Monash University
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The effect of the funding status of defined benefit pension plans on tax avoidance and investment efficiency

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Version 2 2017-05-19, 03:18
Version 1 2017-03-01, 00:20
posted on 2017-05-19, 03:18 authored by Chaudhry, Neeru
The objective of this thesis is to understand the complex nature of defined benefit (DB) pension plans offered by private employers in U.S. and to examine its impact on firms’ tax avoidance behaviour and investment efficiency. DB pension plans are important because of the economic size and the impact they have on firm’s free cash flow. These pension plans are associated with high information asymmetry arising from the complex financial reporting and changing regulatory environment. This complexity makes it difficult for investors to estimate the true impact of pension liabilities on firm’s performance. It also provides opportunities to managers to exploit information asymmetry for making decisions, which may not be in the best interest of shareholders. This thesis investigates two such issues related to DB plans. The first empirical study examines whether the decline in the funding of pension plans is associated with more tax avoidance. Results reveal that firms engage in more tax avoidance as the size of pension deficit (defined as pension liabilities less pension assets scaled by total assets) increases. Specifically, I find that one standard deviation increase in pension deficit is associated with annual tax savings of approximately $3.7 million. This positive relation between pension deficit and tax avoidance is not driven by financially constrained firms, loss-making firms or firms with foreign operations. The results hold after controlling for board characteristics and CEO equity risk incentives. The observed relation between pension deficit and tax avoidance is robust to alternative variable definitions and model specifications. In the second empirical study, I investigate whether the flexibility in making pension contributions and high information asymmetry associated with pension plans motivate managers to over-invest. The empirical analysis reveals that firms invest more at higher levels of pension deficit. Specifically, I find that at the median level (90th percentile) of pension deficit, investment increases by 6.7 cents (9.3 cents), for each dollar increase in cash. Furthermore, I find that as pension deficit increases, firms’ invest more than the predicted investment level. Results show that the market values an additional dollar lower than $1 as pension deficit increases, indicating that shareholders anticipate that some of the value is lost because managers will waste cash by investing in negative net present value projects. Collectively, these findings provide evidence that increased investment more likely represents over-investment by managers. I find that the results are robust to alternative variable definitions, alternative model specifications and endogeneity concerns that may arise if managers decide investment jointly with the funding policy of pension plans and firm’s target cash level. This thesis documents that the decline in the funding of pension plans is positively associated with tax avoidance and over-investment. The findings from the two empirical studies provide evidence that higher pension deficit firms are likely to have more agency problems and managers may be motivated to engage in activities that reduce firm value.


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Principal supervisor

Chris Veld

Year of Award


Department, School or Centre

Banking and Finance


Doctor of Philosophy

Degree Type



Faculty of Business and Economics

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