Pension Plan Assets and Liabilities and WACC

Today I am reading SS 5 Reading 22, an edited transcript of a speech delivered in London in 2004 by Robert C. Merton, titled Allocation Shareholder Capital to Pension Plans. Below is an excerpt from the text:
“ That brings me to the concept of a “risk budget” I mentioned earlier. I find it useful to think of companies as having risk budgets that are very much analogous to their capital budgets. Reducing risk in one place releases capacity to increase risk elsewhere without having to add more equity capital to the firm. And this means that the total opportunity created by reducing risks in the pension fund is to enable the firm to take more risk in its operating business, which is presumably where it is most likely to find positive net present value opportunities. The expected net effect of such changes is an increase in firm value. Although you reduce the expected return on your pension assets, you gain more from the new operating assets that you are now able to hold without additional equity capital – all of which is made possible by the reduction of risk in the pension fund.”
Merton pointed out that most firms do not include their pension plan risk when they explore capital structure decision. A firm sponsoring a DB plan should realize that it has two sets of assets and liabilities components, one is obvious as can be found on accounting statement, the operating assets and liabilities; while the other is less obvious and is probably showing nowhere on accounting statement (except in the filing footnotes), the pension assets and pension liabilities. Merton argued that the traditional WACC where only operating asset and liabilities are included overstated the WACC, that to truly reflect how investors perceive the firm’s total risk one need to include pension assets and liabilities in the calculation.
Here is an example he gave to illustrate the point:
Table 1 Errors in Estimates of Weighted Average Cost of Capital
Pension Assets ($bn) Pension Liabilities ($bn) Pension Surplus/ Deficit ($bn) Market Cap ($bn) Book Value of Debt ($bn) Standard WACC WACC Adjusted for Pension Risks
Boeing 33.8 32.7 1.1 30.9 12.3 8.8% 6.09%
DuPoint 17.9 18.8 (0.9) 42.6 6.8 9.44% 8.15%
EK 7.9 7.4 0.5 8.6 3.2 9.75% 7.47%
Textron 4.5 3.9 0.6 5.9 7.1 7.98% 6.81%

*EK-- Eastman Kodak

All four firms are doing just fine with their pension plans, but notice how the WACC adjusted is much lower than the traditional WACC in the last two columns. That is an example of how to calculate the adjusted WACC. We saw the adjusted WACC smaller than standard WACC probably because their equities holding in the pension plan is no more than 50%.
DB sponsors that invest heavily in equities expose themselves to greater market risk and their price tend to be less attractive. According to Merton analysts and market participants at large already pricing company’s pension management.
“But if the pension assets were largely in equities and the liability is largely fixed-rate debt, the risk exposure would be huge. And the question we were attempting to answer in our study was: Does the market capture that risk? Given the arcane accounting and institutional separation between the pension plan and the rest of the business, I did not think the market would take it into account.
But our results suggest that, during the period of our study – 1993 to 1998 – the U.S. stock market did a pretty good job of picking up the differences in risk. More specifically, a company with a larger fraction of equity in its pension portfolio tended, all other things equal, to have a larger “beta” – a widely used measure or risk that reflects, among other things, the “systematic-risk” volatility of the stock price itself. In other words – and this is simplifying things a bit – the greater risk associated with equity-heavy pension plans seemed to show up in more volatile stock prices.”