Does Economic Policy Uncertainty Affect Corporate Pension Plans?

Abstract

Prior research shows that corporate pension policies are significantly influenced by tax incentives. While the existing literature extensively focuses on the effect of firm and pension characteristics on corporate defined-benefit (DB) pension plans, it ignores how economic policy uncertainty may affect DB plans. In other words, does an increase in economic policy uncertainty in the political environmental and economic policies weaken firms’ capacity to contribute cash to DB pension funds, worsening pension portfolio performance? In this thesis, I examine the effect of economic policy uncertainty on firms’ decisions regarding their cash contributions to DB pension plans and the level of underfunding of pension plans. Consistent with risk-shifting theory, I find that the underfunding of DB pension plans increases when economic policy uncertainty rises. This result holds after addressing potential endogeneity issues. The unfavourable effect of economic policy uncertainty on the funding status of corporate pension plans is more pronounced during periods of financial crises and economic recessions. A subsample analysis indicates that this unfavourable effect is also stronger in firms with higher capital expenditure, dividend payouts and executive salaries and weaker in firms with higher corporate social responsibility scores. In addition to reducing cash contributions to corporate pension funds when economic policy uncertainty increases, firms may also use aggressive asset allocation strategies to increase the risk and return of pension assets, again supporting risk-shifting theory. The final part of the empirical analysis is a channel analysis, which finds that the effect of economic policy uncertainty on pension underfunding levels occurs via a tangible channel, financial constraints.