Default Risk Goes Up When Pension Plans Heavily Invest In Own Shares: Study

Corporate Pension Plans

When a company is close to default, its employees are often at risk on two different fronts: in addition to unemployment, defined contribution (DC) pension plans take a hit if they’re in the company’s own stocks. Some managers and academics have suggested that this will motivate people to work harder to avoid bankruptcy in the first place, and according to a recent study that’s true – but only if the size of the investment is small.

“Increasing company stock exposures in DC plans are associated with significantly lower default probabilities,” write Ying Duan, Edith Hotchkiss, and Yawen Jiao in their paper Corporate Pensions and Financial Distress. “This positive effect, however, is largely driven by firm with lower levels of owncompany stock ownership […] of 10% or less.”

Nonlinear relationship between own-share DC ownership and default probability

The researchers explain that there are two different theories about how holding owncompany stock in a DC pension affects default probabilities. The first is that tying employees’ fate to the company aligns their interests and forces them to work for the company’s survival. It’s not just a vague matter of working harder or putting in longer hours either, the prospect of losing their pension makes a temporary pay cut and other measures harder to refuse.

But another school of thought says that it actually aligns interests of workers with management, not the company, and that this entrenchment makes default more likely because it becomes more difficult for other stakeholders to push for change.

It turns out that both theories hold, but at different levels of owncompany stock ownership. A small investment in the company’s own stock brings default probabilities down in a statistically significant way, but the benefits fall off rapidly. Companies with more than 10% of their DC pension plan invested in their own stock are more likely to default, and the effect gets worse as the size of the investment continues to grow.

Most DC plans that invest in own shares go well past the 10% mark

But this doesn’t prevent management from putting their employees’ pensions on the line. The study found that among defaulting firms that had a non-zero investment in their own stock (about a quarter of the total), the average level of self-investment was 26.2% of plan assets, well above the 10% line where it starts to be harmful. In one case management basically went all-in with the DC pension plan, investing 99.8% of it in its own stock.

See full study below.

For exclusive info on hedge funds and the latest news from value investing world at only a few dollars a month check out ValueWalk Premium right here.

Multiple people interested? Check out our new corporate plan right here (We are currently offering a major discount)

About the Author

Michael Ide
Michael has a Bachelor's Degree in mathematics and physics from Boston University and Master's Degree in physics from University of California, San Diego. He has worked as an editor and writer for several magazines. Prior to his career in journalism, Michael Worked in the Peace Corps teaching math and science in South Africa.

Be the first to comment on "Default Risk Goes Up When Pension Plans Heavily Invest In Own Shares: Study"

Leave a comment