Companies with large pension deficits are more likely to invest cash in research and development or other areas of their businesses, rather than closing shortfalls, research has shown.
Neeru Chaudhry, Hue Hwa Au Yong, and Chris Veld from the Department of Banking and Finance at Monash University in Australia reported that managers of US firms in particular “are motivated to underfund their pension plans as pension deficits could have a significant impact on the firm’s cash flow.”
The authors called for “stricter funding rules” for US companies, “which require firms to fully fund their pension plans.”
“The probability that a firm deviates from its expected level of investment increases as the pension deficit increases.” —Chaudhry, Yong, and VeldUS companies are required to cover unfunded liabilities over a period of seven years through additional top-up payments, but, citing Towers Watson research, the researchers said “firms prefer to contribute the minimum” towards their deficits, in favor of investment elsewhere.
In addition, the paper found evidence that managers of companies with larger pension deficits were more likely to over-invest in areas such as research and development. This was particularly the case for companies in the pharmaceuticals, measuring and control equipment, electronic equipment, and computers sectors.
“For these industries, we observe pension deficit firms that have higher R&D investment compared to pension surplus firms,” the authors wrote.
“We find that the probability that a firm deviates from its expected level of investment increases as the pension deficit increases,” Chaudhry, Yong, and Veld added. “For an increase in pension deficit from the 50th percentile to the 90th percentile, the probability that a firm over-invests increases by 0.6%.”
They concluded that “firms intentionally underfund DB pension plans and use the retained funds for over-investment”—a move that often negatively affects a company’s share price.
The paper, titled “How does the Funding Status of Defined Benefit Pension Plans affect Investment Decisions?”, is available to download.
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