(May 17, 2014) — US firms with underfunded defined benefit (DB) plans are likely to have high cash holdings, according to research.
Neeru Chaudhry of Monash University in Australia argued that plan sponsors may intentionally decide to underfund their pension plans largely to “use retained funds for different activities” and increase their cash holdings.
The research studied over 3,000 US firms with DB plans from 1980 to 2012 and found plan sponsors have withheld contributions to pension funds with either a precautionary motive associated with cash flow volatility or with an intention to save more cash.
“Funding status of pension plans can be significantly affected by market conditions, which are beyond the control of managers,” Chaudhry wrote. “As the level of underfunding increases, firms are required to make high mandatory pension contributions and pay higher insurance premium to Pension Benefit Guaranty Corporation (PBGC).”
This phenomenon creates a cash flow volatility, the paper said, which encourages plan sponsors to save more cash to help the pension plan hold up against adverse market conditions. “Firms may find it profitable to hold cash to mitigate costs of financial distress if the cash flow shortfall prevents a firm from investing in profitable projects.”
Chaudhry also found cash-rich firms have been able to remain more independent from capital markets than those with fewer cash holdings, allowing them to pursue their own investment policies. Firms may also make deliberate managerial decisions to underfund their pension plans to maximize tax benefits, minimize federal penalties, and avoid takeovers, according to the paper.
The study further revealed a high positive correlation between underfunded pension plans and cash holdings.
Companies with DB plans in deficits tended to be larger, with higher cash flow, fewer expenses for physical assets, and more expenditure for research and development (R&D) and acquisitions than overfunded pension plans, Chaudhry said. They were also more levered and paid fewer dividends than companies with plans in surplus.
“Increase in cash ratio is closely related to the disappearing dividends, decreasing net working capital, increase in cash flow volatility, decline in capital expenditure, and increase in R&D expenditure,” the paper said. “These pension deficit firms have higher cash holdings as compared to firms with pension surplus.”
On the other hand, firms—usually larger ones—with higher cash flow and greater access to capital markets may not have enough incentive to increase their cash holdings, the research argued.
“The size of pension plans and latitude managers have in characterizing features of pension plans, along with complex financial reporting and regulatory environment provide managers with an opportunity to intentionally underfund pension plans and increase their cash position,” Chaudhry wrote.
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