How Pensions Impact Corporate Financial Distress

A new academic research paper reexamines how pension costs were related to defaults and bankruptcies at high-profile U.S. corporations in the airline, automotive and steel manufacturing industries.

A team of academic researchers published a new paper, “Corporate Pensions and Financial Distress,” finding greater underfunding of corporate pension plans is not a significant determinant of the outcome of corporate financial distress.

In other words, corporations with large unfunded pension obligations appear no more likely than their counterparts with healthier pension plans to enter bankruptcy rather than achieve an out-of-court restructuring when the going gets tough. The paper’s authors are Ying Duan, at the University of Alberta; Edith Hotchkiss, at the Carroll School of Management, Boston College; and Yawen Jiao, of the University of California, Riverside.

The paper also examines how individual defined benefit (DB) and defined contribution (DC) investors fare under different distressed corporate conditions.

“We find that firms with DB plans typically have little exposure to [company] stock prior to default; the degree of underfunding increases significantly as firms near default, but is not related to restructuring types (bankruptcies versus out of court restructurings),” the authors observe. “In contrast, large exposures to company stock in DC plans often are not reduced prior to default. High levels of own-company stock ownership are positively related to default and bankruptcy probabilities. Our evidence suggests a link between employee-ownership related managerial entrenchment and default risk.”

As the report finds, upon a default, employees can face significant costs through reduced wages and questionable job security, as well as through losses in vested pension benefits, since coverage from the Pension Benefit Guarantee Corporation (PBGC) is often lower than benefits under an ongoing plan. Researchers observe that this was the case with defaults at UAL and Delphi Corporation.

One primary upshot from the paper is that participants in DC plans can incur large losses from retirement assets invested in the firm’s own stock when the company becomes financially distressed, as was the case with employees at Enron and WorldCom.

“Despite such attention, no study has systematically documented the role of corporate pensions in the resolution of financial distress,” the authors claim. “In this paper, we examine whether the structure, funding, and investment of pension plan assets is related to how financially distressed firms are restructured.”

The researchers reviewed a sample of 729 public firms in the U.S. that experience significant financial distress between 1992 and 2012, using data taken from Forms 5500. These firms either have DB pension plans, DC plans, or frequently both, the paper explains.

“For firms with DB plans, the importance of pension underfunding is often cited as complicating attempts to negotiate settlements in bankruptcy cases,” researchers suggest. “Underfunding of DB plans can stem from reduced employer contributions and/or the poor investment performance of plan assets, particularly when the plan has invested in the defaulting firm’s own stock.”

The paper says there can be some employer benefit to offering company stock in DB and DC retirement plans, but the decision to do so can leave employees at greater risk of loss.

“In spite of the risk such ownership imposes on employees when the firm becomes distressed, this form of ownership has been strongly encouraged by corporate executives, citing efficiency enhancements,” the report notes. “Specifically, such ownership aligns the interests of the employees with those of shareholders, motivating the employees to increase productivity, work morale, and ultimately, firm value.”

The report finds employers with this view expect the higher exposures to their company’s stock to give employees a stronger incentive to help their employer perform well. These employers also tend to believe employees with greater exposure to company stock will bring higher human capital investment and be more willing to take temporary pay cuts should serious distress arise, researchers note. “Thus, these firms are expected to manage through the process of resolving financial distress more efficiently,” the report continues.

Alternatively, management may encourage employee ownership in pension plans as a means of entrenchment, the research finds.

“Besides management-employee bonding, employees that are interested in job retention are more likely to side with incumbent management in proxy contests,” researchers find. “Thus, employee ownership in pensions can serve as an effective takeover defense. Under this entrenchment view, firms with higher exposures to company stock in pension plans are expected to have more agency problems and lower operational efficiency, implying a higher likelihood and severity of financial distress.”

So which camp is right?

“Because the motivational and entrenchment views have opposite predictions, the influence of pensions’ own-company stock ownership on the likelihood and resolution process of financial distress is an empirical question,” the report notes. “Our hazard model predicting default shows a non-linear relationship between own company stock ownership and default; firms with lower levels of such investment have a lower likelihood of default relative to firms with no ownership of own-company stock. However, firms with significantly higher levels (more than 10%) of such ownership exhibit higher default probabilities.”

The researchers suggest these findings are consistent with the poor performance and increased default risk of firms that use employee ownership of stock via their DC pension plan as a means of entrenchment.

Lastly, conditional on default, the paper examines how pension plan characteristics are related to whether distressed firms restructure in bankruptcy or through out of court restructurings.

“For DB plans, underfunding has been suggested to increase incentives to file for bankruptcy, since it is then possible to shift the underfunded liability to the PBGC,” researchers note. “In our sample of bankruptcies with DB plans, we find that only 20% of cases in fact terminate the plan and transfer the assets to the PBGC. Further, [logistical] regressions for the probability of a bankruptcy filing show no significant relationship between underfunding and the likelihood of bankruptcy.”

Many of the filing firms may not be able to demonstrate that the reorganized firm would not be viable without terminating the plan; other firms may avoid larger restructuring costs in bankruptcies which involve complex liabilities such as DB pensions. “Thus, our findings cast doubt on the argument that defaulting firms often opt for bankruptcies to terminate underfunded pensions, a practice not allowed in out of court restructurings,” the paper concludes.

The full paper can be downloaded here via the Social Science Research Network.