Do Corporates Set Pension Discount Rates Strategically?

Abstract

A significant number of the U.S. publicly listed firms fail to lower their discount rates used to discount future pension obligations when interest rates decrease, resulting in an understatement of their pension liabilities and a lower charge against corporate earnings. Following the idea that mandatory contributions to underfunded pensions constrain corporate investments, we model and present empirical evidence that a relaxation of such constraint by setting higher pension discount rates helps to improve firm value. We show that rate inflations concentrate among highly capital intensive corporates who are facing tight financing constraints. We also show that such behavior has a positive effect on the operating and stock performance of underfunded firms, which supports the view that the imperfect elasticity of pension discount rates to market interest rates offers firms leeway to alleviate the constraints from defined benefit pension plans.

Keywords: Pension discount rate, Earnings management, Low interest rate, Pension liabilities

JEL Classification: G11, G22