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http://ssrn.com/abstract=921678
 
 

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The Tax Consequences of Long-Run Pension Policy


Fischer Black


Sloan School of Management, MIT


Journal of Applied Corporate Finance, Vol. 18, No. 1, pp. 8-14, Winter 2006

Abstract:     
A firm's pension fund is legally separate from the firm. But because pension benefits are normally independent of fund performance, pension assets impact the firm very much as if they were firm assets.

Because they are worth more when times are good and less when times are bad, common stocks in the pension fund add to the sponsoring firm's leverage. They cause contributions to a pension fund to be high just when the firm can least afford to pay them. Conversely, bonds in the pension fund will make it easier for the firm to avoid default on its own bonds when times are bad all over: The more bonds a pension fund buys, the more the firm can borrow.

The tax treatment accorded the pension fund differs notably from that accorded the firm. Some have argued that a firm can capitalize on the difference by accelerating the funding of its pension plan. The benefits of full funding are wasted, however, unless the added contributions to the fund are invested in bonds; higher pension contributions now mean lower contributions later, hence higher taxes later. The benefits come from earning, after taxes, the pretax interest rate on the bonds in the pension fund.If the firm wants to take advantage of the differing tax treatment of bonds without altering the level of its current pension contributions, it can (1) sell stocks in the pension fund and then buy bonds with the proceeds while (2) issuing debt in the firm and buying back its own shares with the proceeds. An investment in the firm's own stock creates no more tax liability than an investment in stocks through the pension fund.

If the firm wants to take advantage of the differing tax treatment of bonds without altering the level of its current pension contributions, it can (1) sell stocks in the pension fund and then buy bonds with the proceeds while (2) issuing debt in the firm and buying back its own shares with the proceeds. An investment in the firm's own stock creates no more tax liability than an investment in stocks through the pension fund.The tax treatment accorded the pension fund differs notably from that accorded the firm. Some have argued that a firm can capitalize on the difference by accelerating the funding of its pension plan. The benefits of full funding are wasted, however, unless the added contributions to the fund are invested in bonds; higher pension contributions now mean lower contributions later, hence higher taxes later. The benefits come from earning, after taxes, the pretax interest rate on the bonds in the pension fund.

Number of Pages in PDF File: 9

Accepted Paper Series


Date posted: November 16, 2006  

Suggested Citation

Black, Fischer, The Tax Consequences of Long-Run Pension Policy. Journal of Applied Corporate Finance, Vol. 18, No. 1, pp. 8-14, Winter 2006. Available at SSRN: http://ssrn.com/abstract=921678 or http://dx.doi.org/10.1111/j.1745-6622.2006.00071.x

Contact Information

Fischer Black (deceased) (Contact Author)
Sloan School of Management, MIT
Author - Deceased
N/A
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