Why Do Firms Offer Risky Defined Benefit Pension Plans?

24 Pages Posted: 5 Oct 2007 Last revised: 21 Feb 2008

See all articles by David A. Love

David A. Love

Williams College - Department of Economics

Paul A. Smith

Federal Reserve Board of Governors

David W. Wilcox

Federal Reserve Board - Division of Research and Statistics

Multiple version iconThere are 2 versions of this paper

Date Written: June 13, 2007

Abstract

Even risky pension sponsors could offer essentially riskless pension promises by contributing a sufficient level of resources to their pension trust funds and by investing those resources in fixed-income securities designed to deliver their payoffs just as pension obligations are coming due. However, almost no firm has chosen to fund its plan in this manner. We study the optimal funding choice for plan sponsors by developing a simple model of pension financing in which the total compensation offered to workers must clear the labor market. We find that if workers understand the implications of pension risk, they will demand greater compensation for riskier pension promises than for safer ones, all else equal. Indeed, in our model, pension sponsors maximize their value by making their pension promises free of risk. We close by positing some explanations for why no real-world firm follows the prescription of our model.

Keywords: Pensions, risk, compensation, corporate finance

JEL Classification: E21, G23, G30, J32, J33, M52

Suggested Citation

Love, David A. and Smith, Paul A. and Wilcox, David W., Why Do Firms Offer Risky Defined Benefit Pension Plans? (June 13, 2007). FEDS Working Paper No. 2007-36. Available at SSRN: https://ssrn.com/abstract=1019017 or http://dx.doi.org/10.2139/ssrn.1019017

David A. Love

Williams College - Department of Economics ( email )

South Academic Building, RM 202
Williamstown, MA 01267
United States

Paul A. Smith (Contact Author)

Federal Reserve Board of Governors ( email )

20th and C Streets, NW
Washington, DC 20551
United States

David W. Wilcox

Federal Reserve Board - Division of Research and Statistics ( email )

20th and C Streets, NW
Mailstop 153
Washington, DC 20551
United States

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