Should Corporate Pensions Invest in Risky Assets?

57 Pages Posted: 12 Nov 2018 Last revised: 28 Mar 2019

See all articles by Wei Li

Wei Li

University of Iowa - Department of Finance

Tong Yao

University of Iowa - Henry B. Tippie College of Business

Jie Ying

Southern Illinois University at Edwardsville - Department of Economics & Finance

Date Written: March 2019

Abstract

Corporate pensions invest aggressively in risky assets, in a gross mismatch with their fixed-income like obligations. Further, firms increasingly shift away from DB plans into defined contribution (DC) plans, thus offloading investment risk of retirement savings to employees. This is in a sharp contrast to the typical risk-sharing within a firm, where employees receive safe wages and shareholders bear the cash flow risk. We provide a model to understand these intriguing phenomena on corporate pensions. In the model, firms make pension investment decisions to maximize shareholder value, subject to employees' participation. Different from the firm-specific risk considered in the typical context of wage contracts, investment risk of diversified pension portfolios are largely systematic. Wealth-constrained employees view systematic pension investment risk differently from shareholders, while sharing the risk with shareholders via the corporate bankruptcy channel and the pension surplus sharing channel. For reasonable parameter values, the model matches key empirical patterns such as the average pension allocation to risky assets and the relation of pension investment risk with a firm's bankruptcy probability. We show that the investment risk sharing under typical DB plans is inefficient, and may cause DB plans to take more risk than what employees will choose for their DC plans. Further, by switching from DB plans to DC plans, firms may substantially reduce their overall pension funding costs without reducing employees' utility.

Keywords: defined-benefit corporate pensions, asset allocation, external financing cost, systematic risk sharing

JEL Classification: G11, G30, G32

Suggested Citation

Li, Wei and Yao, Tong and Ying, Jie, Should Corporate Pensions Invest in Risky Assets? (March 2019). Available at SSRN: https://ssrn.com/abstract=3277798 or http://dx.doi.org/10.2139/ssrn.3277798

Wei Li

University of Iowa - Department of Finance ( email )

Iowa City, IA 52242-1000
United States
319-335-0973 (Phone)

Tong Yao

University of Iowa - Henry B. Tippie College of Business ( email )

Acquisitions
5020 Main Library
Iowa City, IA 52242-1000
United States

Jie Ying (Contact Author)

Southern Illinois University at Edwardsville - Department of Economics & Finance ( email )

Edwardsville, IL 62026
United States

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