WP#2003-13  

Abstract

This paper addresses the relationship between defined benefit pension plans and corporate profits and examines the outlook for defined benefit plans in the wake of the bear market. Due to a soaring stock market during the extended bull market of 1982-2000, together with federal regulations and legislation that shifted funding requirements forward, pension contributions virtually disappeared as a corporate expense for much of the previous two decades.

Our analysis suggests that in the absence of the stock market boom and the regulatory and legislative changes that reduced funding, the average firm’s contribution to its pension plan would have been 50 percent higher during the 1982-2001 period – 9.9 percent of payroll instead of 6.6 percent of payroll. The downturn in contributions had a significant impact on corporate profits. Lower pension contributions, all else equal, will produce a dollar-for-dollar increase in before-tax profits. Our analysis implies that corporate profits were roughly 5 percent higher than they would have been otherwise. Higher profits produce a feedback effect as they lead to further capital gains and further reductions in contributions.

Given the current bear market and an aging workforce, the feedback now goes in the opposite direction. Now that the stock market bubble has burst, our analysis suggests that contributions relative to wages would return to their pre-1982 levels of about 10 percent. This implies that – on a permanent basis – contributions would double from their current level of $40 billion to $80 billion. Assuming that investors view the increase as permanent, the feedback effect would lower the value of equities held by pension funds by $20 billion. In short, as the economy emerges from recession and the bear market draws to a close, firms and investors must be prepared to contend with a strong headwind from pension funding obligations that could slow the recovery.

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