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«Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Footnotes ...»

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Finance and Economics Discussion Series

Divisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.

Footnotes Arent Enough: The Impact of Pension Accounting on

Stock Values

Julia Coronado, Olivia S. Mitchell, Steven A. Sharpe, and S.

Blake Nesbitt


NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary

materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

Footnotes Aren’t Enough:

The Impact of Pension Accounting on Stock Values Julia Coronado, Olivia S. Mitchell, Steven A. Sharpe, and S. Blake Nesbitt January 2008 This research was conducted with support from Barclays Capital, The Federal Reserve Board, and the Pension Research Council (PRC) at the Wharton School of the University of Pennsylvania. The authors are grateful for data provided by Wharton Data Research Services and useful suggestions from Daniel Covitz. Opinions and errors are solely those of the authors, and not of the institutions with whom the authors are affiliated. © 2008 Coronado, Sharpe, Mitchell, and Nesbitt. All rights reserved.

Footnotes Aren’t Enough:

The Impact of Pension Accounting on Stock Values Abstract Some research has suggested that companies with defined benefit (DB) pensions are sometimes significantly misvalued by the market. This is because the measures of pension cost and pension net liabilities embedded in financial statements, taken at face value, can provide a very misleading picture of pension finances. The more pertinent information on pension finances is relegated to footnotes, but this might not receive much attention from portfolio managers. But dramatic swings in the financial conditions of large DB plans around the turn of the decade focused widespread attention on pension accounting practices, and dissatisfaction with current accounting standards has recently prompted the Financial Accounting Standards Board (FASB) to take up a project revamp DB pension accounting. Arguably, the increased attention should have made investors wise to the informational problems, thereby eliminating systematic mispricing in recent years.

We test this proposition and concludethat investors continued to misvalue DB pensions, inducing sizable valuation errors in the stock of many companies. Our findings suggest that FASB’s current reform efforts could substantially aid the market’s ability to value firms with DB pensions.

Julia Coronado Barclays Capital 200 Park Ave New York, NY 10166 Phone: 212.412.1476 Email: Julia.coronado@barcap.com Steven A. Sharpe (corresponding author) Division of Research and Statistics, Federal Reserve Board, 20th and C Streets, NW Washington, DC 20551 Phone: 202.452.2875 Email: ssharpe@frb.gov Olivia S. Mitchell Pension Research Council, Dept of Insurance/Risk Management The Wharton School, University of Pennsylvania 3000 SH-DH, 3620 Locust Walk Philadelphia, PA 19104-6218 Phone: 215.746.5701 Fax: 215.898.0310 E-mail: mitchelo@wharton.upenn.edu S. Blake Nesbitt Pension Research Council The Wharton School, University of Pennsylvania 3000 SH-DH, 3620 Locust Walk Philadelphia, PA 19104-6218 Phone: 310.486.4871 Email: blake.nesbitt@gmail.com

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About two-thirds of large US companies provide employees with a traditional defined benefit (DB) pension which pays retiree benefits in the form of a life annuity. These annuities are financed by corporate contributions to a separately-managed pension fund invested under the aegis of the plan sponsor. By law, the sponsoring corporation is required to have enough assets on hand to fund, or pay for, all accrued vested benefits, even if the parent company were to go out of business. Yet there is flexibility in the funding rules, and it is often difficult to assess the current health of a corporate pension fund. Determining the plan’s funded status requires knowledge of the present discounted value of future benefit flows and the market value of pension assets, yet pension fund finances are reported under rather arcane accounting conventions (McGill et al., 1996). In particular, current accounting and actuarial practice permits smoothing of changes in the values of pension assets and liabilities, making it difficult for investors to readily ascertain the current funded status of a DB plan.

If defined benefit pension accounting is, in fact, “opaque”, this can make it difficult to properly value firms that sponsor DB plans (Gold, 2005). While the market values of pension assets and liabilities are disclosed in the footnotes to annual financial statements, considerable expertise may be required to evaluate the value-relevance of the pension-related accruals embedded in the income statement. For instance, in the latter half of the 1990s, many corporate DB plans became significantly overfunded and the earnings on pension fund investments significantly boosted the reported profitability of the sponsoring corporations. Some market analysts argued that this produced a misleading picture of the sponsors’ core business performance. Then between 2000 and 2002, when the stock market plunged, interest rates fell, and the net position of most DB plans took a 180-degree turn. The effects on the sponsor financial statements – particularly their profitability – showed up only with a substantial lag.

This paper evaluates whether investors can see through the financial statement, so as to value corporate sponsor DB pension funding status based on economic values of pension assets and obligations. In particular, we test the transparent view of pension valuation, against a specific alternative hypotheses in which firm equity value instead naively reflects the pension accruals located on the income statement, and thus fails to accurately reflect the economic value of net pension assets. In doing so, we extend the work of Coronado and Sharpe (2003) to a period when the distortions to accounting statements were glaring enough to capture the attention of many market analysts and policymakers, and we assess whether increased scrutiny has brought about more accurate pension valuation. Our results thus allow us to comment on the likely impact of new Financial Accounting Standards Board (FASB) statements seeking to incorporate more value-relevant information on current pension values in financial statements.

Despite huge swings in pension valuations and heightened attention devoted to pension funding, we show that equity prices of firms sponsoring DB plans still fail to reflect the true economic value of pension assets and liabilities. Instead, we conclude that firm valuations continue to be unduly influenced by the accruals reported in firm income statements, while placing little or no weight on the incremental information in the fair value of the net pension position reported in the footnotes to annual financial statements. The implication is that proposed changes to accounting standards will likely have an impact on the market values of pension sponsors.

1. Prior Analysis and Regulatory Trends An economic view of DB pension fund valuation takes the perspective of a consolidated corporate balance sheet. Here, pension assets and liabilities are assumed to be marked-to-market by investors, and thus contribute to firm value dollar-for-dollar (or somewhat less once tax effects are considered).1 During the late 1970s, the prevalence of underfunded DB plans spurred several empirical studies aimed at estimating the impact of DB pension plans on firm valuation.

Many of these concluded that the market did, in fact, value net DB liabilities in a manner consistent with the consolidated balance sheet – in accordance with the “transparent” hypothesis.2 Despite these findings, many market participants at the time suspected that the unfavorable financial position of most DB pensions was not fully reflected in share prices. In particular, the financial community worried that the value of plan assets and liabilities was measured inconsistently across firms and inadequately disclosed, making it difficult for investors to accurately determine the impact of DB pensions on firm value. Firms were required to disclose their net pension assets, but they were not required to do so within their financial statements.3 Indeed, the only manifestation of such plans on corporate financial statements was the annual cash contributions to these plans, which flowed through as an expense on the income statement. Furthermore, a variety of actuarial methods and assumptions were used to determine the market value of liabilities.

To address these concerns, the Financial Accounting Standards Board (FASB 1985) Since these plans enjoy special tax treatment, net pension assets or liabilities should reflect after-tax dollars; and since the federal government partially insures these benefits, risky firms actually preserve a “put option” on the government suggesting that the pension liabilities will be valued less than dollar-for-dollar. See Black (1980), Feldstein and Seligman (1981), and Tepper (1981) for a discussion of taxes and Sharpe (1976) for an analysis of the impact of pension insurance.

These papers include Feldstein and Seligman (1981), Feldstein and Morck (1983), and Bulow, Morck, and Summers (1987).

See McGill, et al. (1996) for a more complete description of the evolution of pension accounting.

issued Statement Number 87, Employers’ Accounting for Pensions, stipulating a new accounting approach to be employed in fiscal years beginning after December 15, 1986. Broadly speaking, FAS 87 standardized actuarial assumptions for valuing pension liabilities and set forth a new method for measuring pension expense on the income statements of sponsoring firms. Rather than booking the actual cash contributions, companies now had to calculate pension expense using a complicated accrual methodology in which the cost of new benefits are offset by an expectation of average long-run returns on pension assets. These guidelines also required disclosure of the fair market value of pension assets and liabilities within the footnotes to the annual financial statements, although the plan’s current funding position was still not reflected on the corporate balance sheet.4 The FAS 87 efforts to boost standardization and improve measurement and disclosure of pension finances on company statements were positive steps, but increasingly they too have come under fire. Analysts are concerned about the potential for conflicting signals from the income statement accruals and marked-to-market pension balance sheet information that FAS 87 has required firms to disclose in footnotes to their annual reports. Critics of pension accounting conventions expressed alarm that the serious funding shortfalls for many DB plans which resulted from the stock market bust at the beginning of the decade are not fully reflected in company financial statements. For instance, Zion and Carcache’s (2002) work shows that pension costs reflected in company income statements are a lagging indicator of a pension plan’s true funding status. Moreover, the financial community has been particularly vocal about its concerns. As an example, Standard and Poor’s introduced a “core earnings” concept which gauges corporate operating earnings after stripping out some of the components of the pension While many of the general principles for setting actuarial assumptions used in the accounting calculations are similar in spirit to those used in DB funding calculations required under ERISA, they are not explicitly linked.

accruals as well as other items (Blitzer, et al., 2001). Several Wall Street firms and prominent investment gurus including Warren Buffet have also called for a fundamental revision to the way pension costs are measured.

Responding to the growing concern over the lack of transparency embedded in FAS 87, the FASB (2003) has continued to reevaluate and revise pension accounting. One set of changes, implemented for financial statements ending after December 15, 2006, required pension sponsors to mark their pension assets and liabilities to market on corporate balance sheets as opposed to using actuarially smoothed values. The second phase, which is to review and revise the measures of pension cost reflected on the income statement, is expected to take two to three additional years to complete and implement.

2. Pension Accounting and Value Relevancy The measure of pension expense reflected in the income statement under the FAS 87 guidelines, net periodic pension cost (NPPC), is calculated as the annual accrued costs of the pension plan minus the expected return on plan assets. As shown in Table 1, two key cost components of the NPPC are service cost and interest cost. Other costs include amortization of previous gains and losses, amortization of prior service cost, and finally some ad hoc items such as charges for plan amendments and changes in actuarial assumptions. The service cost is equal to the present value of the pension benefits earned by employees during the year, in essence, the cost of deferred compensation. The interest cost is calculated as the beginning-of-year value of pension obligations multiplied by the plan’s assumed discount rate; this represents the cost of financing the outstanding pension obligation, that is, the increase in the benefit obligation resulting from the passage of time. Under FAS 87 guidelines, the assumed discount rate must reflect the rate at which current liabilities could be settled. As a matter of practice, firms often use the Moody’s AA rate.

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