Post-Retirement Benefit Plans, Leverage, and Real Investment

Abstract

This paper shows that off-balance sheet pension and health care benefit plans are important for firm leverage and real investment around the world. Post-retirement assets and liabilities of nonfinancial corporations are economically sizable in many countries (often more than in the U.S.), but are not fully reflected on the balance sheet despite plans generally being underfunded. While consolidating off-balance sheet post-retirement plans typically increases effective leverage by 32%, they do not matter for gearing of firms in about half the sample countries. Moreover, there is significant variation across countries with regards to the extent to which firms with large projected benefit obligations reduce their level of regular debt, ranging from no to perfect substitution. Since postretirement benefit obligations have more flexible terms than regular debt, they can be used as an instrument to investigate the effect of financial flexibility on real investment. The results show that the relation is conditional on the type of investment opportunity (i.e. type of growth option). Postretirement benefit obligations have a positive effect on R&D, which generates growth options, and a negative effect on capital expenditures, which exercises growth options. Compared to an otherwise similar firm without a post-retirement plan, the average plan sponsor has 5.4% less capital expenditures and 13.1% more research and development. The results are robust to other dimensions of financial policy, such as debt maturity, dividends, preferred stock, convertible debt, and leverage that also affect real investment.