Pension Risk and the Sustainable Cost of Capital

Prior research empirically finds that the systematic equity risk for US firms as measured by beta reflects the risk of their defined benefit pension plans, despite opaque and complicated pension accounting rules. This paper re-examines this question in the context of subsequent clarification of these rules, and the growing importance of non-defined benefit pension funds. This issue is examined by comparing standard equity-based models with a broader pre-existing shareholder model of the reporting entity to re-examine the relationship between firm equity risk and pension plan risk. The empirical tests are conducted on a sample of S&P 500 firms during the first three years of the introduction of the revised pension accounting rules (2006–2008), based on panel data regression relating firm risk to pension risk and controlling for other variables. In contrast to the prior findings of JMB, the estimated cost of capital is additionally sensitive to the following: (a) alternative explicit versus implicit definitions of pension liability; (b) the nature and scope of long-term deferred compensation arrangements; and (c) the scope and nature of investment-related risks through investment in sponsoring company stock that are associated with these pension arrangements.