Allocating Funding to Pension Plan

Asset/Liability mismatch: Economic factors affect the pension asset and liability differently.

Firm Equity Bea is the asset beta levered up the debt

Beta(Equity) = Beta(Asset)*(1+Debt/Equity)

Pension: Asset=Liability, so equity = 0

Asset_Beta = weighted average of invested equity and debt. Debt Beta is assumed to be zero.

Asset_Beta = W_e*Equity_Beta

For firm, D/E increases, risk increases

For Plan, D/E increases, risk decreases (As D here is investment in debt, which is less risky than Equity)

When plan is taken into account, WACC of a firm usually is lower than just considering the balance sheet asset. The manager has to either increase D/E or use the new WACC for project evaluations.

Overall asset Beta = Firm Asset Beta + Pension Asset Beta

Overall Equity Beta = Firm Equity Beta + Pension Equity Beta (not those invested in equity. Zero when fully funded)