Finance and Economics Discussion Series

Should Risky Firms Offer Risk-Free DB Pensions?

David A. Love, Paul A. Smith, and David Wilcox
2009-20

Abstract: We develop a simple model of pension financing to study the effects of pension risk on shareholder value. In the model, firms minimize costs, total compensation must clear the labor market, and a government pension insurer guarantees a portion of promised benefits. We find that in the absence of mispriced pension insurance, the optimal pension strategy under most specifications is to immunize all sources of market risk. Mispriced pension insurance, however, gives firms the incentive to introduce risk into their pension promises, offering an explanation for some of the observed prevalence of risky pensions in the real world.

Keywords: Pensions, bankruptcy, risk, portfolio choice