Chapter 25 pension fund deficits and stock market efficiency; evidence from the united kingdom

U sing a s ample o f UK FTSE350 fi rms with defi ned benefi t pension schemes, we fi nd that although unfunded pension liabilities reduce the market value of the fi rm, the coeffi cient

25.2 Related Research on the Stock Market Reaction

25.6.1 Portfolio Formation Procedure and Descriptive

25.6.2 Parameter Estimates for the Factor Model 682

25.7 C onclusions 685

This ch a pter e xa mines t he eff ect of a co mpany’s u nfunded

pen-sion l iabilities o n i ts st ock ma rket va luation U sing a s ample o f

UK FTSE350 fi rms with defi ned benefi t pension schemes, we fi nd that although unfunded pension liabilities reduce the market value of the fi rm, the coeffi cient estimates indicate a less than one-for-one eff ect Moreover, there is no evidence of signifi cantly negative subsequent abnormal returns for highly underfunded schemes Th ese results suggest that shareholders

do take into consideration the unfunded pension liabilities when valuing the fi rm, but do not fully incorporate all available information

Keywords: Pension assets, pension liabilities, stock market

or i ncreased l iabilities Pension defi cits represent a t rue l iability for t he sponsoring company and should aff ect the fi rm’s value on a one-for-one base if no tax and government regulations are taken into consideration.* Pension liabilities can aff ect a fi rm’s earning and cash fl ow through both accounting and government regulations Either the fi nancial contribution

to the plan or the amortization of the liabilities can lower the earning of the fi rm Government regulations also impose compulsory contributions

on se verely u nderfunded p lans E xamples i nclude t he P ension B enefi t

* For t he s ample p eriod ( 2001–2005), i n t he U nited K ingdom, t he a ccounting s tandard Financial Reporting Standard 17 (FRS17) does not require compulsory disclosure of the pen- sion defi cit on the balance sheet Th e transitional regulations only require disclosure in the notes that accompany the balance sheet Th e relationship between corporate debt and pen- sion defi cit will be discussed in more details in Section 3.2.

Guaranty C orporation ( PBGC) c reated b y t he E mployee Re tirement Income Security Act (ERISA) of 1974 in the United States and the Pension Protection Fund (PPF) in the United Kingdom.

Th e U.K pension system is distinctive in having very high levels of DB pension commitments, although the low stock market returns in recent years have meant that many fi rms have chosen to close their DB schemes in the hope of transferring the investment risk from employers to employees (evident from the hand-collected data of FTSE350 fi rms with DB schemes during 2001 and 2002, see Section 3.4 for details) However, statistics show that DB pension liabilities still amount to about 30% of the overall value of major U.K corporations compared to 13% in the United States It is natu-ral to ask whether the stock market correctly values these liabilities

Th e correct valuation of the corporate pension liabilities not only cerns stock market effi ciency but also has macroeconomic implications for national savings Th is chapter uses U.K data for all the companies that com-prise the FTSE350 stock market index with defi ned benefi t pension schemes over t he per iod 2 001–2005 t o ex amine wh ether pens ion f und defi cits are refl ected in the stock market value of the company, using two alternative empirical approaches: a market valuation approach (Feldstein and Seligman, 1981) and an asset pricing methodology (Franzoni and Marin, 2006) Th e market valuation approach examines whether the value of unfunded pen-sion liabilities is r efl ected in a co mpany’s market value Th e asset pricing method examines the stock market response to subsequent corporate earn-ings announcements of fi rms with pension defi cits, on the basis that any defi cit will need additional contributions out of company earnings

con-In t he U nited K ingdom, t he n ewly i ntroduced F inancial Repo rting Standard 17 (FRS17) enables one to get access to the fair value of pension assets and liabilities from the fi rm’s annual report Using data from 2001

to 2005, we estimate the eff ect of unfunded pension defi cit on corporate share price using two alternative models Using a sample of UK FTSE350

fi rms with defi ned benefi t pension schemes, we fi nd that unfunded pension liabilities reduce the market value of the fi rm, but the coeffi cient estimates indicate a less t han one-for-one eff ect Moreover, t here is no signifi cant evidence of subsequent negative abnormal returns for highly underfunded schemes Th e results from these two models are consistent with each other and i mply t hat sha reholders d o t ake i nto co nsideration t he u nfunded pension l iabilities wh en va luing t he fi rm, b ut d o n ot f ully i ncorporate the information, and this causes an overvaluation of the fi rm Th e results could also be caused by the pension contribution regulations in the United

Kingdom: pension contributions made t o cover the defi cit are smoothed over a number of years and any fi nancial pressure they impose on earnings

is consequently weakened As a robustness check, equivalent regressions are run using data under the most recent funding requirements

Th e rest of t he cha pter i s organized a s follows S ection 25.2 reviews the previous literature on the topic Section 25.3 describes the methodol-ogy and the hypothesis to be tested following the Feldstein and Seligman (1981) and Franzoni and Marin (2006) approaches Section 25.4 defi nes the pension plan va riables a nd su mmarizes t he data Sections 25.5 and

25.6 present the regression results for the market value and asset pricing models, respectively Th e last section summarizes the chapter

25.2 RELATED RESEARCH ON THE STOCK MARKET

REACTION TO PENSION DEFICITS

A number of papers have evaluated the stock market reaction to publicly available information on pension defi cits Th is literature can be b roadly attributed to two main strands: the effi cient pension liabilities valuation approach or the market valuation model, and the asset pricing methodol-ogy Th is section relates t his chapter to t hese t wo st rands a nd provides further explanation of the determinants of pension liabilities

Th e market valuation model argues that the stock market reaction to unfunded pension liabilities depends critically on shareholders’ ability to recognize that there is an obligation to make future payments to fund the promised pensions, and this realization should leave their consumption unchanged in response to the increased accounting profi t, from the tem-porary u nfunding Feldstein (1978) d iscusses t he relation between pen-sion liabilities and aggregate savings by employers and employees based

on these arguments

Earlier w ork ( Feldstein a nd S eligman ( 1981), F eldstein a nd M orck (1983), and Bulow et al (1987) ) fi nds that the results are consistent with the conclusion that share prices fully refl ect the value of unfunded pension obligations; so the market correctly takes into account pension liabilities when valuing a company—a one dollar change of pension funding status will change the share price by one dollar (both relative to the fi rm’s mar-ket value) However, a more recent paper by Coronado and Sharpe (2003)

fi nds evidence of overvaluation of all DB fi rms by looking at the diff erent measures of underlying values of net pension obligations

Recent studies for the U.K market have found that the valuation of sion defi cits is subject to the choice of actuarial valuation methods such

pen-as discount rates and investment strategies (Klumpes and Whittington, 2003) and the stock market reacts diff erently to the pension funding sta-tus under diff erent accounting assumptions (Klumpes and McMeeking, 2007) Besides share prices, evidence has also been found that investors tend to give diff erent weightings to pension defi cits recognized in the bal-ance sheet as opposed to off -balance sheet defi cits (disclosed in footnotes)

in t he determination of other ma rket va riables such a s corporate bond spreads (Cardinale, 2005)

Th e market valuation model is by defi nition a c ross-sectional test and

so it has low data requirements and the interpretation of the parameters is relatively straightforward However, like many other valuation models, the choice of explanatory variables (or determinant of the dependent variable)

is quite “ad hoc” (Coronado and Sharpe, 2003) and subject to individual cretion It has a severe problem of potential omitted variables that may bias the estimation and aff ect the explanatory power of the model Moreover, the model does not take into account the endogeneity of pension funding status variables and the correlation (time lag) between share price and pension defi cit Last but not least, as Franzoni and Marin (2006) argue, given the low standard error for the coeffi cient of pension defi cit, a coeffi cient estimate for pension defi cit less than minus one cannot be rejected either, which means that the model still leaves the question of overvaluation unanswered

dis-Th e asset pricing method attempts to circumvent the above problems Rather than focusing on the determinants of market value, it uses an asset pricing m odel t o i nvestigate t he r eturn a nomalies c aused b y t he m is-pricing of pension defi cits and the model is related to a body o f work in accounting, in which a number of accounting items could have an infl u-ence on future earnings For example, Bernard and Th omas (1990) report the failure of stock prices to refl ect the implications of current earnings for future earnings, which is a result of systematic surprise about autocor-related earnings

Using U.S data for the past 20 years, and applying this methodology to pension defi cits, Franzoni and Marin (2006) fi nd that the decile portfolio

of the most underfunded companies earns lower raw returns than nies with healthier pension schemes Th is mispricing is magnifi ed when they use the Fama and French (1993) factor model to compute the abnor-mal returns by looking at the diff erence between portfolio mean returns and the expected return estimated from the factor model Th ey attribute this earning anomaly to be a manifestation of the price adjustment follow-ing the negative surprise of the market

compa-25.3 MODEL SPECIFICATIONS

25.3.1 Market Valuation Models

Th e starting point of the market valuation model is Tobin (1969), where he sets up a general framework for monetary analysis He argues that the mar-

ket va lue of a fi rm’s assets (V) should be proportional to t he replacement value of the assets (A), i.e., V = qA.* Th e parameter q would be equal to one in

equilibrium under some strict assumptions but normally this value may also depend on other variables that could aff ect the fi rm’s ability to provide excess

return A higher ratio of total earning to assets (E/A) or a higher growth rate of

it (GROW) would increase q for their positive eff ects on fi rm’s profi tability.

Th e level of corporate debt could also aff ect the equilibrium value of q

By Modigliani and Miller (1958), a fi rm’s total market value is independent

of its capital structure; thus, corporate leverage would have no eff ect on the fi rm’s market value under the strict M&M assumptions However, in the real world debt may have positive or negative implications for market

value of the fi rm—a high debt/capital (DEBT/A) ratio could decrease fi rm’s

market value by increasing the bankruptcy risk or increase it because of any tax benefi ts Another variable related to the perceived riskiness of a fi rm, and which could infl uence its market value is the fi rm’s beta coeffi cient.Pension liabilities are similar to corporate debt and if pension defi cit has to

be disclosed on the balance sheet then it represents a true liability for the soring fi rm in accounting terms as well If unfunded pension liabilities are not recorded in the corporate balance sheets, as in the transitional arrange-ments for FRS17 where only footnote disclosure is required, then pension liability and corporate debt will have some subtle diff erences, as described

spon-in the spon-introduction Pension liabilities and corporate debt are also diff erent

in terms of their tax treatments: the interest cost a rising from a fi rm’s debt

is a tax-deductible expense, whilst the interest income received by the sion fund (and pension contributions) is not taxed Th erefore, theoretically a pound of unfunded pension liability will reduce the market value of a fi rm by

pen-only 1 − tc where tc is the marginal corporate tax rate However, given the fact that many fi rms do not take advantage of this tax benefi t, Feldstein (1978) argues that it is because shareholders anticipate this implicit tax benefi t and adjust their consumption that the reduction in fi rm value approaches its pre-tax level Given the above considerations, if the unfunded pension liabilities (PD) are correctly valued, they would be equivalent to an equal value of debt,

* Detailed defi nitions of the variables are presented in Section 3.4.

but under FRS17 transitional arrangements, they only appear as footnotes to the accounts Th erefore, unfunded pension liabilities will not decrease the current assets and will increase the accounting profi t Th is joint eff ect will

reduce the relative value of the fi rm’s market value to its total assets (i.e., q) from 1 − tc to 1, given that the pension defi cits are correctly valued by share-holders To summarize, the total market value equation can be written

DEBT PDGROW BETA

PDit is the pretax pension defi cits of company i in year t

εit is the error

α5 is the main coeffi cient of interest and should be negative

−1 < α5 < −(1 − tc) (for the United Kingdom, α5 should lie between 0.7 and

1 since the United Kingdom’s tc was 30% during our sample period) before tax (PD)

If we replace PD with the pension defi cit aft er deferred tax and other nonrecoverable su rplus (N ETPD), α5 sh ould eq ual −1 We sh ould a lso observe positive values for α1 and α2 Th e coeffi cient estimates of corpo-rate beta (α3) and leverage ratio (α4) are more ambiguous and depend on whether the tax benefi t or bankruptcy risk dominates in the analysis

An alternative specifi cation is to rewrite Equation 25.1 only including the equity components of the variables Since the total market value of the

fi rm consists of both equity and debt parts, those two specifi cations would

be diff erent from each other if one assumes diff erent q value for debt and

equity Th e following equity value equation assumes that the market value

of equity (VE) of the fi rm is proportional to the equity asset (AE): VE =

qEAE Th e complete specifi cation of the equity value equation is similar to the total market value equation:

EEit is the fi rm’s equity earnings

GROWEit is the 10-year growth of the EE

Th e parameter estimations from Equation 25.2 are expected to have lar signs to those of Equation 25.1, but possibly of diff erent magnitude.

simi-Up till now pension defi cit (PD) has been treated as an exogenous able; however, the correct valuation of unfunded pension liabilities involves dealing appropriately with three issues: fi rst, the tax deductibility of pension obligations; second, the accounting methods, such as the discount rate used

vari-to calculate the present value of assets and liabilities and the assumptions made for benefi t and asset yields; and third, the uncertainty of benefi ts and asset yields Consider a fi rm with an obligation to pay future pension ben-efi ts, the fair value of this liability incurred will obviously depend on the tax treatment of pension expenses and thus infl uence the way it aff ects the

fi rm’s share price Under the accounting standard, FRS17 pension scheme liabilities must be measured using a projected unit method and discounted

at an AA corporate bond rate so that little confusion is likely to appear However, under FRS17, scheme assets are measured at “fair value” using assumed expected returns for diff erent investment instruments Th er efore, the market value of the pension defi cit depends on the discretion of diff er-ent accountants Even if the dispute about accounting methods was elim-inated, the uncertainty about pension benefi ts and asset yields in future years still remains Th is could be c aused by the uncertainty about future infl ation rate or real wage growth or even the possibility of the failure of the pension plan or bankruptcy of the fi rm Th e riskiness of the securities in which the pension assets are invested in can also infl uence the share price,

as corporate debt or the beta coeffi cient does A higher proportion invested

in equities may increase their riskiness and thus decrease the present value

of pension assets Managers of immature pension schemes with few rent pension obligations may be m ore willing to invest pension assets in equities that have a higher return than bonds, whilst those mature schemes that have to pay a large amount of pension benefi ts in a short time may be less inclined to invest in risky securities Finally, fi rms may del iberately leave their pension scheme with large defi cits so as to take advantage of the government insurance protection schemes such as the PBGC in the United States and the PPF in the United Kingdom

cur-25.3.2 Asset Pricing Method

Unfunded DB pension liabilities are likely to have negative implications for future earnings and cash fl ows of fi rms According to Franzoni and Marin (2006), this is mainly caused by the institutional and accounting

regulations that require mandatory amortization for highly underfunded schemes If investors are unaware of this eff ect, when pension liabilities are d ue a nd st art t o a ff ect e arnings a nd c ash fl ows, t he i nvestors w ill

be surprised by a n egative shock to earnings As a ma nifestation of the price adjustment following this negative surprise, low returns should be observed for those fi rms with highly underfunded pension schemes.Our measurement of a fi rm’s funding status follows Franzoni and Marin (2006) Since it is the relative value of the pension defi cit that has implica-tions for a sch eme’s funding status, the pension defi cit (PD) is scaled by relevant variables in both the market valuation model and the asset pric-ing model Franzoni and Marin (2006) use market capitalization as the scaling parameter Th ey argue that it is a fi rm’s future cash fl ows, informa-tion diff usion, and credit constraints that vary the extent to which pension defi cits may aff ect the return Since market capitalization is correlated to all these three variables, it is chosen as the scaling parameter We defi ne

the funding ratio of scheme i in year t as

FRMkt Capit it Mkt Capit

PAit is the pension scheme’s assets

PLit is its liabilities, both reported according to FRS17

One benefi t of u sing t he above measurement is t hat a h ighly u funded fi rm (with high positive FR since PD is defi ned as pension liabili-ties net of assets) is likely to be a s mall fi rm with high book-to-market* ratio Given t he fact t hat small fi rms w ith high book-to-market usually earn high returns, if low returns are observed for those fi rms they are not likely to be explained by risk factors such as size or book-to-market ratio

nder-To assess whether highly underfunded fi rms earn lower risk-adjusted returns, the asset pricing model uses the calendar-time portfolio meth-ods introduced by Lyon et al (1999), who discuss an improved method for long-run abnormal returns tests Th is method i nvolves calculating the return on a po rtfolio composed of fi rms t hat had a n event w ithin

* By simple manipulation FR can be rewritten as FR = PL PA Book−

Book MktCap For a fi xed fi rst

ratio, a higher FR corresponds to a higher B/M ratio.

some pe riod o f i nterest Th en t he F ama–French t hree-factor fac tor model is applied to the calendar-time return on the portfolio to estimate the abnormal return:

RFRM SMB HML

R = α + β +s +h + ε (25.4)where

R it is the excess return of portfolio i at time t

εit is the error term

For t he fac tors, R MRFt i s t he d iff erence b etween t he r eturn o f v weighted market index and the return of the monthly return on 3 month Treasury b ills, S MBt i s t he d iff erence be tween t he r eturns o n va lue-weighted small- and big-stock portfolios and HMLt is the diff erence for high and low book-to-market portfolios Th e time series estimate of the intercept αi provides a test of the null hypothesis that the mean monthly abnormal return on the calendar-time portfolio is zero In this chapter, calendar portfolios are constructed by sorting the fi rms according to the funding ratio (FR) Since pension data are updated annually by the require-ment of FRS17, portfolios are reformed annually rather than monthly as in Lyon et al (1999) If fi rms with large pension defi cits are overvalued, the market should be negatively surprised about the defi cits and as the result

alue-of the negative surprise, highly underfunded companies should have low expected returns (i.e., negative αi)

However, a s t he na me “ market va lue eff ect” in dicates, u sing F R t o measure the funding status could cause severe problems as well Failure

to fi nd a negative abnormal return for highly underfunded fi rms cannot lead to a rejection of the hypothesis that those fi rms are overvalued since this could just be bec ause t he positive eff ect of a h igh book-to-market ratio is so la rge that it dominates the negative impact of unfunded pen-sion liabilities

25.4 DATA

This sec tion r eports t he d ata sel ection a nd co nstruction m ethod for t he r egression va riables We st art b y d iscussing pens ion-related data ma inly collected ma nually f rom t he FR S17 d isclosure i n f irms’ financial r eports a nd t hen n onpension-related d ata co llected f rom Datastream

25.4.1 Pension Plan Data

Th e sample period of this chapter ranges from 2001—the fi rst year U.K

fi rms were required to disclose their pension funding data in companies’ reports and accounts by FRS17—to 2005.* For the sample period, FRS17 does not require compulsory disclosure of the pension defi cit on the bal-ance sheet Transitional stage regulations only require disclosures in the notes that accompany the balance sheet Not much inference can be drawn from the data prior to 2001 since before FRS17 fi rms were only required to publish smoothed pension costs occasionally, but these data are diff erent from the market value of pension defi cits

Pension data were manually collected for all FTSE350 companies in the U.K market with at least one defi ned benefi t pension scheme from the cor-porate fi nancial statement According to FRS17 transitional requirements, pension data can be found in the footnote to the fi nancial statement Th e statement of Financial Reporting Standard 17 by the Accounting Standard Board (ASB) defi nes pension scheme assets (PA) and liabilities (PL) and their valuation methods as following:

Assets in a defi ned benefi t scheme should be measured at their fair

•

value at the balance sheet date Scheme assets include current assets

as w ell a s i nvestments A ny l iabilities such a s acc rued ex penses should be deducted

Defi ned benefi t scheme liabilities should be measured on an

actu-•

arial basis using the projected unit method Th e scheme liabilities include: (a) a ny benefi ts promised under t he formal terms of t he scheme; a nd ( b) a ny constructive obligations for f urther benefi ts where a public statement or past practice by the employer has cre-ated a valid expectation in the employees that such benefi ts will be granted

A vested pension liability (which is what appears on fi rm’s fi nancial ments) can be decomposed into funded and unfunded liabilities: the former m eans t he l iability i s co vered b y sch eme a ssets a nd v ice v ersa Obviously what matters is the unfunded pension liability, which in this

state-* For the cross-sectional tests in the market valuation model (Equations 25.1 and 25.2) only data f rom 2 001, 2 002 a re u sed 2 001 a nd 2 002 we re t he fi rst 2 ye ars F RS 17 t ransitional arrangement was introduced Th e whole data set from 2001 to 2005 is used in the asset pric- ing model.

chapter w e w ill c all t he pens ion defi cit ( PD) a nd b y defi nition PD =

PL − PA A scheme is said to be overfunded if one observes a negative PD and u nderfunded i f PD is positive N ETPD denotes pension defi cit net

of deferred tax* and other nonrecoverable surplus and this is usually the term that will enter the balance sheet under the requirement of FRS17.†25.4.2 Nonpension Variables

Th is section summarizes t he defi nition a nd c alculation methods for t he nonpension va riables for t he empirical tests of t he ma rket va luation a nd asset pricing model Detailed defi nitions of the variables are to be found in the appendix Th ese variables are constructed to be consistent with the defi -nitions in Feldstein and Seligman (1981) All the accounting data are either found in Datastream or from Th omson ONE Banker Datastream reports the market capitalization of each fi rm (VE) at the end of every fi nancial year

Th e equity earning (EE), defi ned as total earnings net of the interest expense

on debt, is the sum of net income available to common and preferred dends Th e book value of each fi rm’s net debt (DEBT) is defi ned as the sum

divi-of short-term and long-term debt minus cash and it is provided by the fi rm’s cash fl ow statement (or its note) and to be consistent with the sign of PD, positive DEBT means defi cit and negative value stands for surplus For the beta coeffi cients (BETA) the value given in Datastream is adopted

Th e total market value of the fi rm (V) is calculated as the sum of the

book value of the long-term debt and common equity, both of which are available in Th omson ONE Banker Th e replacement value of a fi rm’s plant and eq uipment i s available on t he fi rm’s ba lance sh eet, wh ich t ogether with the book value of the fi rm’s total inventories form the market value

of the fi rm’s capital stock (A).‡ By de fi nition the total earning (E) equals

EE plus the interest expense on debt Th e net asset value of the

corpora-* Th e term “deferred tax” means “the estimated future tax consequences of transactions and events recognized in the fi nancial statements of t he current and previous periods.” It con- cerns the tax treatment of most types of timing diff erence, which includes “accruals for pen- sion costs and other post-retirement benefi ts that will be deductible for tax purposes only when paid.” See FRS19: Deferred Tax for details.

† Diff erence between the asset or liability in the balance sheet and the surplus and defi cit in the scheme will arise because of the related deferred tax balance and also when part of a surplus

or defi cit has not been recognized in the balance sheet, for example, when part of the surplus

in the scheme is not recoverable by the employer or when past services awards have not yet vested.

‡ To run the Tobin’s Q regressions in Feldstein and Seligman (1981), where A is needed, the

sample only includes nonfi nancial fi rms; thus, no intangible assets are included in the

calcu-lation of A.

tion’s equity (AE) is calculated as the fi rm’s physical assets minus the sum

of debt and preferred stock, i.e., AE = A − DEBT − PS Th e growth rate of

total earnings (GROW) is defi ned as the diff erence between the average

E in the most recent 5 years and the previous 5 years, divided by A and

the growth of EE (GROWE) is the 10-year diff erence in equity earnings divided by AE, the value of equity asset

25.5 ESTIMATION OF MARKET VALUATION MODELS

25.5.1 Descriptive Statistics

Th e sample covers all FTSE350 nonfi nancial fi rms with at least one defi ned benefi t pension scheme in 2001 and 2002 and cross-sectional regressions are run for each year Th ese were the fi rst and second years for which pen-sion f unding st atus d ata become available on corporate fi nancial state-ments u nder FR S17 Th e f ootnote d isclosure ensu res t hat t he pens ion defi cit will not reduce the assets of the fi rm like debt, and so we are more likely to fi nd a r esult similar to Feldstein a nd S eligman (1981) To cor-

rect for outliers, the dependent variables (V/A or VE/AE) are winsorized

at 99% level For total market value equations, there are 129 fi rms in 2001 and 127 fi rms for 2002 whilst for equity value equations the sample size is

130 and 112 for 2001 and 2002, respectively

Table 25.1 reports the mean and standard deviation for the variables

used in Equations 25.1 and 25.2 In both years, qE is greater than q and whilst q (i.e., V/A) is close to its equilibrium value, qE is signifi cantly greater than unity especially in 2001 when it is greater than two Th is refl ects overvaluation in the stock market and results in the dramatic decrease of

both total earnings (E) and equity earnings (EE) and their growth Th is

eff ect is most obvious in 2002 for equity earnings, with an average value of

−5% of equity assets and together with the large standard deviation, which refl ects the market crash around 2000

Another interesting feature is that in both cases the net tal ratio remains at fairly high levels On t he one hand, this refl ects the shrinking market in the sample years and on the other hand the debt is

debt-to-capi-so high that the tax saving it created exceeds the bankruptcy risk and this eff ect is especially dominant for equity variables

In the fi rst year of FRS17 implementation, 2001, fi rms have relatively low unfunded pension liabilities or are in surplus However, in 2002, the average defi cit has increased dramatically to more than 10% of assets Th is may result from pension schemes putting a la rge proportion of assets in

TABLE 25.1 Descriptive Statistics for Total Market Value and Equity Value Equations

No of fi rms closing (at least 1)

equities, whose value decreased signifi cantly due to the low stock returns Facing these large pension defi cits, more employers chose to close their defi ned benefi t pension schemes to new members and the number of clo-sures more than doubled in 2002 Th is observation is consistent with the discussion at the beginning of the chapter that DB schemes have severe funding problems and they tend to be replaced by defi ned contribution (DC) schemes Th e pension defi cit/surplus net of deferred tax and other nonrecoverable surplus (NETPD) is less than the mean PD if it is negative and vice versa because of the tax savings for pension liabilities.

25.5.2 Parameter Estimates

Table 25 2 r eports t he pa rameter e stimates f or t he t otal ma rket va lue, Equation 25.1 for all FTSE350 nonfi nancial fi rms with at least one defi ned benefi t pension scheme in 2001 and 2002, the fi rst and the second year that FRS17 was introduced For both years, the coeffi cient estimations of pen-sion defi cit (PD) are negative but signifi cantly diff erent from minus one

Th is is consistent w ith t he hypothesis t hat u nfunded pension l iabilities reduce the market value of the fi rm, although the specifi c point estimates suggest that unfunded pension liabilities are undervalued for most cases, which is compatible with the conclusion of Franzoni and Marin (2006)

In 2001, the coeffi cient of pension defi cit before tax (PD/A) stands at

−0.46, which implies that a £1 of unfunded pension liability reduces fi rm value by £0.46 Th e coeffi cient for 2002 is lower at −0.36 For both years, the point estimates for pension defi cits are signifi cantly negative, indicating

TABLE 25.2 Coeffi cient Estimates for Total Market Value Equation

Year Spec Constant E/A GROW DEBT/A PD/A NETPD/A BETA R2

2001 2.1 1.029 −0.318 0.470 −0.126 −0.455 0.023 0.181

(0.037) (0.096) (0.245) (0.070) (0.148) (0.015) 2.2 1.032 −0.324 0.503 −0.131 −0.798 0.020 0.194 (0.037) (0.096) (0.244) (0.069) (0.235) (0.015)

2002 2.3 1.012 −0.198 0.293 0.001 −0.356 0.031 0.092

(0.053) (0.078) (0.211) (0.072) (0.172) (0.039) 2.4 1.008 −0.205 0.307 −0.001 −0.421 0.030 0.083 (0.053) (0.078) (0.212) (0.073) (0.239) (0.039)

Note: Regression results for Equation 25.1 using hand-collected data from corporate fi

nan-cial statement and Th omson ONE Banker Th e dependent variable in each specifi tion is the fi rm’s total market value (debt and equity) scaled by the capital stock (fi rm’s physical ass ets, including t angible ass ets and inventories) of t he fi rm Th e sample period is 2001 and 2002 fi scal year Robust standard errors are shown in parentheses.