Pension Risk and Firm Cost of Capital: A Pre-existing Equity Model Approach

The consistent recognition of both explicit short term and implicit long term elements of post-retirement contracts between employees and the firm can have a significant implication for estimating a long term sustainable cost of capital. In this paper, we show that the significant levels of investment in company own stock by pension and post-retirement plans can effectively dilute the interest of pre-existing shareholders in the enterprise value of corporations in ways which are not revealed by a classic entity theory perspective on equity. We test the empirical implications of adopting a pre-existing shareholder model of the reporting entity to re-examine the relationship between a firm’s overall cost of capital and various sources of idiosyncratic risk. We find that the estimated cost of capital is sensitive to: (a) alternative explicit versus implicit definitions of pension liability; (b) the nature and scope of long-term deferred compensation arrangements; and (c) the scope and nature of investment-related risks through investment in sponsoring company stock that are associated with these pension arrangements. We also find that incorporating idiosyncratic risk exposure into a pre-existing equity model of the reporting entity allows us to better discriminate between the nature of pension risks borne by firms that terminate or continue their defined benefit pension plans, and significantly enhances explanatory power of the Fama-French model in explaining the cross-section of returns for severely underfunded firms.