Pension plan funding, technology choice, and the equity risk premium

Abstract

In this paper, the impact of Lazear contracts with defined-benefit pensions on aggregate technology composition and the aggregate risk premium is examined. In the presence of capital market constraints affecting workers, defined-benefit pensions bias the economy towards risk-free production. Leveraging the risky technology relaxes the constraints and results in more risky production and a fall in the aggregate risk premium. This effect holds with risky debt and low pension shortfall risk but breaks down with high pension shortfall risk. A key prediction is that as Lazear contracts become less common, risky production will increase and the aggregate risk premium will fall. © The editors of the Scandinavian Journal of Economics 2011.