This study investigates how to evaluate the risk of the unfunded pension liabilities in Korean stock market and bond market. In order to pursue the research objective, I use non-financial companies listed in the KOSPI and KOSDAQ which adopted DB pension plans over the period of 2005 to 2014. The funding level of the pension plan(PFL) is measured by pension assets divided by pension liabilities.
According to the Guarantee of Workers’Retirement Benefit Act (Article 16), firms with DB pension plans shall maintain the ability to pay the benefits. In order to secure such ability, employers are required to maintain ‘minimum level of reserve’at the end of each fiscal year. If the reserve balance proves to be less than the required minimum level at any fiscal year end, employers should make up for the deficiency in the following 3 years. The replenishment process has a direct impact on the company’s internal cash resources, resulting in a significant impact on the value and investment of the firms.
To see how to evaluate the risk of unfunded pension liabilities in Korean stock market, I use portfolio analysis. I sort firms into 10 portfolios according to the funding level of the pension plan(PFL) and examine the risk-adjusted returns of 10 portfolios after portfolio formation by running time-series regressions. The results show that market tends to undervalue the firms with relatively lower level of the pension plan. This result is also robust to alternative definitions of the funding level of the pension plan. In robustness analysis, I use the Fama and Macbeth (1973) cross-sectional regressions and find that PFL is a significantly negative predictor of stock return, which is consistent with the results of time-series regressions.
Additionally, I examine to see whether the high returns of under-funded companies can be related to the potential risk factor or the firms'' characteristics. After analyzing portfolio characteristics and double sorting portfolio, I find that the firms with lower level of pension funding tend to have the lower accruals and higher probability of default. Also, these firms have relatively small size. Thus, it seems reasonable to conclude that the high returns of under-funded companies are not the compensation for a potential risk factor which is not included in the existing capital asset pricing models.
To see how to evaluate the risk of unfunded pension liabilities in Korean corporate bond market, I examine the relationship between corporate bond credit ratings and the funding level of the pension plan(PFL) using ordered probit and ordinary least square analysis. Firms with DB pension plans shall maintain the ability to pay the benefits. Moreover, pension liabilities shall be paid in preference to taxes, public charges and other claims. When a firm goes into bankruptcy, unfunded pension liabilities are senior to secured or unsecured bond payments. As such, the claim of unfunded pension obligations could potentially reduce the future payoff to other bondholders, resulting in lower credit ratings.
Consistent with expectations, my findings suggest that low pension funding levels tend to decrease bonds’ credit ratings. In addition, the improvement or deterioration of the pension funding levels is associated with bond rating changes. I find that this relationship is more pronounced for under-funded firms, whose reserve balance is below the required minimum level.
This study is, to my knowledge, among the first research endeavors undertaken to examine how to evaluate the risk of the unfunded pension liabilities in Korean stock market and bond market. The result of this study is expected to provide practical implications to stock and bond investors and contribute to rational decision making by capital market participants.