Pension Plan Funding Effect on Shareholder Equity

A pension plan often tends to be one of the company’s biggest liabilities. Before 2008, pension plans were not directly included in the financial statements, but could only be found in the footnote disclosures. Such accounting convention essentially made pensions a type of off-balance sheet financing resulting in a misrepresentation of valuation ratios and earnings due to the exclusion of such a significant liability. The objective of this research is to determine whether the funded status of a pension plan will significantly affect a company’s shareholder equity. As part of this research, I analyzed 4 years (2001-2004) of financial statements for a sample of 30 companies, focusing on earnings per share, book value per share, and percentage by which the pension plan is overfunded or underfunded. Using regression analysis, I determine whether the funded status of a pension plan will affect the company’s stock price. The results indicated a statistically significant correlation between level of pension plan funding and shareholder equity, with an R2 of 0.65 and 0.59 in years 2001 and 2004 respectively. In 2002 and 2003 the results were less conclusive exhibiting a lower R2 of ~0.44 and not providing enough evidence to conclusively reject the null hypothesis. The latter findings may be attributed to an inadequate sample size or other significant external factors such as interest rates and economic conditions, which may have a critical affect on my findings. Pension plan underfunding, plan freezing, and the recent implementation of FAS 158 result in significant accounting issues for today’s companies. The most notable example with wide media coverage was the General Motors debacle, which resulted from a massive pension liability. This liability would become the responsibility of the Pension Benefit Guaranty Corp (PBGC), an entity that protects the pensions of 44 million American workers and is funded by the premiums from the participating companies in case the company goes into bankruptcy. This could set precedence for companies with massively underfunded pension plans which don’t want to pay pension obligations to their employees. Another important issue affecting companies and their pension plans is pension plan freezing. In order to reduce costs and stay competitive, more firms are freezing their defined benefit pensions. The last issue considered is the recent implementation of FAS 158, which requires companies to put their pensions on the financial statements preventing off balance sheet reporting and leading to increased transparency. Given current financial and actuarial challenges in valuing their plans, I would suggest that companies use realistic discount rates, expected rates of return and longevity models. Additionally, it is essential that the duration of plan investments is appropriately matched to expected liabilities. Such practices will lead an increase in accuracy of pension plan valuations. Since companies are now obligated to record their pensions on the financial statements, they will be increasingly focusing on decreasing their liabilities as well as the volatility of their financials in order to enhance shareholder value.