Should Corporate Pension Funds Invest in Risky Assets?

Whether defined-benefit corporate pension plans should invest in risky assets has always been subject to debate, and the risky pension asset allocation frequently causes concerns. In this study, we model corporate pension decisions in a setting where a firm balances its risk management concern with employees’ preference for systematic risk exposure. For a reasonable set of parameter values, the optimal pension investment risk-taking and its relations with a firm’s bankruptcy probability and pension funding ratio predicted by the model are consistent with empirical observations. We show that the inefficient systematic risk sharing by defined benefit pension plans may cause pensions to take even more investment risk than what employees desire if they were to manage their own retirement wealth. Further, firms may substantially reduce their overall pension funding costs under an alternative arrangement with employees bearing all systematic investment risk. This is consistent with the observed shifting from defined benefit plans to defined contribution plans.