Corporate Pensions and Financial Distress
Ying Duan
University of Alberta – Department of Finance and Statistical Analysis
Edith S. Hotchkiss
Boston College – Carroll School of Management
Yawen Jiao
University of California, Riverside
AFA 2015 Boston Meetings Paper
Abstract:
We examine the role of corporate pension plans in determining how firms restructure in financial distress. Both defined benefit (DB) and defined contribution (DC) plans can have significant exposures to the company’s own stock, imposing significant losses on employees if the firm defaults and/or files for bankruptcy. We find that firms with DB plans typically have little exposure to the stock prior to default; the degree of underfunding increases significantly as firms near default, but is not related to restructuring types (bankruptcies versus out of court restructurings). In contrast, large exposures to company stock in DC plans often are not reduced prior to default. High levels of own-company stock ownership are positively related to default and bankruptcy probabilities. Our evidence suggests a link between employee-ownership related managerial entrenchment and default risk.
How Corporate Pension Plans Help Restructure Firms In Financial Distress – Introduction
Ballooning pension costs have been cited as an important contributor to the defaults and bankruptcies of many high profile U.S. corporations in the airline, auto manufacturing, and steel industries, among others. Upon a default, employees can face significant costs through reduced wages and job security, as well as through losses in pension benefits. For example, participants in defined benefit (DB) plans often lose a large fraction of benefits if a firm enters bankruptcy and terminates a plan, since coverage from the Pension Benefit Guarantee Corporation (PBGC) is often lower than benefits under an ongoing plan (e.g., UAL and Delphi Corp). Participants in defined contribution (DC) plans can incur large losses from retirement assets invested in the firm’s own stock when the company becomes financially distressed (e.g., Enron and WorldCom). Despite such attention, no study has systematically documented the role of corporate pensions in the resolution of financial distress. In this paper, we examine whether the structure, funding, and investment of pension plan assets is related to how financially distressed firms are restructured.
We examine a sample of 729 firms public firms in the U.S. that default between 1992 and 2012, for which data on the firm’s pension plan is available from Form 5500. These firms either have DB pension plans, DC pension plans, or frequently both. For firms with DB plans, the importance of pension underfunding is often cited as complicating attempts to negotiate settlements in bankruptcy cases.1 Underfunding of DB plans can stem from reduced employer contributions and/or the poor investment performance of plan assets, particularly when the plan has invested in the defaulting firm’s own stock.2
DB plans have experienced large declines in number in the last two decades. In contrast, defined contribution plans have experienced steady growth and become pivotal in the U.S. retirement system. One of the most striking features of DC plans is the high percentage of assets frequently invested in the sponsor company’s stock.3 The lack of diversification from high levels of own-company stock ownership can impose substantial costs on plan participants, particularly in firms’ financial distress.4 In spite of the risk such ownership imposes on employees when the firm becomes distressed, this form of ownership has been strongly encouraged by corporate executives, citing efficiency enhancements. Specifically, such ownership aligns the interests of the employees with those of shareholders, motivating the employees to increase productivity, work morale, and ultimately, firm value. This motivational view is consistent with Alchian and Demsetz (1972) and Holmstrom (1979), and implies a reduced likelihood and severity of financial distress for firms with higher exposures to company stock in pensions. Further, in the state of financial distress, employees with higher pension exposures to their company’s stock have stronger incentives to reduce the value loss through increased support for the distressed firm – such as higher human capital investment and temporary pay cuts (Benmelech et al, 2011). Thus, these firms are expected to manage through the process of resolving financial distress more efficiently.
Alternatively, management may encourage employee ownership in pension plans as a means of entrenchment. Jensen and Meckling (1976) list strong relations between management and employees as a non-pecuniary benefit enjoyed by managers, which has led to management employee allies in many proxy contests (e.g., Stulz, 1988; Pagano and Volpin, 2005). Besides management-employee bonding, employees that are interested in job retention are more likely to side with incumbent management in proxy contests. Thus, employee ownership in pensions can serve as an effective takeover defense (Rauh, 2006; Coco and Volpin, 2013). Under this entrenchment view, firms with higher exposures to company stock in pension plans are expected to have more agency problems and lower operational efficiency, implying a higher likelihood and severity of financial distress. Because the motivational and entrenchment views have opposite predictions, the influence of pensions’ own-company stock ownership on the likelihood and resolution process of financial distress is an empirical question. We explore this issue in our analyses for both firms with DB and DC plans.
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