UK – Defined benefit pension funds amplify shocks to companies’ shares and affect stock market volatility, according to a Bank of England study.

That’s because companies effectively invest in each other via their pension funds - and there’s the additional leverage of pension liabilities, the working paper explained.

And it found that UK firms may be more leveraged than thought.

“The main conclusion of this paper is that company sponsored DB pension funds amplify the effect of common shocks on the value of corporate equity, affecting stock market volatility through two distinct channels,” BOE researchers Kamakshya Trivedi and Garry Young write.

“The first derives from the fact that through their pension funds, companies invest in each other. The second relates to the additional leverage induced by pension liabilities.”

“Simulations based on a stylised model of company net worth suggest that the amplification in volatility on account of these channels may be of an economically significant magnitude.

“The simulations also suggest that the total ‘economic leverage’ effect is larger than the cross-holdings effects.”

The comments come in the central bank’s Working Paper no. 289: “Defined benefit company pensions and corporate valuations: simulation and empirical from the United Kingdom”. The views expressed in the 33-page study are not necessarily those of the bank.

An econometric analysis of market data confirmed that these effects are statistically significant, the researchers write.

The paper emphasises the additional volatility to share prices that comes about as a consequence of corporates holding shares in other companies via their pension funds.

The paper adds that the results “also point to the need to monitor the whole ‘economic’ balance sheet of companies in assessing corporate health.

“From a systemic perspective, they underline the fact that the aggregate UK corporate sector may be more highly leveraged than what would be apparent from standard gearing measures.

“After all, if a proportion of the equities held by pension funds are cross-holdings, then at the aggregate level equity claims are smaller relative to the total ‘economic leverage’ of the sector.”

In addition, cross-holdings may also affect corporate valuations in ways that the paper doesn’t consider.

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