Did Pension Plan Accounting Contribute to a Stock Market Bubble?

46 Pages Posted: 2 Oct 2003

See all articles by Julia Lynn Coronado

Julia Lynn Coronado

Federal Reserve Board - Division of Research and Statistics

Steven A. Sharpe

Federal Reserve Board - Research & Statistics

Date Written: July 2003

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 overvaluation before 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.

Keywords: Pension, accounting, firm valuation, bubble, stock market

JEL Classification: G23, G14, M41

Suggested Citation

Coronado, Julia Lynn and Sharpe, Steven A., Did Pension Plan Accounting Contribute to a Stock Market Bubble? (July 2003). FEDS Working Paper No. 2003-38. Available at SSRN: https://ssrn.com/abstract=436823 or http://dx.doi.org/10.2139/ssrn.436823

Julia Lynn Coronado (Contact Author)

Federal Reserve Board - Division of Research and Statistics ( email )

Washington, DC 20551
United States
202-452-3044 (Phone)
202-872-4927 (Fax)

Steven A. Sharpe

Federal Reserve Board - Research & Statistics ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-2875 (Phone)
202-452-3819 (Fax)

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