Do a Firm's Equity Returns Reflect the Risk of its Pension Plan?

43 Pages Posted: 19 Jul 2004

See all articles by Zvi Bodie

Zvi Bodie

Boston University

Robert C. Merton

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit

Li Jin

Harvard Business School - Finance Unit

Multiple version iconThere are 2 versions of this paper

Date Written: December 2005

Abstract

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.

Keywords: Defined Benefit Pension Plan, Market Efficiency, Cost of Capital, Capital Budgeting

JEL Classification: G14, G23, G31

Suggested Citation

Bodie, Zvi and Merton, Robert C. and Jin, Li, Do a Firm's Equity Returns Reflect the Risk of its Pension Plan? (December 2005). HBS Finance Working Paper No. 05-011, Available at SSRN: https://ssrn.com/abstract=565261 or http://dx.doi.org/10.2139/ssrn.565261

Zvi Bodie

Boston University ( email )

12 Salisbury Road
Brookline, MA
United States
617 306 5556 (Phone)

HOME PAGE: http://www.zvibodie.com

Robert C. Merton (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

77 Massachusetts Avenue
E62-634
Cambridge, MA 02139-4307
United States
617 715 4866 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6678 (Phone)

Li Jin

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-5590 (Phone)
617-496-5271 (Fax)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
2,037
Abstract Views
8,269
Rank
11,842
PlumX Metrics