Defined benefit (DB) pension plans of both U.S. and European companies are significantly underfunded because of the low interest rate environment and prior decisions to invest heavily in equities. Additional contributions and the recovery of stock markets since the end of the crisis have helped a bit but pension underfunding remains significant. Pension underfunding has substantial corporate finance implications. The authors show that companies with large pension deficits have historically delivered weaker share price performance than their peers and also trade at lower valuation multiples. Large deficits also reduce financial flexibility, increase financial risk, particularly in downside economic scenarios, and contribute to greater stock price volatility and a higher cost of capital.
The authors argue that the optimal approach to managing DB pension risks relates to the risk tolerance of specific companies and their short and long-term strategic and financial priorities. Financial executives should consider the follow pension strategies:
Voluntary Pension Contributions: Funding the pension gap by issuing new debt or equity can provide valuation and capital structure benefits—and in many cases is both NPV-positive and EPS-accretive. The authors show that investors have reacted favorably to both debt- and equity-financed contributions.
Plan de-risking: Shifting the pension plan’s assets from equity to fixed income has become an increasingly popular approach. The primary purpose of pension assets is to fund pension liabilities while limiting risk to the operating company. The pension plan should not be viewed or run as a profit center.
Plan Restructuring: Companies should also consider alternatives such as terminating and freezing plans, paying lump sums, and changing accounting reporting.
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