Corporate Valuation and Asset Allocation for
Defined Benefit Pension Funds
Phillip R. Daves
Finance Department
University of Tennessee
Knoxville, TN 37996-0540
Michael C. Ehrhardt*
The Paul and Beverly Castagna Professor of Investments
Finance Department, SMC 424
University of Tennessee
Knoxville, TN 37996-0540
Phone: 865-974-1717
Fax: 865-974-1716
E-mail: ehrhardt@utk.edu
Revised: 9/19/2006
*Professor Ehrhardt acknowledges and appreciates the support provided by the 2005
Summer Grant Program of the Finance Department at the University of Tennessee.
1
Corporate Valuation and Asset Allocation for
Defined Benefit Pension Funds
Abstract
This paper extends the literature in pension fund asset management by explicitly
taking into account the expected return and risk of the sponsoring company’s stock. We
develop a new pension plan objective function which is consistent with firm value
maximization and find optimal pension plan portfolios for a variety of simulated pension
asset and liability mixes. We find that, consistent with the intuition behind
diversification, the optimum asset portfolio should not hold assets that are highly
correlated with the sponsoring firm’s operations.
I. Introduction
An important issue that pension fund managers face is how to allocate pension
funds among the various assets or asset classes. As many firms today can attest, a
pension deficit, in which the value of pension assets is less than the value of pension
liabilities, can have serious consequences for the sponsoring firm. Although a deficit in a
given year does not necessarily mean the fund is unable to meet its current pension
obligations, the adverse consequences of a deficit include reduced reported earnings if the
pension assets underperform the pension liabilities, reduced reported earnings if the
difference between the value of pension assets and liabilities must be amortized, higher
Pension Benefit Guarantee Corporation (PBGC) prem