Managing Pension Risks: A Corporate Finance Perspective

Abstract

Defined benefit (DB) pension plans of both U.S. and European companies are significantly underfunded because of the low interest rate environment and prior decisions to invest heavily in equities. Additional contributions and the recovery of stock markets since the end of the crisis have helped a bit but pension underfunding remains significant. Pension underfunding has substantial corporate finance implications. The authors show that companies with large pension deficits have historically delivered weaker share price performance than their peers and also trade at lower valuation multiples. Large deficits also reduce financial flexibility, increase financial risk, particularly in downside economic scenarios, and contribute to greater stock price volatility and a higher cost of capital. The authors argue that the optimal approach to managing DB pension risks relates to the risk tolerance of specific companies and their short and long‐term strategic and financial priorities. Financial executives should consider the follow pension strategies: