Financial Flexibility and Tax Incentives: Evidence from Defined Benefit Corporate Pension Plans in Japan

Abstract

Contrary to the objective of a major corporate pension reform in Japan to enhance retirement income security, and despite the increased relative tax benefits of externally-funded plans, the number of firms that do not sponsor externally-funded defined benefit plans or defined contribution plans has been increasing steadily. We study the common characteristics of firms sponsoring only traditional internally-funded lump sum plans that provide only weak protection of the employees’ retirement benefits. We find that smaller firms with higher growth prospects (price-to-book ratios) and a younger workforce are less likely to adopt externally-funded plans and more likely to terminate them when they have one. Firms sponsoring only internally-funded plans tend to exhibit lower profitability than their peers with otherwise similar characteristics. These results suggest that smaller firms with higher growth prospects and a younger workforce tend to have stronger incentives to ensure financial flexibility by providing only weak protection of their employees’ retirement benefits.