Dec 24, 2008

Pension plans, firm risk, and the cost of capital

This Times article discusses some firms that are dealing with the impact of shrinking pension plan funds. Another one at Bloomberg mentions a $230B decline in pension plan funding just in October and November of 2008, reducing funding levels from 97 percent down to 80 percent.

Unless you are in a very countercyclical industry and/or your stock has an extremely low beta, it's likely that your pension plan returns are going to be correlated with your overall business. So right as the economy tanks, your business slows, and the value of your pension assets declines - this is what's happening right now to many firms. That's one argument against putting all your pension funds in high risk, high return equities.

Zvi Bodie published an interesting paper that explored another reason not to invest pension funds in risky assets: Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan? He argues that the market beta for your stock reflects the risk implicit in your pension plan assets. Even though these funds are technically segregated, most analysts combine all assets and liabilities when looking at the firm as a whole. This makes sense, as the company is still on the hook to pay its retirees even if the pension's investments decline in value. Therefore, the observed firm beta in the market may overstate the true risk of the firm's operating assets, which would lead to a higher discount rate than is warranted for capital budgeting projects. In turn, this could lead to incorrect rejection of positive NPV projects.

Maybe they should just put all the pension funds in fixed income?

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