Corporations seeking to increase the security of pensions while limiting investor risks

In the current issue of Journal of Applied Corporate Finance, Robert Merton discusses the corporate challenge of providing retirement income to employees while limiting the costs and risks of pension plans to the sponsoring companies and explaining the risks to investors and rating agencies. Although the shortfalls in corporate defined benefit (DB) plans have been the main focus of attention, Merton argues that the more serious concern is the risk stemming from the mismatch between pension assets and liabilities--that is, the funding of debt-like liabilities with equity-heavy asset portfolios. After presenting evidence that the risk from this mismatch is transmitted to corporate "economic" balance sheets and reflected in stock prices, the author urges companies to adopt an integrated perspective that views pension assets and liabilities as parts of the balance sheet, and the pension asset allocation decision as a critical aspect of an enterprise-wide risk management program.

Some companies, notably IBM, have recently chosen to shift their pension investment risks to employees by converting their DB plans to defined contribution, or DC, plans. For companies contemplating such a shift, Merton argues that DC plans without some corporate oversight or responsibility for results are not a long-term solution. In his words, "If lots of people do not receive in the future what they were promised, companies may find themselves making good, either voluntarily or otherwise, on what prove to be the implicit obligations associated with being a long-lived institution."

This speech is published in the current issue of the Journal of Applied Corporate Finance. Media wishing to receive a PDF please contact JournalNews@bos.blackwellpublishing.net

Journal of Applied Corporate Finance is a Morgan Stanley Publication. Published since 1988 and reaching a broad audience of senior corporate policy makers, this highly regarded quarterly brings together academic thinkers and financial practitioners to address topics driving corporate value. The Journal covers a range of topics, including risk management, corporate strategy, corporate governance and capital structure.

Robert C. Merton was awarded the 1997 Nobel Prize in Economics. Dr. Merton is a John and Natty McArthur University professor at the Harvard Business School.

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