The relationship between pension plan funding levels and capital structure: further evidence of a pecking order

Journal of the Academy of Business and Economics, Jan, 2003 by Aaron L. Phillips, Sharon M. Moody

ABSTRACT

The literature on defined benefit pension plans presumes firm managers make an economic choice to overfund or underfund their defined benefit pension plans irrespective of other firm operating conditions and/or financing practices. Theoretically, overfunding is encouraged due to the tax deductibility of the pension expense and the non-taxed status of pension plan earnings. Alternatively, underfunding might occur due to poor cash flow or the firm's ability to earn a greater after-tax rate of return on firm assets than on pension plan assets. This study demonstrates that underfunding occurs principally due to a firms' incapacity to fully fund. By examining a period when multiple defined benefit pension funding disclosure criteria existed, the results are seen not to be dependent on the form of pension disclosure requirements.

1. INTRODUCTION

The accounting, finance and economic literatures on pension funding theory and practice make the a priori assumption that firms make an economic choice with respect to funding defined benefit pension plans irrespective of firm operating conditions or financing policies. Much of the literature is either prescriptive as to what funding policy should be (Ippolito, 1985; Sharpe, 1976; and Tepper, 1981) or descriptive as to what funding policy is (Bodie, et al, 1987; Francis and Reiter, 1987 and Thomas, 1988). Neither the prescriptive nor the descriptive literature explicitly addresses the role of funding defined benefit pension plans as being integral to broader capital structure and operating policy decisions. This oversight is surprising given Stone's (1987) conclusion that firms build financial slack by overfunding defined benefit pension plans and recouping excess funds for internal financing purposes in times of need. The creation of financial slack, a central component in capital structure theory, by overfunding defined benefit pension plans suggests a direct linkage between operating decisions and capital structure decisions.

Myers' (1984) modified pecking order theory (MPOT) provides an empirically testable hypothesis for capital structure decisions. MPOT proposes that financial managers (1) avoid using external equity and risky debt, (2) set dividend policies which can be maintained by internally generated equity, (3) maintain financial slack, and, since dividends are "sticky" while investment opportunities are variable, (4) fund additional needs with risky debt before using new equity. The level of funding defined benefit pension plans fits perfectly into this pecking order framework. Pension funding is, to a major extent, contingent on discretionary managerial assumptions; consequently, pension plans could be overfunded in periods when internal funds exceed the need for investments and dividends and underfunded in those periods when internal funds are insufficient for investment and dividend needs. Overfunding is consistent with building financial slack whereas underfunding is consistent with managerial motives of imposing on employees an unsecured interest in the long term viability of the employer (Ippolito, 1985).

In a review of capital structure theory and research, Harris and Raviv note that "[t]his area is still in its infancy and is short on implications relating capital structure to industrial organization variables ..." (1991, p. 351.) This paper investigates firms' pension funding policies as being jointly determined with their capital structure and dividend policy decisions, consistent with Myers' pecking order theory. The paper begins with a review of the literature, linking the operating decision to fund defined benefit pension plans with the firm's capital structure and dividend policies. The subsequent sections discuss the methodology for investigating these linkages and a discussion of the empirical results. The paper concludes with a summary of significant findings and conclusions drawn from the results.

2. PENSION RESEARCH, CAPITAL STRUCTURE, AND DIVIDEND POLICY

Early pension theory research focused on the tax aspects of corporate pension plan funding. According to Black (1980), Feldstein and Seligman (1981), Ippolito (1985), and Tepper (1981) tax reasons justify funding defined benefit pension plans to the maximum extent possible. Pension plan payments are fully tax-deductible, plan earnings are tax-deferred to the firm and the firm earns a before-tax rate of return on the assets it places in the trust. The firm has a distinct financial incentive to over fund its defined benefit pension plans. Empirical examinations link pension funding levels to taxes, as-well-as profitability and firm risk levels, but these studies produce conflicting outcomes.

Bodie, Light, Morck, and Taggart (1987) investigate the funding level of pension plans subsequent to Statement of Financial Accounting Standards (SFAS) No. 36 (1980). Firms which had greater tax burdens, higher profitability, and less risky debt (measured by bond ratings) funded pension plans at higher levels than less profitable, more risky firms. Francis and Reiter (1987) found that firms with the highest average tax rate had higher (safer) bond ratings but lower pension funding ratios than less profitable, more risky firms, a contradiction to Bodie et al. Taxes and pension funding are more fully explored by Thomas (1988), who finds pension contributions and tax status are positively correlated. Over the period 1980 to 1984, firms that decrease pension funding also decrease in tax status from being tax-paying firms to non-tax-paying. Thomas confirms pension funding level is linked to profitability and financial slack. His results have significant implications for capital structure research.