Pensions and Corporate Finance: An Empirical Perspective. Corporate pension finance. Corporate Pension Finance: Comments

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1 s and Corporate Finance: An Empirical Perspective Presentation by Mike Orszag at the Seminar on Finance and Economics June 11, 2004, Staple Inn, London Corporate pension finance (Slide 3 of Bodie): s are an integral part of the sponsoring firm and are viewed by the market as debt. Proposition 2: (Slide 7 of Bodie): Because pensions are bondlike companies should invest in bonds to hedge risk ( For a healthy company, the optimal pension policy is to. immunize its defined-benefit liabilities with a fixed-income portfolio. ) Proposition 3: (Slide 7 of Bodie): Optimal policy is to fully fund. and there are lot of obstacles to why this does not happen in practice (like accounting bias). Corporate Finance: Comments Proposition 3: Optimal policy is to fully fund? Modigliani- Miller: value of company invariant to funding (Sharpe 1976). However, because deferred members cannot negotiate, shareholders may gain from underfunding, especially with closed schemes (deferred members). Proposition 2: Are pensions really bond- like? Are rents bond- like? 1

2 Propositions : s are viewed by the market as debt. Proposition 2: Healthy companies should invest in bonds. Proposition 3: Healthy companies should be closer to full funding. Research Literature Largely US- based Somewhat dated in cases Concentrates on proposition 1 and 3 Empirical Evidence Thies-Sturrock (JRI, 1988). Do profitable firms with high tax rates overfund their pension plans? Bodie (FAJ, 1985). Key conclusions: Corporations manage their pension funds as if the funds were an integral part of overall corporate financial policy. Reported fund liabilities linked to company profitability by management's discount rate choice. Profitability and the proportion of pension assets invested in fixed securities have positive associations with funding level. Bulow-Morck-Summers (1985, NBER volume), Feldstein-Morck (1985, NBER Volume). Feldstein-Seligman (1981) 2

3 Empirical Evidence Bulow-Morck-Summers (1985, NBER volume), Feldstein-Morck (1985, NBER Volume). Feldstein-Seligman (1981) They also find that the type of adjustment performed on the liabilities to set these onto a standard interest rate significantly affects the results. Empirical Evidence Coronado and Sharpe (2003) Market does not see through accounting veil - accounting earnings matter more than financial earnings. Multiplier on pension earnings higher than normal earnings. Empirical Evidence Other studies: Chen- D Arcy (JRI 1986). Event study examines the impact of mandated publication of plan assets, liabilities and interest rate assumption on share prices. Finds that low- interest- rate assumption share prices out- performed highinterest- rate assumption share prices. 3

4 Empirical Evidence Thies-Sturrock (JRI, 1988). Do profitable firms with high tax rates overfund their pension plans? Bodie (FAJ, 1985). Key conclusions: s appear to be viewed as significant by the market Reported fund liabilities linked to company profitability by management's discount rate choice. Profitability and the proportion of pension assets invested in fixed securities have positive associations with funding level. Data UK listed companies have had to report pension liabilities on FRS17 basis since late 2001 Collected roughly 150 data items for FTSE350 on corporate finance from FRS17 disclosures Matched data to other data on market returns/option price data, betas, etc. Some of this data also available for Japan, Europe, US Accounting Dates Roughly 48% of FTSE350 (168 companies) use Dec. 31 as end of year, 17% (60 companies) use 31 March, 8% (29 companies) use 30 September, remainder use a variety of dates Define a panel with three waves: 2001 Wave = Accounting dates between 30 June 2001 and 29 June Wave = Accounting dates between 30 June 2002 and 29 June Wave = Accounting dates between 30 June 2002 and 1 January

5 Are Assumptions Reasonable? Yes, broadly so. Regressions of assumptions on risk fundamentals reveal no anomalies or correlations of a significant nature. Look at how pension variables relate to volatility and beta Summary of results: variables do matter But not necessarily as one would expect Liabilities matter more than deficits coefficients different than debt coefficients Try to explain beta with pension variables in 2002 Observations 253 Exclude zero liability companies and investment trusts Coefficien t T- statistics (3.48)** 5

6 Try to explain beta with pension variables in 2002 Observations 253 Exclude zero liability companies and investment trusts BS exposure Coefficien t T- statistics (3.12)** (0.28) Try to explain volatility with pension variables in Coefficien t T- statistics (5.54)** Try to explain volatility with pension variables in 2002 BS exposure Coefficien t T- statistics (3.00)** (1.84) 6

7 Effect on beta Coefficient T-statistics How about? On its own it has an effect but not with pension variables BS exposure (0.20) (2.98)** Ordinary (0.90) How about with other controls? Same qualitative results Effect on beta (including controls for maturity, and equity allocation of pension plan) BS exposure Coefficient T-statistics (2.84) (0.18) How about looking at lags? Worse: 2002 (N=238) Explaining 2003 volatility BS exposure T-statistic

8 How about looking at a panel? Random/fixed effect regressions Same basic pattern: liabilities relative to market cap matters much more than pensions as debt How about looking at a panel? Random/fixed effect regressions Same basic pattern: liabilities relative to market cap matters much more than pensions as debt How about implied volatility? Same basic results (at least in 2002) 8

9 How about other countries (Japan) Volatility (360 day) Lowess smoother defi cit/market cap bandwidth =.8 : Summary Market appears to take into account pensions but do participants seem to look at it as debt??? Proposition 2 Proposition 2: Healthy companies should invest in bonds or are asset allocation of pension funds determined by corporate fundamentals? 9

10 Liabilities/Market Cap (2001) equity_share P ension Risk Granada Group WM Vodaf D ixmorrison on one s G Group rousupermarkets p P lc BG 3I GHBOS lax Group os m ithkline British Next Friends Diageo Prov ident Hays RAbbey BAA entokil Safeway Centrica Land Group NInitial ational Co P lc Capita Hilton Bunzl Schroders Group Com Sm BP ith pass & Nephew Group NAnglo HSBC Bradford Alliance Prudential Cable BOC Scottish and Group & and W ireless Newcastle Scottish Sev J Sainsbury ern Gus orth ern Am Holdings & Ex and Bingley Trent el Leicester Southern Energy Rerican k Rio Cadbury Johnson Lloy Tinto ds TSB Schweppes Matthey Group Am Tesco Si ersham Kingf Gallaher x C isher tinplc en Royal Av Ba iv rcl Scottish Associated D a ay aily Bank (f s orm Mail PR oy Power Group ts erly British a nd l & of Scotland known G SBT eneral un Allian Foods as CGNU) Trust c e Insurance Pl c EMI National Marks Hanson and Group Grid Spencer BAE Sy stem s R olls -R oy c e Allied United nilevdomecq Uer tilities GGKN roupp Land Reckitt Pearson Reed Securities Benckiser Elsevier Reu In BHP Legal t e rn ters a Billiton ti& og Im na General rou perial l P p o wetobacco Group r P lc Group Lattice Group British Inv Amensy erican s Tobacco Man WPP Group OAstraZeneca ld Wolseley Sm Mutual P iths Group Standard Chartered P & O Princess Cruises Boots Com pany British Airway s Im perial Chem ical Industries Corus Group pen s ion _lia bility market_c ap bandwidth =.8 Liabilities/Market Cap (2002) equityshare W Dixons Group mmo2 M Morrison Supermarkets Diageo Granada Group BG Next RFriends Abbey Centrica e GroupProvident Hays HBOS Lloyds n to kil National In BOC Group TSB itia l GP roup lc Bram GlaxoSm Schroders BP Kelda bles Group ithkline Industries Capita Safeway Exel Group In Smith H 3i BAA te ilton Prudential Cable and Wireless Group Daily rn ation G roup M aail l P and o wegbae r Peneral lc Systems Trust P lc Bunzl SAB Anglo Amersham Cadbury Royal Scottish Scottish W& hitbread Johnson Scottish Miller AVIVA American Bank Schweppes & Power M GUS (formerly PLC Southern Tomkins Nephew Severn Trent & atthey of New Scotland castle BT R o Energy lls-r oyce P lc Tesco United Utilities known as CGNU ) BH Reckitt Compass Rio Gallaher Bradford Alliance Reed Allied P J Tinto Billiton Sainsburys Elsevier Benckiser Domecq and EMGKN Group & I Bingley Leicester P HSBC Holdings Vodafone British Alliance ImMarks Unilever perial Group Land Unichem and Tobacco Group Spencer Company Group PLC Northern Reuters Group Kingfisher Barclays Rock Six Continents Legal Pearson & General Group EMAP Royal Sun & Alliance Insurance Liberty British Hanson International American Tobacco Land AstraZeneca W olseley Smiths Securities National Grid Transco Rexam Group Man WPP Group Group Old Mutual P Associated & O Princess B ritish Cruises Foods Standard Chartered Imperial Chemical Industries Boots Com pany B ritish A irw a ys p lc Invensys Corus bs1 Proposition 2 Possible fundamentals to consider Market/book ratio Price/earnings ratio Maturity of the scheme Credit rating 10

11 Do A rated companies hold less equity in their pension plans? Sample all S&P rated companies in 2002 A rated companies no more or less likely to hold equity Equity share of total assets arated (0.11) ftse (0.16) Constant (17.56)** Observations 94 R-squared 0.00 Absolute value of t statistics in parentheses * significant at 5%; ** significant at 1% Do companies with more mature pension funds hold less equity? Equity share of total assets amlin rit interserve capital partners xansa powderject william hill redrow pharmaceuticals vt dixons hmv mmo2 premier farnell paragon john wood wolseley aggreko ultra shanks electronics bg jarvis cos holdings carpetright victrex bovis punch homes taverns berkeley hays nestor stanley next abbey edinburgh first centrica waste barratt recycling developments choice healthcare national leisure isis halma go-ahead stagecoach asset investment holidays trust /the woolworths mitie wilson national cobham mfi informa brit hbos furniture insurance management connolly express holdings holdings schroders law capita jardine safeway hiscox debenture lloyd corp thompson electrocomponents hammerson close brambles spirax-sarco bellway geest cattles friends signet chrysalis lloyds rentokil provident diageo novar greene granada tsb initial king provident caledonia yule brothers industries financial investments catto & glaxosmithkline boc engineering wolverhampton co pennon awg eurotunnel millennium avis international hilton persimmon carillion sig arriva europe copthorne power st 3i bunzl british baa smith westbury rac dairy great ives crest vita & nephew hotels amersham davis northern first daily marshalls cable brixton exel portland croda bp kelda mail & service foods & wireless countrywide & assured dudley brew international estates general trust rps tesco gus debenhams taylor & francis vodafone kidde scottish tbi johnson severn rotork gwr ds smith prudential trent matthey scottish cadbury sabmiller royal scottish bank schweppes & newcastle of scotland celltech slough crest serco bpb rmc nicholson estates investment reed elsevier bhp compass cookson de aviva headlam united tibbett rue utilities billiton trust smith imi fki johnston viridian rolls-royce bae systems whitbread power tomkins & wh britten press chubb bt anglo smg american britannic reuters alliance british greggs marks bradford j sainsbury rio tinto gallaher alliance unichem land & spencer & taylor bingley hsbc holdings co northern trinity somerfield unilever alfred woodrow mcalpine & leicester mersey peninsular securicor emi reckitt meggitt gkn benckiser rank rock mirror carlton imperial communications docks and & harbour oriental tobacco steam pilkington allied navigation domecq spectris united john laing business media kingfisher barclays brown amec six (n) inchcape continents aggregate pz cussons industries land liberty selfridges balfour royal associated hanson british & capital legal pearson beatty sun & alliance radio general astrazeneca securities international american british insurance tobacco ports holdings emap smiths bodycote tate & lyle international british airways national grid premier wpp oil laird man south corus aga invensys rexam foodservice wimpey staffordshire bba george old mutual p&o princess associated cruises british foods de vere taylor nelson singer standard sofres & friedlander chartered london stock exchange imperial chemical industries abbot cox insurance holdings boots Interest cost over Current service cost bandwidth =.8 Lowess smoother How about directional movements? Not much of statistical significance however, pension coefficient lends some support to Proposition 2 Change in equity share Lagged exposure Lagged Coefficient T statistic ftse Constant N=314 11

12 Proposition 2 Proposition 2 Proposition 2: Asset allocation of pension plan determined by fundamentals Does not work well in practice. Proposition 3 Healthy companies should be closer to full funding 12

13 Proposition 3 A- rated companies in 2003: 5.7% greater funding A- rated companies in 2003: 6.4% greater funding (lower for FTSE100) Direction of change is also positive for top rated companies Does the theory work in practice? : s are viewed by the market as debt. Proposition 2: Healthy companies should invest in bonds. Proposition 3: Healthy companies should be closer to full funding. 13