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DISCUSSION PAPER PI-0501

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

Li Jin, Robert C. Merton and Zvi Bodie

ABSTRACT

This paper examines the empirical question of whether systematic equity risk
of U.S. 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 Pension Benefit Guaranty Corporation further 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. They do not
adjust the estimated beta for the risk of non-operating assets such as pension plan
assets and for off-balance sheet risks such as pension plan liabilities. Failure to make
this adjustment will typically bias upwards 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 U.S. companies. This bias can result in positive net-present-value projects
being rejected.