Should Corporate Pensions Invest in Risky Assets?

Abstract

We use a modified corporate risk management framework (e.g., Froot and Stein, 1998) to understand how inefficient risk sharing between firms and employees leads to aggressive investment policies of defined corporate pensions as well as their declining popularity. For reasonable parameter values, our model matches key empirical patterns including pension’s risk allocation and the relations among pension investment risk, corporate bankruptcy probability, and pension funding. Further, we show that inefficient risk sharing may cause pensions to invest more aggressively than what employees choose for DC plans. By switching from DB plans to DC plans, firms may substantially reduce pension funding costs.