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1 September 1983 Financial Analysts Journal Volume 39, Issue 5

Pension Funds and the Value of Equities

  1. Martin Feldstein
  2. Randall Morck

The value of reported vested pension obligations depends critically on the interest rate a firm uses to discount future benefit obligations. Firms with substantial benefit obligations relative to existing pension assets tend to reduce the reported present value of their obligations by using a high interest rate assumption. Conversely, firms with substantial pension assets relative to benefit obligations tend to choose low interest rate assumptions in order to increase the present value of their pension obligations so that they may take advantage of the tax benefits of early funding.

The financial market appears to see through this manipulation of pension liabilities, using a common average rate to discount pension obligations. Market values correlate more closely with pension obligations when those obligations are valued at an average of the rates actually used by firms than when they are valued at those actual rates. This average rate is significantly below the long-term rate prevailing in the market. Pension liabilities are thus overemphasized by the market.

Furthermore, there is some indication that the market gives more weight to pension liabilities than to pension assets; that is, each dollar increase in pension liabilities tends to translate into a dollar decrease in market value, whereas the same increase in pension assets increases firm value by less than a dollar. This may be because the market views a substantial increase in pension assets as an indication that the firm expects a corresponding increase in future pension liabilities. In any event, the fact that the market overemphasizes pension liabilities and may underestimate pension assets suggests that the growth of the private pension system may increase savings by investors and firms.

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