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

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. see front matter r 2006 Elsevier B.V. All rights reserved. .jfineco.2005.06.005 k Anna Yu, Alvaro Vivanco and especially Jason Oh for excellent research assistance, and the of Research at Harvard Business School, especially Sarah Eriksen and Sarah Woolverton, for help in ta used in this paper. We benefited greatly from discussions with Lisa Meulbroek, Akiko Mitsui and en and comments from two anonymous referees as well as seminar participants at the Harvard ool and the Brattle Group. nding author. dress: [email protected] (R.C. Merton). ARTICLE IN PRESS L. Jin et al. / Journal of Financial Economics 81 (2006) 1–26 2 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. r 2006 Elsevier B.V. All rights reserved. JEL classifications: G14; G23; G31