Shivdasani and Stefanescu, 2010). According to the BrightScope and Investment

Company Institute (2014), at the end of the second quarter of 2014, the total value

of defined benefit (DB) pension assets held by U.S. firms was about $3.2 trillion, an

amount far greater than that of any other off-balance-sheet item. Those firms that offer

traditional DB plans to salaried employees are the focus of this article.

DB pensions introduce significant risks that arise frommarket downturns, low interest

rate environments, new pension accounting standards, and improved life expectancy

of retirees. If firms do not control expenses arising from pension risk, they will have

to cut costs elsewhere and that will diminish their ability to maintain current opera-

tions and invest in new positive net present value (NPV) projects. First, unanticipated

improvements in mortality rates increase pension liabilities (Lin and Cox, 2005; Cox,

Lin, and Wang, 2006; Cox, Lin, and Petersen, 2010; Cox and Lin, 2007; Milidonis, Lin,

and Cox, 2011). Second, investment risk constitutes another significant concern for DB

plans. The 2007–2009 mortgage and credit crisis and the subsequent drop in discount

rates caused double-digit rises in pension funding deficits and notable decreases in

the value of many firms. For example, the DB plans of General Motors (GM) were un-

derfunded by $8.7 billion in year 2012. As GM was obligated to infuse cash to cover

gaps created by the market downturns, the pension underfunding was one factor

decreasing GM’s share value even if it operated profitably (Bunkley, 2012).