Risk Shifting versus Risk Management: Investment Policy in Corporate Pension Plans

Abstract

Firms financed with debt face conflicting incentives with respect to the management of cash flow risks. Risk reduction can benefit liquidity constrained firms, but increased risk taking can increase the value of shareholders’ equity through asset substitution when firms are close to default. In this paper I examine these conflicting motivations in a setting where risk shifting incentives should be particularly strong: the investment of defined benefit pension plans sponsored by U.S. companies. Empirically, firms with poorly funded pension plans allocate a greater share of pension fund assets to safer securities such as government debt and cash, whereas well-funded plans invest more heavily in volatile asset classes such as equity. Among large public firms, those with better credit ratings allocate greater shares of pension fund assets to equity and smaller shares to government debt and cash. These relations hold both in the crosssection and within firms and plans over time. The higher the probability of bankruptcy, the safer the observed pension fund asset allocation. Furthermore, the realized investment return volatility of plans that eventually terminate in financial distress is no greater than that of plans that do not terminate. I conclude that the incentive to limit the cash flow risk from pensions plays a considerably larger role than risk shifting in explaining pension fund investment policy among U.S. firms.