Pensions and Corporate Capital Structure Decisions

(Editor’s Note: This post comes to us from Anil Shivdasani of the University of North Carolina at Chapel Hill and Irina Stefanescu of Indiana University.)

In our paper, How Do Pensions Affect Corporate Capital Structure Decisions?, which was recently accepted for publication in the Review of Financial Studies, we investigate the importance of pension contributions as a source of tax shields and their effect on companies’ marginal tax rates, and whether companies treat pension liabilities as a substitute for debt financing. To date, the bulk of capital structure research has focused on explaining the leverage choice as it is reported on the balance sheet. Yet companies have sizable assets and liabilities that do not appear anywhere on the balance sheet, the largest of which relates to corporate pension plans.

We study all publicly traded firms on Compustat from 1991 to 2003. About a fourth of these firms have defined benefit pension plans. For some companies, the magnitude of pension assets and liabilities is substantial. On average, pension plan assets are 16.4% of the book value of assets recorded on the balance sheet and represent 62% of the market value of the firm’s equity, though there is considerable variation across firms.

We examine the importance of pension assets and liabilities in the context of the overall capital structure of the firm. Though they reside in a separate legal trust, the assets and liabilities belong to the firm which is responsible for any shortfalls between promised benefits and the assets set aside to cover these benefits. We treat the pension plan as a fully owned subsidiary of the firm and calculate consolidated (pension and financial debt) leverage ratios. We show that the difference in balance-sheet leverage ratios and consolidated leverage ratios is substantial. For Compustat firms with defined benefit plans, both book and market leverage are about one-third larger when calculated on a consolidated basis: average book leverage increases from 25% to 34%, while market leverage increases from 20% to 27%.

Taxes play a central role in corporate financing decisions, and accurate measurement of the marginal tax rate is of importance in capital structure tests. Since pension contributions are tax deductible, they can be an important source of tax savings and in turn can affect the marginal tax rate a company faces in its debt financing decisions. In our sample, pension contributions amount on average to 56% of the total interest expense reported by firms, though the distribution is skewed by some very large pension plans. To evaluate the effect of pension contributions on tax shields, we conduct a detailed calculation of corporate marginal tax rates that includes the effects of pension contributions. With the recalculated marginal tax rates, we estimate that the tax benefits of consolidated leverage are 31% higher than the tax benefits of financial debt alone. The tax savings from pension contributions account for 1.5% of the market value of the firm, on average. Importantly, we demonstrate that the existence of a pension plan significantly lowers the extent to which firms can afford to take on additional leverage from a tax perspective.

According to the tradeoff theory of capital structure, firms balance the benefits of debt such as those arising from tax shields against the costs of debt. In a treatment effects model that incorporates the self-selectivity of pension plans and the endogeneity of pension liabilities, we estimate that a 1 percentage point increase in the pension liability to total assets ratio is associated with a 0.36 percentage point decrease in the debt to total assets ratio. This suggests that managers partially substitute pension-related deductions for interest deductions in capital structure decisions. As an alternative to the treatment effects approach, we estimate the relation between pension liabilities and financial debt in a firm fixed-effects framework. We show that pension liabilities remain a highly significant determinant of capital structure in a firm fixed-effects model.

Given the substitution between pensions and financial debt, we examine whether corporate pension plans help explain why firms appear to be underleveraged from a tax perspective. By our estimates, the gap between optimal leverage from a tax perspective and observed leverage shrinks by about one-third when pension plans are included, indicating that firms are less conservative in their capital structure decisions than has been previously thought.

The full paper is available for download here.

Anil Shivdasani is the Wachovia Distinguished Professor of Finance at UNC’s Kenan-Flagler Business School. Irina Stefanescu is an Assistant Professor of Finance at Indiana University’s Kelley School of Business.

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