Keywords: Pension, accounting, firm valuation, bubble, stock market
Abstract: During the 1990s, the asset portfolios of defined-benefit (DB) pension plans ballooned with the booming stock market.
Due to current accounting guidelines, the robust growth in pension assets resulted in a stealthy but substantial boost
to the profits of sponsoring corporations. This study assesses the extent to which equity investors were fooled by
pension accounting. First, we test whether stock prices reflected the fair market value of sponsoring firms' net
pension assets reported in footnotes to the 10-K or, instead, some capitalization rate on the pension cost accruals
embedded in the income statement. The results strongly favor the latter view. Additional tests indicate that the
market does not value a firm's "pension earnings" differently from its "core earnings", suggesting that pension
earnings are often overvalued. Simulations show that a failure to differentiate between core and pension earnings
induces large valuation errors for many firms, although this pension effect did not materially contribute to
aggregate in overvaluation 2000. However, overvaluation from pension earnings reached 5 percent in the aggregate
in 2001, when the steep stock price decline and the drop in interest rates had slashed pension net asset values
but not pension earnings.
Full paper (279 KB PDF)
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Last update: August 13, 2003