Taxation and Corporate Pension Policy

Abstract

IntroductionAs a result of rapid growth in the post-war period, pension plans have become a major component of the financial structure of large corporations. A recent survey [5] of 475 of the Fortune 500 companies revealed that pension cost in 1978 averaged 12.5% of pretax profits and 7.2% of wages and salaries. Vested liabilities and pension assets averaged 34% and 26% of book net worth, respectively.1 Given a typical debt/net worth ratio of 40% this data implies that pension assets for this group of companies approximate 19% of corporate assets and vested liability is 85% of long term corporate liability.2 Despite these magnitudes, pension items do not appear on the corporate balance sheet and little has been known about how pension decisions are and/or should be made.3In the past few years there has been a growing interest in pension 4This has arisen in part from the growth of the private pension system and in part from the public policy concerns as reflected in the Employees Retirement Income Security Act of 1974 (ERISA). The act regulates various aspects of the major policy decisions facing the corporation; (1) benefit provisions, (2) funding and (3) investment of pension fund assets. It lso established the Pension Benefit Guarantee Corporation (PBGC) which is a quasi-government corporation that insures pension benefits and has the power within limits to assess corporations for funding deficiencies in the event of a plan termination. 5See Fama [3] for a review of this framework.-2- Sharpe [8] demonstrates that funding and investment policy will have no effect on the value of the total compensation of employees--current plus deferred wages (pensions)--so long as employees are rational, the capital market is perfect and individuals and firms have equal access to it. In this world the firm will have to pay the price of providing risk-free pension promises; if the funding and investment strategy is risky, then employees or the Pension Benefit Guaranty Corporation will demand that the firm acquire insurance to protect their claims or pay them excess current wages so that they can acquire it themselves. enhe value of tle compensation package is fixed,a it is in Sharpe's case, Black [ii has shown that the level of funding and the investment policy should not affect shareholder value.This comes about because investors can offset any corporate asset/liability decision on personal account. This conclusion can be expanded to a world of uncertainty, including the possibility of corporate bankruptcy and/or pension plan termination so long as claimants on the firm (i.e. shareholders, beneficiaries, bondholders) protect themselves from one another with costlessly enforced me-first rules which ensure that the characteristics of the payoffs on the firm's outstanding claims are unaffected by changes in financial policy (see Fama [3] for the argument as applied to capital structure decisions).The special tax status of corporate pension plans is a major factor that is ignored in the perfect markets assumptions underlying the...

Integrating corporate ownership and pension fund structures: A general equilibrium approach

“…Our unique solutions for the interest rate, the loan amount and firm prices are ascribed to our non-linear (risk-averse) framework, where the value-additivity, assumed in Miller (1977), fails to hold. Our conservative debt ratio corroborates the empirical observation of Frank (2002) that individual firms do not implement tax arbitrage fully (Black, 1980;and Tepper, 1981). Furthermore, these simultaneously occurring twin results contradict those of Dammon et al (2004), which are realized separately under a restricted borrowing framework (in the absence of liquidity shocks).…”

“…In other words, the framework does not facilitate the adjustment of the IMRSs to simultaneously own a fraction of a firm and trade-off debt claims against its cash flows. This yields an indeterminate solution in the case of Miller (1977) (where the personal tax liability of debt completely offsets the corporate tax benefit of debt); and an extreme (i.e., corner) solution in the case of Black (1980) and Tepper (1981) (where the net tax advantage of debt still persists, allowing it to be arbitraged away). Recent studies, which assume the exogeneity of stock and bond returns, do not capture their interaction in terms of the capital structure of corporations.…”

“…A critical examination of the literature leads to the following realizations: The capital structure irrelevance result of Miller (1977) and the pension fund dedication to bonds advocated in Black (1980) and Tepper (1981) is attributed to a dominance (arbitrage) argument.…”

“…The Miller study inspired numerous researchers to focus on the issue of tax clienteles of debt and equity. For instance, the financial management perspective of a pension fund's investment policy studied by Black (1980) and Tepper (1981) theorizes that the portfolio of DB pension plans should be composed only of bonds. The rationale behind this argument derives from the tax arbitrage opportunities related to a firm's organizational form (returns on assets held in pension funds are tax deferred), financial policy (interest expense is tax deductible while dividends are not), and investment policy (interest income is fully taxable while some portion of equity returns may be subject to favorable tax rates).…”

How unobservable bond positions in retirement accounts affect asset allocation

“…It goes back to studies of Tepper and Affleck (1974), Black (1980) and Tepper (1981). They analyze optimal investment strategies of companies that run defined-benefit pension plans.…”