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Why Do Firms Offer Risky Defined Benefit Pension Plans?

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Even risky pension sponsors could offer essentially riskless pension promises by contributing a sufficient level of resources to their pension trust funds and by investing those resources in fixed-income securities designed to deliver their payoffs just as pension obligations are coming due. However, almost no firm has chosen to fund its plan in this manner. We study the optimal funding choice for plan sponsors by developing a simple model of pension financing in which the total compensation offered to workers must clear the labor market. We find that if workers understand the implications of pension risk, they will demand greater compensation for riskier pension promises than for safer ones, all else equal. Indeed, in our model, pension sponsors maximize their value by making their pension promises free of risk. We close by positing some explanations for why no real-world firm follows the prescription of our model.

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  • David Love & Paul Smith & David Wilcox, 2007. "Why Do Firms Offer Risky Defined Benefit Pension Plans?," Department of Economics Working Papers 2007-04, Department of Economics, Williams College.
    • Handle: RePEc:wil:wileco:2007-04
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    1. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
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    13. David W. Wilcox, 2006. "Reforming the Defined-Benefit Pension System," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 37(1), pages 235-304.
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    Cited by:

    1. Christine Mayrhuber & Gerhard Rünstler & Thomas Url & Werner Eichhorst & Michael J. Kendzia & Maarten Gerard & Connie Nielsen, 2011. "Pension Systems in the EU. Contingent Liabilities and Assets in the Public and Private Sector," WIFO Studies, WIFO, number 43938.
    2. Thomas Url, 2015. "Altersvorsorgesysteme in Europa," WIFO Studies, WIFO, number 57913.
    3. Margaret J. Lay, 2020. "Pension Regulation, Firm Borrowing, and Investment Risk," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 87(4), pages 935-968, December.
    4. Love, David A. & Smith, Paul A. & Wilcox, David W., 2011. "The effect of regulation on optimal corporate pension risk," Journal of Financial Economics, Elsevier, vol. 101(1), pages 18-35, July.
    5. David A. Love & Paul A. Smith & David W. Wilcox, 2009. "Should risky firms offer risk-free DB pensions?," Finance and Economics Discussion Series 2009-20, Board of Governors of the Federal Reserve System (U.S.).

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