Pension Contributions and Firm Performance: Evidence from Frozen Defined Benefit Plans

Article excerpt

We study the impact of freezing defined benefit (DB) pension plans and replacing them with defined contribution (DC) plans on liquidity, financial leverage, investment, and market value of a sample of firms over 2001-2008. We find evidence that the pension freeze tends' to attenuate the drain on corporate liquidity and relieve the pressure to borrow to pay for mandatory contributions (MCs) associated with underfunded DB plans. Although investors seem to favor the pension freeze as evidenced by positive announcement abnormal stock returns, there is little reliable evidence that the freeze increases investment efficiency and long-term stock performance.

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In recent years, an increasing number of corporations have resorted to altering the structure of employee retirement plans from defined benefit (DB) to defined contribution (DC) in response to escalating pension costs. For example, in 2008, the dramatic decline in the stock market resulted in a sharp drop in DB pension plan assets, whereas the fall in interest rates raised the value of pension liabilities. Consequently, pension plans of S&P 1,500 companies showed an aggregate deficit of $409 billion with overall funding at 75% of pension obligations. Press reports suggest that the shortfall forced companies to divert funds from growing their businesses to pay for pension obligations, to freeze DB plans, and to replace them with DC plans.

A DB plan promises employees a stream of monthly retirement benefits that are determined based on their age, earnings, and years of service. Typically, only the employer makes regular and consistent contributions to the DB plan and bears the full investment risk and beneficiaries' longevity risk. In contrast, a DC plan specifies the contributions that the employee and the employer choose to make and promises no specific retirement benefits, except that the employee is entitled to the investment results derived from those contributions. DB plan contributions are higher, on average, and less predictable than DC plan contributions (Munnell et al., 2006). The former tends to depress corporate liquidity and capital expenditures as a firm with underfunded pension obligations is required, under pension laws, to make annual contributions by applying an arbitrary nonlinear formula based on its pension funding status (Rauh, 2006). In comparison, DC plans are viewed as more flexible because they allow firms to vary contributions according to their cash flow and lower their operating leverage (Petersen, 1992). Retirement analysts observe that though DB plans tend to place too much burden on employers, DC plans swing to the opposite end of the spectrum by dumping much of the burden on the individual.

In this paper, we investigate the response of corporate liquidity, financial leverage, investment, and firm value to potential reductions in legally required pension contributions caused by the strategic decision of sponsoring firms to freeze DB plans and replace them with DC plans. Our research is closely related to some recent papers. First, Shivdasani and Stefanescu (2010) observe that the magnitude of the liabilities arising from DB pension plans is substantial and firms incorporate the magnitude of their pension assets and liabilities into their capital structure decisions. Additionally, examining the impact of negative shocks to internal resources caused by required pension outlays based on sharply nonlinear funding rules under pension laws governing DB plans, Rauh (2006) reports that capital expenditures decline with mandatory contributions (MCs), particularly so for financially constrained firms. Moreover, Franzoni and Marin (2006) find that the emergence of large pension deficits for sponsors is followed by negative stock returns. Finally, Franzoni (2009) concludes that MCs associated with underfunded DB plans lead to negative stock returns and are more pronounced for firms exposed to financial constraints and strong governance structures. …