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.
