The Impact of Taxes on Corporate Defined Benefit Plan Asset Allocation

Abstract

This paper investigates the extent to which taxes affect a corporation?s decision to allocate its defined benefit plan?s assets between equity and bonds. Prior theoretical research shows that if a corporation integrates its pension investment policy and corporate financial policy, differences in tax rates create an arbitrage opportunity. By borrowing at the corporate level and investing the pension assets in bonds, the corporation generates tax benefits. The tax benefits from the arbitrage opportunity should be positively related to the percentage of pension assets allocated to bonds. Consistent with this prediction, but contrary to prior empirical work, this paper finds firms? tax benefits are positively and significantly associated with the percentage of their pension assets in bonds. Using a database created from proprietary tapes, this paper extends prior empirical work by: 1) examining a longer time horizon for a broad spectrum of firms, 2) utilizing a control sample, 3) investigating an additional source of tax benefits, and 4) incorporating more nontax factors.

JEL Classification: G31, H25