In this paper we analyse the relationship between firm capital expenditure, profitability and employer contributions to defined benefit pension schemes. For most companies, contributions to finance pension obligations are generally equal to the service cost of the pension scheme. Contributions therefore equal the increase in the pension liability from one year’s additional pension benefit accrual by employees. However, for a large number of companies, their pension schemes are severely under-funded. Managers of these schemes will be pressured by employees and pension scheme trustees to provide additional financing so as to ensure sufficient assets in place to provide for future pension benefits to employees.
Rauh (2006) examines the relationship between capital expenditures and mandatory contributions to defined benefit pension schemes in a large sample of US corporations. He shows that capital expenditures fall in response to increased mandatory pension contributions. This relationship is shown to be present after controlling for pension scheme funding and the unobserved investment opportunities of the firm. For firms that are already financially constrained (low credit ratings), this result was shown to be even stronger.
Reducing capital expenditure to fund pension contributions is an obvious internal strategy for management to exploit. However, there are a number of other actions that management could employ, such as reducing dividends or increasing asset disposals. One consequence of reducing capital expenditure is the potential impact on the profitability of the firm. Falls in capital expenditure may therefore result in firms rejecting profitable projects that would otherwise have been undertaken if the financial resources were available to management. Conversely, falls in capital expenditure may result in a reduction in over-investment and an increase in asset utilisation.
We make four contributions to the existing literature on internal capital markets and pension plan funding. First we document the relationship between pension contributions, the magnitude of the pension liability and pension scheme funding levels. This relationship is clear in the US because of complex legally defined funding rules. The UK however, is a different regulatory environment, and there is no legally imposed trigger point that forces management to provide additional financing to fund a pension scheme deficit. Managers of firms with poorly funded schemes may elect to maintain this position and not provide large amounts of finance to the scheme. Conversely, management may provide additional financing as a result of pressure from employees and trustees or because the funding level of the scheme is seen as a risk to the business.
Second, we analyse the relationship between capital expenditure and large voluntary pension contributions. Rauh (2006) observes that pension contributions can be separated from the firm’s investment opportunities and therefore presents a situation where the impact of changes in the internal financial resources of the firm can be tested. The UK environment presents a more direct opportunity on how managers choose to allocate the resources of the firm, since there is no legal compulsion on managers to provide high levels of additional finance to fund their pension scheme. In undertaking this analysis we can therefore gain insights into how managers allocate the resources of their firm in response to a tangible risk to operations.
Download
Do Defined Benefit Pension Contributions Reduce Capital Expenditure and Profitability?
