Reading 22: Allocating Shareholder Capital to Pension Plans

The firms equity beta remains the same as the asset allocation in the pension assets changes but the total asset beta, equity capital, debt financing, and debt-to-equity ratio will all change. As the percentage of pension assets invested in equities increases the total asset beta will increase and to maintain the same equity beta the level of risk in the firms capital structure must decrease, thus the firm must issue more equity and reduce the amount of debt financing hence the debt-to-equity ratio will decrease.

A higher percentage of the pension assets invested in equities will increase the risk of the pension assets resulting in a higher total asset beta. To maintain the same equity beta there must be a decrease in risk in the capital structure of the firm. To accomplish this the amount of equity issued must increase along with a decrease in debt financing thus the debt/equity ratio will decrease.

As the pension assets are invested more heavily in bonds the pension asset risk will decrease causing the total asset beta to decrease. To keep the equity holders and creditors satisfied that the overall risk of the firm has not changed there must be a corresponding increase in debt financing thus the debt/equity ratio will increase.

Decreasing the percentage of pension assets invested in equities will decrease the risk of the pension assets decreasing the overall total asset beta. To maintain the same equity beta there must be an increase in risk in the overall capital structure of the firm which would be accomplished by using more debt financing and decreasing the amount of equity capital.