Pension Funding Constraints and Corporate Expenditures*
| Author | Weixi Liu,Ian Tonks |
| DOI | http://doi.org/10.1111/j.1468-0084.2012.00693.x |
| Published date | 01 April 2013 |
| Date | 01 April 2013 |
235
©Blackwell Publishing Ltd and the Department of Economics, University of Oxford 2012. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 75, 2 (2013) 0305-9049
doi: 10.1111/j.1468-0084.2012.00693.x
Pension Funding Constraints and Corporate
ExpendituresÅ
Weixi Liu†,‡ and Ian Tonks§
†Renmin University of China, Haidian District, Beijing, China
(e-mail: W.Liu@exeter.ac.uk)
‡University of Exeter Business School, Exeter, EX4 4ST, UK
§School of Management, University of Bath, Bath, BA2 7AY, UK
(e-mail: I.Tonks@bath.ac.uk)
Abstract
This paper examines the impact of a company’s pension contributions (PCs) on its div-
idend and investment policies. The effects of shocks to cash flows on these corporate
expenditures are identified by changes to pension funding regulations. Using a sample
of DB pension schemes in FTSE350 UK-listed firms we find a strong negative relation
between PCs and corporate dividends even after controlling for the correlation between
funding status and unobserved investment opportunities. We find that the more stringent
funding requirements under the Pensions Act 2004 had a more pronounced effect on both
dividend and investment sensitivities to PCs.
I. Introduction
Recent legislation in the United Kingdom (Pensions Act 1995, Pensions Act 2004) has
required companies to ensure that their defined benefit (DB) pension liabilities are appro-
priately funded through mandatory pension contributions (PCs). In response to the Maxwell
scandal, the Pensions Act 1995 introduced a Minimum Funding Requirements (MFR) for
sponsors of DB pensions, and the Pension Act 2004 strengthened the regulatory regime by
introducing scheme-specific funding requirements and established the Pension Regulator
with the powers to require companies to fully fund their pension liabilities. In the presence
of financing pressures, meaning it is costly for companies to raise external finance, such
regulations may impose constraints on company expenditures, since increased PCs will
reduce the proportion of earnings available for investments and/or dividends payable to
shareholders. It is well-known that in perfect markets, these decisions are unaffected by
financial considerations, but there is a large literature focusing on balance sheet adjust-
ments in the presence of financial constraints (Hubbard, 1998). If required PCs act as a
ÅThis paper has benefited from seminar presentations at the University of Exeter and University of Bath, and
we are grateful for comments from David Blake, George Bulkley, Paul Draper, Andy Snell, David Webb and two
anonymous referees. Errors remain the responsibility of the authors. We are grateful to Helen Cochrane funded by
CMPO, Bristol for collecting some of the data used in this study.
JEL Classification numbers: G11, G18, G23, G32, G35, C23.
236 Bulletin
shock to cash flows, an increase in a firm’s PCs may influence other uses of the firm’s
capital such as dividends or investments because otherwise the firm will need costly exter-
nal finance.
Bunn and Trivedi (2005) have previously established a negative relation between PCs
and dividends for UK-listed companies. However their sample only extends to 2002 and
does not include information on pension funding status – defined as the percentage deficit
of the pension scheme – since companies have only been required to reveal this information
after the introduction of accounting standard FRS17 in 2001. In the absence of funding
status details, it is not possible to separate out firms with defined contribution (DC) pension
schemes; yet such firms are not required to make mandatory PCs. In addition Rauh (2006)
cautions whether a negative relationship between investments and PCs should be inter-
preted as evidence for financial constraints, since this correlation could also imply limited
investment opportunities with firms making voluntary PCs instead. He suggests that to
identify the effect of required PCs on investments one needs to condition on pension fund-
ing status, since in the United States when funding status is negative, regulations require
companies to make PCs. But he notes that funding status might be correlated with invest-
ment opportunities, since if a firm has funding problems this could be because asset values
are low due to low investment returns. Similarly, funding status might be correlated with
dividends, through investors’ preferences. For example, in the United Kingdom the 1997
changes to dividend tax relief for pension funds may have induced funding problems and
at the same time changed institutional investors’ preferences for dividends. Rauh (2006)
argues that since the function relating funding status to investment opportunities or divi-
dend preferences is different from the function relating funding status to PCs, it is possible
to identify the effect of contributions on investment and dividends.1
Weextend the research on dividend/investment sensitivity to PCs in two ways. First we
investigate whether for UK firms the relationship persists after controlling for the potential
correlations between the firm’s pension funding status and unobserved investment oppor-
tunities (Rauh, 2006), and unobserved preferences for dividends, making use of data on
pension funding status, that has only become available in the United Kingdom after the
introduction of transitional arrangements associated with the new accounting standard
from 2001. Second, we examine whether the scheme-specific funding requirements and
the establishment of the Pension Regulator under the Pensions Act 2004, with the enhanced
powers to ensure companies’ pension liabilities are fully funded, has further affected divi-
dends and/or investments. In the United Kingdom between 1995 and 2005, private-sector
DB pension schemes were subject to the MFR (Pensions Act, 1995). However, there was
widespread dissatisfaction with the operation of the MFR (Myners, 2001), which was
replaced with a new scheme-specific funding objective under the Pensions Act 2004, and
the establishment of a Pensions Regulator with the power to require companies to make
contributions to ensure that this funding objective is met. These regulations imply that
mandatory PCs are exogenous and cannot be manipulated by managers. This is the key to
the validity of our empirical specifications, as required PCs are an independent source of
financial pressure distinct from those imposed by other cash flow requirements of the firm.
1The relationship between pension funding status and investment opportunities is likely to be smooth, whereas
the correlation between mandatory contributions and funding status is given by the legal framework, with a ‘kink’ at
100% funding ratio. This will be discussed in more detail in section III.
©Blackwell Publishing Ltd and the Department of Economics, University of Oxford 2012
To continue reading
Request your trial