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Other Issues—Pensions

Although pension liabilities or pension assets are not tools of corporate finance, the implications of pension plans on capital structure are similar. Under the current U.S. GAAP, there are two types of pension plans, the defined contribution plan (e.g., a 401k plan) and the defined benefit plan. The former involves the employer, and at times, employees contributing specific sums of cash into a pension fund, the size and timing of which are usually mutually determined. The cash benefits to be secured upon retirement will depend on the size of contributions and the efficiency of the pension fund in managing its investments. The corporation assumes no long-term obligations of the retirees' benefits, the latter bearing the risks should a shortfall occur. In contrast, the defined benefit plans involves the employer having to assume long-term obligations for the amount retirees will receive. Employers thus bear the risk of plans having inadequate assets to pay.

In 2005, FASB statement no. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, required that firms report whether their pension fund was overfunded or underfunded on the balance sheet. When projected benefit obligations (PBO) are larger (smaller) than the fair value of the plan assets, the pension is underfunded (over-funded) and reported as a pension liability (asset). Market participants criticized previous standards for not adequately communicating pension fund status in the financial statements, requiring only that details be included in the footnotes. The nature and size of the pension deficit problem probably explains why some companies sought to understate the depth of their pension funding problems. For example, in 2004, 26 of the 30 firms included in the Dow Jones index had defined benefit plans, with 22 of the 26 reporting total net pension assets of $119 billion. The 22 pension funds were underfunded by a total of $46.9 billion or $1.8 billion per firm.55 This represents $165.9 billion of off-balance sheet obligations. For the entire population of 10,100 active U.S. firms in 2005, it was estimated that a total of approximately $414 billion in net pension liability may have remained off-balance sheet (net assets of $213 billion less an underfunded amount of $201 billion).56

Implications of Pensions on Corporate Financial Strategy

Merton pointed out that the conventional WACC does not fully reflect the riskiness of a firm's operating assets since it includes only on-balance sheet debt when estimating asset risk.37 He argued that pension funds generally have different risk characteristics than other operating assets; thus investors and managers should adjust the WACC accordingly. Jin, Merton, and Bodie calculated the standard cost of capital (WACC) for four large companies, Boeing, Du Pont, Eastman Kodak, and Textron for 2001 and then adjusted them for pension risks.58 They claimed that pension assets invested in equities had significantly higher beta risk than firm debt, whereas the risks of pension liabilities and firm debt were similar. After estimating pension asset and liability betas, they adjusted the cost of capital by the pension values and their weights relative to those of operational assets. Of the four companies, the pension plans of Boeing, Eastman Kodak, and Textron were overfunded, whereas Du Pont had a small pension deficit. The results (Table 8.2) of their analysis revealed that the failure to incorporate pension plan risks could materially overestimate discount rates for operating projects. For example, the correct cost of capital for Boeing was 6.59 percent, whereas the standard approach yielded 8.80 percent, an overestimate of about 34 percent. This shows that the managers of these companies could have applied higher discount rates for evaluating new projects, which would have led them to rejecting potentially profitable projects. It should be noted that the overfunding of the pension funds was the result of a bullish stock market in the late 1990s and early 2000s. As the stock market started to drop in 2002, the pension

Table 8.2. Estimating Cost of Capital for 2001

Estimating Cost of Capital for 2001

status of many firms changed to underfunded, thus the effects illustrated in Table 8.2 would have been different. Shivdasani and Stefanescu also examined the capital structure implications of pension plans, and showed that the leverage ratios for firms with pension plans were about 35 percent higher when pension assets and liabilities were incorporated in the capital structure.59

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