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Allocating Assets and Discounting Cash Flows: Pension Plan Finance

Abstract

This paper examines two pension decisions which firms must make when they offer a defined benefit pension plan: how to pick the appropriate rate for discounting pension liabilities and how to allocate the assets in the pension plan. The correct allocation of assets must be driven by frictions which occur in real world financial markets. In the absence of market frictions, the asset allocation decision is irrelevant. The paper first reviews the theory which describes the optimal asset allocation in the presence of distortionary taxes and imperfect capital markets. This allows us to examine the role played by the pension plan in the financial structure of the firm. It also provides us the background for examining the actual asset allocation of defined benefit pension assets. The paper then turns to the choice of discount rates. If the goal is to value the pension liabilities, the correct discount rate should depend upon the type of risk inherent in the pension promise. The paper begins by developing the theory behind choosing the discount rate in a world without market frictions and then extends the analysis to the presence of market imperfections. I then compare the theory to the actual discount rates chosen by firms. I find that the discount rates are significantly lower than equivalent market rates and are very insensitive to changes in market rates. The framework of the paper provides a background for discussing the implications of the shift from defined benefit to defined contribution pension plans on capital markets -- given the perceived difference in how these two types of plans invest their assets.

Type

Book Chapter

Author(s)

Mitchell A. Petersen

Date Published

1996

Citations

Petersen, A. Mitchell. 1996. Allocating Assets and Discounting Cash Flows: Pension Plan Finance.

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