Pension Transparency and Idiosyncratic Risk: An Empirical Study of Debt-Equity Implications for Cost of Capital
Posted: 26 Feb 2011
Date Written: February 25, 2011
Viewing pension contracts between employees and the firm as having both explicit and implicit elements can have a significant implication for estimating the cost of capital and capital structure. We examine the relationship between firm’s cost of capital and pension risk for recent economic environments of uncertainty and more fluidity in the nature of pension arrangements. We find that the relation of firm risk to pension risk is equivocal, and that the estimated cost of capital is sensitive to: (a) alternative explicit versus implicit definitions of pension liability; (b) the nature and scope of other long-term deferred compensation arrangements; and (c) the scope and nature of risks associated with these pension arrangements that are equity consolidated with the firm. Correcting measures of risk to incorporate both the value and risk of idiosyncratic elements of post-retirement benefit plans further increases the strength of association between pension risk and overall firm risk but not in the way implied by Jin, Merton and Bodie (2006). We also find that incorporating idiosyncratic risk exposure allows us to discriminate between the nature of pension risks borne by firms that terminate or continue their defined benefit pension plans, and significantly enhances explanatory power of the Fama-French model in explaining the cross-section of returns for severely underfunded firms.
Keywords: Pension Plans, Cost of Capital
JEL Classification: J23, M41
Suggested Citation: Suggested Citation