Academic journal article Risk Management and Insurance Review

Stock Market Sensitivity to U.K. Firms' Pension Discounting Assumptions

Academic journal article Risk Management and Insurance Review

Stock Market Sensitivity to U.K. Firms' Pension Discounting Assumptions

Article excerpt

ABSTRACT

New U.K. pension accounting regulations significantly increase the exposure of the balance sheets of U.K. firms to volatilities in pension fund valuations. We examine whether the abnormal returns of firms that voluntarily used market-based pension discount rates are significantly different from the abnormal returns of industry-matched pair samples of firms that retained traditional cost-based valuation assumptions during the period surrounding the release of the related exposure draft. We also examine the interest rate sensitivity of stock price returns over the 4-year period before and after the announcement date. Consistent with our hypotheses, U.K. stock price returns incorporate the effect of unexpected interest rate changes on sources of pension earnings for firms that voluntarily switched to market-based assumptions but do not incorporate these effects for firms that did not switch. These results suggest that unexpected changes in interest rates have a differential effect on a firm's sources of pension, financial, and core earnings.

INTRODUCTION

U.K. pension accounting rules formerly required pension employers to recognize only the accrued or prepaid pension cost, and usually defer and amortize any actuarial gains or losses. However, Financial Reporting Standard 17 (FRS17) requires full recognition of the excess pension deficit or surplus on the employer sponsors balance sheet and the immediate write-off of actuarial gains or losses (Accounting Standards Board, 2000). FRS17 is significantly different from the former U.K. GAAP requirements that pension gains or losses be smoothed over time. Assuming that markets are efficient, one important question raised by the new policy concerns the implications of the newly reported pension exposure on firms' stock returns in the period surrounding the announcement of the regulatory change. If firms' stock prices react to apparently minor changes in actuarial assumptions underlying firms' pension obligations, more effective corporate risk management policies would be needed to mitigate these exposures.

The objective of this research is to determine if the release of the exposure draft that preceded FRS 17 affected the abnormal returns of the securities of U.K. firms that voluntarily chose to adopt the new pension accounting rule in a significantly different way than the abnormal returns of firms that did not adopt the new rule.1 We test this prediction using both an event study and variable effect methodology around the time of the announcement and over the 4-year period before and after the announcement date. We condition any stock price reaction on the level of the firm's pension exposure and managerial discretion over the choice of valuation assumption. The reaction to regulatory induced changes in pension discounting assumptions should be of interest to corporate decision makers, financial economists, and accounting researchers for two reasons. First, strong evidence that capital market participants fail to account for the effect of unexpected changes in pension discount rate assumptions on U.K. firms' reported balance sheets would either challenge the efficient markets hypothesis or conflict with the conventional "corporate finance" view (and FRS17) that the firm owns the pension surplus (e.g., Bulow, 1982).2 Second, these regulations are potentially value relevant if around the time of regulation the stock price returns differ systematically across firms that use significantly different pension discounting rates.

Our event-study empirical results show that allowing for control variables, the abnormal returns of firms that use market-based (FRS17) discount rate assumptions are sensitive to unexpected interest rate changes. These results support the hypothesis that the U.K. stock market is able to evaluate the effect of unexpected interest rate changes on the stock price returns of firms that adopt market-based discount rate assumptions. …

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