Do a Firm’s Equity Returns Reflect the Risk of Its Pension Plan?

Purpose - To find out if the beta from the capital asset pricing model (CAPM) accurately measures the systematic equity risk of a firm's pension funds. Design/methodology/approach -Takes 4,453 observations of equity beta using the market model on weekly return data for up to one year from 1993 to 1998, adds firm risk (weighted average beta for equity and risk) and pension risk (pension asset risk minus pension liability risk) obtained from ERISA Form 5500. Tests results for robustness. Findings - Finds that, in theory, following Merton (2002) the cost of capital is severely overvalued if pension assets and liabilities are ignored, or if the risk of the pension plan is ignored. However, in the market, shows that prices reflect the risk level of the pension funds. Research limitations/implications - Points out that these findings predate the pension fund deficit crisis of the 2000s. Notes that the market does not differentiate between operational and pension fund risk, and that the distortions caused by this risk to the calculation of cost of capital need further research. Practical implications - Indicates that project financing needs to be recalculated to reflect the pension fund risk; otherwise good projects may be rejected. Originality/value - Presents the view that pension fund risk is detected by the markets, even if the data are not easily available, by means unknown.