Allocating Shareholder Capital to Pension Plans

Robert Merton

Journal of Applied Corporate Finance, 2006, vol. 18, issue 1, 15-24

Abstract: This article discusses the corporate challenge of providing retirement income to employees while limiting the costs and risks of pension plans to the companies themselves by addressing five main questions: • What are the major issues and challenges surrounding pensions? Although the pension shortfalls have been the focus of attention, the author argues that the more serious concern is the risk stemming from the mismatch between pension assets and pension liabilities— that is, the funding of debt‐like liabilities with equity‐heavy asset portfolios. • To what extent do the equity market and equity prices reflect the shortfall in value and the mismatch in risk? While the author describes some evidence of the market's ability to capture pension risk, analysts' P/E multiples and management's assessments of cost of capital may still be distorted by failure to take full account of the risks associated with pension assets. • How should management analyze and formulate strategic solutions? Without offering specific solutions, the author presents a framework for analyzing the problem from a strategic perspective that can be used in formulating a company's pension policy. In particular, the article recommends that companies take an integrated perspective that views pension assets and liabilities as parts of the corporate balance sheet, and the pension asset allocation decision as a critical aspect of a corporate‐wide enterprise risk management program. • If a company chooses to make a major change in its pension policy, such as a partial or complete immunization accomplished by substituting bonds for stocks, how would you communicate the new policy to the rating agencies and investors? • What are the major issues to be thinking about when contemplating a change from a DB plan to a defined contribution, or DC, plan? The author argues that DC plans without some corporate oversight or responsibility for results are not a long‐term solution.

Date: 2006
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