Changes in the Funded Status of Retirement Plans after the Adoption of SFAS No. 158: Economic Improvement or Balance Sheet Management?

Transcription

1 Changes in the Funded Status of Retirement Plans after the Adoption of SFAS No. 158: Economic Improvement or Balance Sheet Management? DENISE A. JONES, College of William & Mary May 2011 Please address correspondence to Denise A. Jones, Mason School of Business, The College of William & Mary, P.O. Box 8795, Williamsburg, VA, 23187; ;

2 Changes in the Funded Status of Retirement Plans after the Adoption of SFAS No. 158: Economic Improvement or Balance Sheet Management? Abstract Statement of Financial Accounting Standards No. 158 (SFAS 158) requires all companies to report the funded status of defined benefit pension plans and other postretirement plans, such as retiree healthcare plans, on the balance sheet for fiscal years ending after December 15, Prior to this, underfunded retirement plans were often not recorded as a liability on company s balance sheets. At the end of 2005, the average defined benefit pension plan of the companies in this study was underfunded by $324 million and the average other postretirement plan was underfunded by $760 million. After the adoption of SFAS 158 in 2006, this average underfunding decreased. After controlling for changes in market conditions, I find that companies with debt contracting incentives to manage their balance sheets had a larger increase in their defined benefit pension plan funded status subsequent to the adoption of SFAS 158. This increase was at least partially due to the choice of assumptions used to measure the pension obligation. Keywords Defined benefit pension plans, other postretirement plans, pension assumptions, balance sheet management

3 Changes in the Funded Status of Retirement Plans after the Adoption of SFAS No. 158: Economic Improvement or Balance Sheet Management? 1. Introduction Statement of Financial Accounting Standards No. 158 (SFAS 158) requires all companies to report the funded status of defined benefit pension plans and other postretirement plans (hereafter referred to as pension plans and postretirement plans respectively, and collectively as retirement plans) on the balance sheet for fiscal years ending after December 15, The funded status is defined as the fair value of the retirement plan assets less the benefit obligation (expected liability). Prior to this, underfunded retirement plans were often not recorded as a liability on company s balance sheets due to accounting rules designed to smooth the effect of changes in interest rates and volatile stock market returns on retirement plan assets and liabilities. In 2005, the average pension plan in this study s sample was underfunded by $324 million, and the average postretirement plan was underfunded by $760 million. Interestingly, after the mandatory adoption of SFAS 158 in 2006, this declined to an underfunding of $117 and $695 million for pension plans and postretirement plans, respectively. In this study, I investigate three related research questions. First, why is there an improvement in the funded status of retirement plans after the adoption of SFAS no. 158? Second, is the improvement in the funded status of retirement plans after the adoption of SFAS 158 associated with management s contracting and other incentives to manage the balance sheet by reducing the recognized retirement liability? Third, did companies with contracting and other incentives manage the assumptions used to estimate the retirement obligation to a greater extent after the adoption of SFAS 158? For a sample of 433 companies with defined benefit pension plans in existence over the period 2003 to 2006, I find that the funded status increased in part due to the overall improvement in the economy leading to large positive returns on pension plan assets. However, the return on pension plan assets in the post-sfas 158 period is not statistically different from the return in the 1

4 previous three years. The funded status also increased due to changing actuarial assumptions, plan amendments, and plan freezes. The increase due to both actuarial changes and plan amendments is significantly larger in the post-sfas 158 period than in the previous three years. In addition, I find that companies with debt contracting incentives to manage their balance sheet, companies with a higher unrecognized liability, and smaller companies had a larger increase in their pension plan funded status after the adoption of SFAS 158. Both changes in the funded status due to changes in actuarial assumptions and plan amendments are associated with debt contracting incentives and the magnitude of the unrecorded liability in the post-sfas 158 time period. Finally, I directly examine the assumptions selected by managers to measure the retirement obligations. After the adoption of SFAS 158, I find that companies with debt contracting incentives used a higher discount rate and a lower rate of compensation increase, which would reduce the retirement obligation. However, I find no relation between the magnitude of the unrecorded asset or liability and the discount rate or rate of compensation increase. I also examine a subsample of 355 companies with postretirement plans and I find mixed results. Similar to pension plans, I find that after the adoption of SFAS 158, smaller companies and companies with a large underfunding not previously recognized on the balance sheet had a larger increase in the postretirement plan funded status attributable to actuarial changes. However, I find no relation between changes in the funded status and debt contracting incentives. When I directly examine the postretirement assumptions, I find that companies with debt contracting incentives had a larger decrease in their assumed healthcare cost trend rate, which would decrease the benefit obligation and increase the funded status. This paper contributes to the literature in several important ways. First, while there is extensive evidence that managers make accounting choices related to managing earnings (see Fields et al. 2001), there has been very little research on whether managers attempt to manage the balance sheet. One exception is Gramlich et al. 2001, who document that companies reclassify 2

5 short-term debt to long-term in years when the current ratio before the reclassification would have been lower than the prior year and industry benchmarks. In this study, I examine a situation where a new accounting pronouncement affected only the balance sheet, and provide evidence that accounting choices were related to contracting and other incentives to manage the balance sheet after the adoption of SFAS 158. Second, prior to SFAS 158, even when the retirement plan funded status was not recognized on the balance sheet, it was still disclosed in the footnotes along with other extensive retirement plan disclosures. Although recognition versus disclosure is an important issue, there has been relatively little research in this area, primarily because there are very few circumstances where the same item is both recognized and disclosed. Prior research on two situations where a disclosed item was subsequently recognized, capital leases and employee stock options, has documented that management s actions may be influenced by whether an item is recognized versus disclosed (see, e.g., Johnston 2006; Brown and Lee 2007; Carter et al. 2007; Aboody et al. 2004; Imhoff and Thomas 1988). In this study, I extend this literature by providing evidence that recognition versus disclosure of retirement liabilities may affect management s accounting choices. In addition, the adoption of SFAS 158 takes place in a setting that overcomes a couple of difficulties faced by prior studies. First, when there is a switch from disclosure to recognition, there is often a concurrent change in measurement. 1 The adoption of SFAS 158 provides a unique opportunity where information measured in the exact same way was disclosed one year and recognized the next year. Second, it is often difficult to compare accounting choices across companies because different accounting choices may be due to real economic differences. Retirement plan assumptions are expected to be homogeneous across companies (Amir and Gordon 1996), providing a good setting to examine management s incentives across companies. Finally, one reason that recognition versus disclosure of retirement liabilities may matter to managers is that accounting based debt contract provisions, such as performance pricing 3

6 provisions, dividend restrictions or debt covenants, might be affected by the recognition of a new retirement plan liability. The empirical evidence on whether accounting choices are motivated by debt contracting concerns is inconclusive (Fields et al. 2001). Managers often have conflicting motivations for making accounting choices, and managers can also take multiple actions to accomplish the same goal (e.g., accrual manipulation, changing accounting methods, etc.), making it difficult to document manipulative behavior (Fields et al. 2001). In this study, I extend the debt contracting literature by documenting managers reaction to a mandatory accounting change that affected a large number of companies, and where the magnitude of the liability is potentially large. The adoption of SFAS 158 affected the balance sheet only, and potentially conflicting earningsrelated motivations, such as maximizing bonuses, did not change. In addition, managers choices to mitigate the impact of this event were limited, making it easier to design a test of the association between management s incentives and accounting choices. The remainder of this paper is organized as follows: section 2 discusses the background of the accounting for retirement plans, trends in retirement plans over time, and incentives to manage retirement plan obligations; section 3 describes the research design and sample selection; section 4 reports the results; and section 5 concludes the paper. 2. Background and literature review Accounting for retirement plans For all fiscal years ending after December 15, 2006, SFAS 158 requires companies to recognize on the balance sheet the funded status of pension plans and postretirement plans, such as retiree health care plans (FASB 2006). The funded status is defined as the fair value of retirement plan assets less the expected liability or projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for postretirement plans. Prior to this, an amount different from the funded status was reported on the balance sheet due to accounting rules 4

7 designed to smooth fluctuations in the market return on retirement plan assets and changes in actuarial assumptions. For underfunded retirement plans, this delayed recognition of economic events could result in a balance sheet liability that was significantly less than the underfunding of the plan, and in some situations resulted in an asset being reported on the balance sheet. The measurement of retirement related items did not change under SFAS 158. In addition, the measurement of retirement expense on the income statement remains the same and any adjustment necessary to record the funded status on the balance sheet is recorded directly to stockholder s equity. The PBO is defined the actuarial present value of future pension benefits attributed to service rendered to date, and should be based on estimated future events such as compensation increases, turnover, and mortality (FASB 1985). The APBO is defined the actuarial present value of future postretirement benefits attributed to service rendered to date, and should be based on the expected future costs of providing the benefits to the employee and other covered dependents, and the extent to which the costs are expected to be shared by the employee (FASB 1990). For the PBO and APBO, management must decide on a discount rate to compute the present value of expected future benefits. The discount rate should be based on the rate at which the retirement benefit could be effectively settled and should reflect the return on high quality fixed-income investments (FASB 1990; FASB 1985). Incentives to manage the retirement liability A manager concerned about recognizing a large retirement liability on the balance sheet has multiple options to reduce that liability. The manager could take real actions such as reduce retirement benefits, freeze retirement plans, or redirect cash flows to fund the plans (see, e.g., Beaudoin et al. 2010; Campbell et al. 2010; Mittelstaedt et al. 1995). These actions are all costly to the firm either directly by requiring cash or indirectly by hurting the motivation of the workforce. A manager could instead choose the less costly route of changing the assumptions used to measure the retirement liability. This section discusses four incentives that managers have to manage the 5

8 retirement plan liability: debt contracting incentives, the magnitude of the unrecorded retirement liability, the ability to fund the retirement plan, and the size of the company. There are debt-contracting incentives to minimize the retirement liability recognized on the balance sheet (Watts and Zimmerman 1990). Debt contract provisions can take many forms. Performance pricing provisions make interest rates charged on a bank loan a function of current credit ratings or debt-related financial ratios (see Asquith et al. 2005). In addition, debt contracts often contain dividend restrictions that limit the amount of dividends that can be paid out using a formula typically based on accumulated retained earnings (see Healy and Palepu 1990). Finally, affirmative debt covenants often require a firm to meet certain accounting-based financial ratios, stocks or flows (see Duke and Hunt 1990; Press and Weintrop 1990). Companies with high leverage reduced retiree health care benefits after adopting SFAS 106 (Mittelstaedt et al. 1995) and companies with higher liabilities were more likely to choose prospective adoption of SFAS 106, which postpones the recognition of a liability (D Souza et al. 2001). In addition, previous studies have documented that in the pre-sfas 158 time period, companies with higher leverage tend to make income-increasing retirement plan related actuarial choices (Asthana 1999; Amir and Gordon 1996; Godwin et al. 1996). Although the opportunistic choice of retirement assumptions has been previously documented, I expect the period after the adoption of SFAS 158 to be different. In the pre-sfas 158 time period, management had incentives to use the retirement assumptions as an earnings management tool. Indeed, some of the strongest evidence in the pre-sfas 158 period is related to the expected rate of return assumption (see Bergstresser et al. 2006; Comprix and Muller 2006), which affects pension expense but not the PBO. In addition, the strongest incentive for early adoption of SFAS 87 was the ability to increase reported earnings on the income statement (see Tung and Weygandt 1994; Langer and Lev 1993; Scott 1991). SFAS 158 changed the reporting of retirement amounts on the balance sheet but did not change how retirement expense is reported on 6

9 the income statement, leading to incentives to manage the potential new balance sheet liability that are unrelated to the prior profitability based incentives. Even small changes to the balance sheet can make a difference to managers as debt covenants are set tightly and violations are common (Dichev and Skinner 2002). 2 In addition, financial ratios are often used by debt rating agencies in determining credit ratings, which may affect performance pricing provisions or future debt contract negotiations. In summary, the adoption of SFAS 158 has the potential to have a large impact on the ratios commonly used in debt contracting if previously unrecorded retirement liabilities are recognized on the balance sheet. This leads to the following hypotheses: HYPOTHESIS 1a. After the adoption of SFAS 158, companies with debt contracting incentives will have a larger increase in the retirement plan funded status. HYPOTHESIS 1b. After the adoption of SFAS 158, companies with debt contracting incentives will make larger PBO or APBO decreasing changes to the assumptions used to estimate the retirement plan obligations. The second incentive relates to the magnitude of the unrecorded retirement liability. Larger retirement obligations are more likely to make a material difference to the financial statements. Asthana (1999) documents that the more underfunded a firm s pension plan is, the more likely managers are to make PBO decreasing actuarial pension choices. Similarly, companies with large postretirement obligations reduced retiree health care benefits after adopting SFAS 106 (Mittelstaedt et al. 1995) and tend to select more obligation decreasing postretirement assumptions (Amir and Gordon 1996). As discussed above, SFAS 158 requires recognition of the retirement plan funded status on the balance sheet, whereas previously this information had been partly disclosed and partly recognized. Prior research has documented that the capital market assigns a greater weight to recognized items than disclosed items (see, e.g., Picconi 2006; Davis-Friday et al. 2004; Chen and Schoderbek 2000; Davis-Friday et al. 1999; Aboody 1996). 3 Because of this and for other 7

10 contracting reasons, managers perceive recognized amounts to be different from disclosed amounts and this affects their actions (see, e.g., Bens and Monahan 2008; Brown and Lee 2007; Carter et al. 2007; Johnston 2006; Aboody et al. 2004; Imhoff and Thomas 1988). Therefore, I expect management s incentives to be different after adoption of SFAS 158, when previously disclosed retirement obligations became recognized on the balance sheet and the larger the previously unrecorded amounts the stronger the incentives to minimize their impact. This leads to the following hypotheses: HYPOTHESIS 2a. After the adoption of SFAS 158, companies with a larger unrecorded retirement liability will have a larger increase in the retirement plan funded status. HYPOTHESIS 2b. After the adoption of SFAS 158, companies with a larger unrecorded retirement liability will make larger PBO or APBO decreasing changes to the assumptions used to estimate the retirement plan obligations. Management s incentives are also related to the ability to fund the retirement plan through either operating profits or returns on existing retirement assets. Companies whose retirement plan assets are earning a poor return on investment and that are unable to fund the retirement plan due to weak operating cash flows have incentives to manage the actuarial assumptions. Asthana (1999) finds that companies with lower cash from operations tend to make PBO decreasing actuarial pension choices. Similarly, Healy and Palepu (1990) find that firm s adopt income increasing (PBO decreasing) pension accounting assumptions during the four years surrounding a near violation of a dividend covenant, but attribute this to changes in operating cash flows, not the dividend covenant. Finally, Eaton and Nofsinger (2004) document that government sponsors of public pension plans facing financial constraints are more likely to make obligation decreasing retirement assumptions. As discussed above, the incentives to reduce the retirement obligation are expected to be stronger after the adoption of SFAS 158 because previously disclosed obligations will be recognized on the balance sheet potentially triggering debt contract provisions. Companies 8

11 without the ability to fund the retirement plan through operating cash flows or returns on existing assets have a stronger incentive to minimize the liability through changing the actuarial assumptions. This leads to the following hypothesis: HYPOTHESIS 3. After the adoption of SFAS 158, companies with less ability to fund the retirement plan will make greater PBO or APBO decreasing changes to the assumptions used to estimate the retirement plan obligations. It is unclear what the relation between the ability to fund the retirement plan and the change in the funded status will be. If hypothesis 3 is correct then there would be a negative relation between the ability to fund the plan and the funded status, due to managing the assumptions to decrease the obligation. However, there may also be a positive relation because companies with strong operating cash flows have the resources to fund the retirement plan and strong returns on plan assets also increase the funded status. Therefore, I make no predictions about the relation between the ability to fund the retirement plan and the change in the funded status. Finally, Watts and Zimmerman (1990) propose that size is a proxy for political attention and, therefore, larger companies are more likely to make accounting choices that reduce profits. In recent years some larger companies, such as Ford and General Motors, have come under SEC scrutiny for possibly changing their retirement plan assumptions to make the retirement plans look healthier (Solomon and Hawkins 2005; Schultz 2004). Therefore, managers of larger companies have incentives to make PBO/APBO increasing (net income decreasing) retirement assumptions to avoid political scrutiny. In addition, smaller companies might be at greater risk of having their debt ratings downgraded if they were to recognize a liability. Regulators are sometimes less stringent with larger companies (O Hara and Shaw 1990) and D Souza et al. (2001) find that larger companies were more likely to elect immediate recognition of a liability upon adoption of SFAS 106. This leads to the following hypotheses: 9

12 HYPOTHESIS 4a. After the adoption of SFAS 158, smaller companies will have a larger increase in the retirement plan funded status. HYPOTHESIS 4b. After the adoption of SFAS 158, smaller companies will make larger PBO or APBO decreasing changes to the assumptions used to estimate the retirement plan obligations. 3. Research Design Empirical models and variable definitions This study investigates three related research questions. First, why is there an improvement in the funded status of retirement plans after the adoption of SFAS no. 158? Second, is the improvement in the funded status of retirement plans after the adoption of SFAS 158 associated with management s contracting and other incentives to manage the balance sheet by reducing the recognized retirement liability? Third, did companies with contracting and other incentives manage the assumptions used to estimate the retirement obligation to a greater extent after the adoption of SFAS 158? To answer the first research question, I collect data from the sample firm s retirement plan footnote on the reasons why the funded status changed. The empirical models used to investigate the second and third research question are discussed below. Changes in the funded status of defined benefit pension plans To answer the second research question, I begin with a model explaining the changes in the pension plans funded status: ΔFS_PEN it = β 0 + β 1 MKTRET it + β 2 DEBT it-1 + β 3 ΔNW it + β 4 UNREC_PEN it-1 + β 5 ΔCFO it + β 6 SIZE it + β 7 ΔEMP it + β 8 DURATION it +β 9 FIRMAGE it + β 10 FREEZE_PEN it + β 11 FAS158 + β 12 DEBT it-1 *FAS158 + β 13 ΔNW it *FAS158 + β 14 UNREC_PEN it-1 *FAS β 15 ΔCFO it *FAS158 + β 16 SIZE it *FAS j IND j + 24 yyear y + ε it (1) j 0 2 y 0 The dependent variable (ΔFS_PEN it ) is the change in the pension plan funded status deflated by total assets, where the funded status is defined as pension plan assets less the PBO. 4 As discussed in section 2, there are several reasons why the funded status of the pension plan can 10

13 change, and in their footnote disclosures companies typically break down the change in the PBO into several standard categories. In addition to the total change in the funded status (ΔFS_PEN_TOT it ), I also examine the change in the funded status due to changes in all actuarial assumptions (ΔFS_PEN_ACT it ) and due to plan amendments (ΔFS_PEN_AMD it ). I estimate model (1) three separate times for each of the dependent variables. 5 Each dependent variable is defined such that a decrease in the PBO, which increases the funded status, is a positive number. This information was hand-collected from the retirement plan footnote for all companies and all years. All data requiring hand collection are noted in the variable description below; the remainder of the data are obtained from Compustat. The first independent variable (MKTRET it ) controls for the change in the funded status due to changing market conditions. Retirement plans typically invest in a mix of stocks and fixed income investments. As the stock market grows or declines and fixed income investment yields change, retirement plans realize gains or losses on the retirement plan assets. MKTRET it is defined as the return on large company stocks (from Ibbotson s Stocks, Bills, Bonds, and Inflation) weighted by the percentage of pension plan assets held in equity investments plus the yield on high quality corporate bonds (average of the yield on corporate bonds rated Aaa and Baa by Moody s as reported in the monthly Federal Reserve statistical release) weighted by the percentage of pension plan assets held in debt and other investments. The percentage of pension plan assets held in equity and debt investments is from Compustat and hand-collected if missing. The next two variables (DEBT it-1 and ΔNW it ) are proxies for the existence of debt contracting incentives. 6 Performance pricing provisions are often based on debt-related financial ratios or on credit ratings, which are affected by debt-related financial ratios (Asquith et al. 2005). In addition, Duke and Hunt (1990) and Press and Weintrop (1990) find that leverage ratios capture the existence of common debt covenant restrictions. 7 I use the ratio of total liabilities to total assets (DEBT it-1 ) as a measure of leverage. 8 Beginning of the year leverage is used to capture the level of 11

14 leverage before any changes to the pension liability recorded that year. In addition to a leverage variable, I also include a proxy for one of the most commonly violated debt covenants net worth. Press and Weintrop (1990) find that 46% of their sample companies had net worth restrictions, and Sweeney (1994) finds that net worth covenants are the most commonly violated debtcovenants (60% of sample companies). Following Sweeney (1994), I use the change in net worth (deflated by total assets) as a proxy for changes in the tightness of a firm s net worth debtcovenants (ΔNW it ). The magnitude of any unrecognized pension assets or liabilities is captured by UNREC_PEN it-1, which is the beginning of the year pension plan funded status less the amount recognized on the balance sheet, deflated by total assets. Similar to the leverage variable, I use the beginning of the year funded status to capture the extent of any unrecognized amounts before changes to the balance sheet that year. As UNREC_PEN it-1 would be negative for companies with unrecognized liabilities (and positive for unrecognized assets), I expect a negative relation between UNREC_PEN it-1 and the change in the funded status. As a proxy for the ability to fund the pension obligation out of operating income, I use the average change in cash from operations over the past three years, deflated by total assets (ΔCFO it ). Finally, firm size (SIZE it ) is defined as the log of the market value of equity. I include several control variables (ΔEMP it, DURATION it, FIRMAGE it, FREEZE_PEN it, IND j, and YEAR y ). The change in the number of employees deflated by total assets (ΔEMP it ) controls for changes in the growth or decline in the pension plan due to events like expansion or restructuring. Managers of older companies and companies with pension plans with a shorter duration might have different incentives. For example, for pension plans with a shorter duration, the interest cost component of pension expense is often larger than the service cost component and managers may find it beneficial to decrease the discount rate. I control for both duration and the age of the firm. DURATION it is defined as the accumulated benefit obligation divided by the 12

15 projected benefit obligation. Both the accumulated benefit obligation and the projected benefit obligation are from Compustat and are hand-collected if missing. FIRMAGE it is defined as the number of years that Compustat has reported information on the company. There has been an increase in the number of companies freezing their pension benefits in recent years and companies with a higher unfunded pension liability prior to the adoption SFAS 158 in 2006 are more likely to freeze their pension benefits (Beaudoin et al. 2010; Campbell et al. 2010). I control for pension benefit freezes with FREEZE_PEN it, which is an indicator variable that is 1 if there was a hard freeze (complete freeze of all future benefits), soft freeze (freeze of some but not all future benefits), or closed freeze (plan closed to new employees) during the year, and 0 otherwise. Benefit freezes were identified by reading the retirement footnote disclosures for each sample company each year. Finally, included in each regression, but not reported in the tables, are dummy variables to control for industry differences at the one-digit SIC code level (IND j ) as well as year dummy variables to control for year-specific effects (YEAR y ). To test whether the post-sfas 158 time period is different, I interact each of the incentive-related variables (DEBT it-1, ΔNW it, UNREC_PEN it-1, ΔCFO it, and SIZE it ) by a dummy variable that is 1 after the adoption of SFAS 158, and 0 otherwise (FAS158). I estimate model (1) with and without the interaction terms. Changes in the funded status of other postretirement plans For postretirement plans, I estimate the following models: ΔFS_OPEB it = α 0 + α 1 MKTRET t + α 2 MEDACT it + α 3 DEBT it-1 + α 4 ΔNW it + α 5 UNREC_OPEB it-1 + α 6 ΔCFO it + α 7 SIZE it + α 8 ΔEMP it + α 9 FIRMAGE it + α 10 FREEZE_OPEB it + α 11 FAS158 + α 12 DEBT it-1 *FAS158 + α 13 ΔNW it *FAS158 + α 14 UNREC_OPEB it-1 *FAS α 15 ΔCFO it *FAS158 + α 16 SIZE it *FAS j IND j + 22 yyear y + ε it (2) j 0 2 j 0 This model is very similar to model (1) with a couple of differences. ΔFS_OPEB it is the change in the funded status of the postretirement plan, deflated by total assets and 13

16 UNREC_OPEB it-1 is the beginning of the year postretirement plan funded status less the amount recognized on the balance sheet. Similar to pension plans, I examine the total change in the funded status (ΔFS_OPEB_TOT it ), the change in the funded status due to changes in actuarial assumptions (ΔFS_OPEB_ACT it ), and the change in the funded status due to plan amendments (ΔFS_OPEB_AMD it ). Similar to model (1), I estimate model (2) three separate times for each of the dependent variables, as well as with and without interaction terms. In addition, I include the variable MEDACT it to capture the effect of the Medicare, Prescription Drug, Improvement, and Modernization Act of For most companies this Act reduced their retiree health care costs and therefore reduced the APBO. Finally, the duration variable is excluded from the model as it relates to the duration of pension plans only. All data specific to postretirement plans were handcollected from the retirement plan footnote. 9 Retirement assumptions To answer the third research question, I directly investigate the assumptions made by management when measuring the pension PBO and postretirement APBO. Three commonly disclosed assumptions are the discount rate, the rate of compensation increase, and the initial and ultimate healthcare cost trend rate. Note that the change in the PBO and APBO due to changes in actuarial assumptions includes these assumptions as well as other assumptions that are not disclosed such as employee turnover, mortality rates, years to retirement, etc. In addition, there is very little variation in the ultimate healthcare cost trend rate (for most companies it is 5 percent) and the following analyses focus on the initial trend rate. I estimate the following models: ΔDISC it = γ 0 + γ 1 YIELD t + γ 2 DEBT it-1 + γ 3 ΔNW it + γ 4 UNREC_PEN it-1 + γ 5 ΔCFO it + γ 6 ΔASSETS_PEN it + γ 7 SIZE it + γ 8 ΔEMP it + γ 9 DURATION it + γ 10 FIRMAGE it + γ 11 FREEZE_PEN it + γ 12 FAS158 + γ 13 DEBT it-1 *FAS158 + γ 14 ΔNW it *FAS158 + γ 15 UNREC_PEN it-1 *FAS158 + γ 16 ΔCFO it *FAS158 + γ 17 ΔASSETS_PEN it *FAS158 + γ 18 SIZE it *FAS j j IND j + 26 yyear y + ε it (3) y 0 14

17 ΔRCI it = η 0 + η 1 DEBT it-1 + η 2 ΔNW it + η 3 UNREC_PEN it-1 + η 4 ΔCFO it + η 5 ΔASSETS_PEN it + η 6 SIZE it + η 7 ΔEMP it + η 8 DURATION it + η 9 FIRMAGE it + η 10 FREEZE_PEN it + η 11 FAS158 + η 12 DEBT it-1 *FAS158 + η 13 ΔNW it *FAS158 + η 14 UNREC_PEN it-1 *FAS158 + η 15 ΔCFO it *FAS158 + η 16 ΔASSETS_PEN it *FAS158 + η 17 SIZE it *FAS j IND j yyear y + ε it (4) y 0 7 j 0 ΔHTR it = θ 0 + θ 1 DEBT it-1 + θ 2 ΔNW it + θ 3 UNREC_OPEB it-1 + θ 4 ΔCFO it + θ 5 ΔASSETS_OPEB it + θ 6 SIZE it + θ 7 ΔEMP it + θ 8 FIRMAGE it + θ 9 FREEZE_OPEB it + θ 10 FAS158 + θ 11 DEBT it-1 *FAS158 + θ 12 ΔNW it *FAS158 + θ 13 UNREC_OPEB it-1 *FAS158 + θ 14 ΔCFO it *FAS158 + θ 15 ΔASSETS_OPEB it *FAS158 + θ 16 SIZE it *FAS j IND j yyear y + ε it (5) y 0 5 j 0 The dependent variable in model (3) is the industry adjusted change in the discount rate used to estimate the PBO (ΔDISC it ). The dependent variable in model (4) is the industry adjusted change in the rate of compensation increase used to estimate the PBO (ΔRCI it ). The dependent variable in model (5) is the industry adjusted change in the initial healthcare cost trend rate used to estimate the APBO (ΔHTR it ). The healthcare cost trend rate is hand-collected from the retirement plan footnote, and both the discount rate and the rate of compensation increase are obtained from Compustat and checked against the retirement plan footnote. 10 The retirement plan assumptions should be relatively homogeneous across companies in the same industry (Hann et al. 2007; Amir and Gordon 1996). In addition, companies in the same industry face similar pressures to attract and retain employees by providing compensation levels commiserate with market rates of employee compensation. Following Hann et al. (2007), I derive the discretionary component of the pension assumptions as the deviation from the industry median. The independent variables are the same variables used to estimate models (1) and (2) with two exceptions. First, for model (3) a variable is added to control for current market discount rates. As discussed in section 2, the SEC requires companies to use the yield on high quality corporate bonds as the discount rate for calculating the PBO and APBO. YIELD t is defined as the 15

18 yield on high quality corporate bonds (average of the yield on corporate bonds rated Aaa and Baa by Moody s as reported in the monthly Federal Reserve statistical release). Second, I added an additional variable to capture the ability to fund the pension plan. When the retirement plan assets earn a higher return, the need to fund the plan is lower and therefore the incentive to manage the PBO and APBO is lower. I define the variable ΔASSETS_PEN (OPEB) it as the percentage change in the pension (postretirement) plan assets. Sample selection and descriptive statistics To select the final sample of companies, I begin with all companies incorporated in either the United States or Canada for which Compustat reports the necessary pension and other data required to calculate the variables over the period 2003 to 2006, except for the variables noted in the previous section as hand-collected. The sample period begins with 2003 as this is when SFAS No. 132 (R), which specified the disclosure of some of the required retirement data, became effective (FASB 2003). Because I am comparing the period pre and post-sfas 158, I exclude companies that do not have the necessary data for the entire 2003 to 2006 time period. Otherwise, the results could be related to the sample having different characteristics in the pre and post-sfas 158 periods. For example, if companies who terminate their pension plan or companies who are acquired by other companies tend to have fully funded plans, then this may cause the post-sfas 158 time period to look worse than it really is. It may also cause the interaction variables to be significant in the post-sfas158 period because the sample changed over time, not because management s incentives were different. Managers of companies for which the retirement obligation is an insignificant portion of their total liabilities have different incentives and might behave differently than managers of companies where the retirement plan is a material part of the balance sheet. Therefore, I exclude from the sample all companies where the combined PBO and APBO (as reported by Compustat) is less than ten percent of total liabilities. This results in a final sample of 433 companies, 355 of 16

19 which have postretirement plans. In each regression, outliers were removed by excluding the top and bottom 1% of all variables. Table 1 provides some descriptive information about the sample companies and the regression variables. Any data hand-collected from the retirement plan footnotes are noted above in the variable definition; all other data are from Compustat. Table 1, panel A reports information for the entire sample of companies with pension plans. The average sample firm is large with a mean market value of equity of $7,484 million. The average firm has also been in business a long time 35 years. This is expected as it is the companies in older, established industries that tend to have defined benefit pension plans. Many newer companies offer defined contribution plans. The mean duration of 91% is also very high. This reflects the growing number of retirement plans where the benefits have been frozen in recent years. In addition, the average firm reports increasing net worth and debt levels that are 64% of total assets. Finally, retirement obligations are a material part of the sample companies balance sheets, with the retirement obligation as a percentage of total liabilities ranging from 17.1% for the 10 th percentile to 93.4% for the 90 th percentile. Table 1, panel B reports information on the postretirement plan variables for the subsample of companies with postretirement plans. This sub-sample is also large, with a mean market value of equity of $8,984 million. The change in operating cash flows, change in net worth, and leverage ratios (untabulated) are similar to the full sample. [Insert Table 1] 4. Results Descriptive information about the funded status and retirement assumptions over time Table 2, panel A reports the average funded status over the period 2003 to 2006 for the sample of 433 companies with defined benefit pension plans. As expected, pension plans were underfunded during the entire sample time period, which follows a sharp decline in the stock 17

20 market from 2000 to The funded status remained at a pretty constant underfunding of $324 to $343 million from 2003 to In 2006, there was a $207 million increase in the average funded status, which is significantly larger than the average change in the previous three years. This is partly due to a 15.8% average stock return leading to a return on pension plan assets of $289 in Although this explains part of the increase in the funded status in the post-sfas 158 time period, the return is not statistically different from the return in the previous three years. In addition, the funded status increased due to contributions made by the firm and decreased due to the accrual of additional service cost and interest cost, all of which are not statistically different in the pre and post-sfas 158 time periods. The change in funded status could also be related to management incentives to improve the funded status and avoid recording a pension liability under SFAS 158. During the 2003 to 2005 time period the funded status decreased on average by $125 to $128 million due to changes in actuarial assumptions. In contrast, in 2006, there was an increase in the funded status of $44 million on average due to changes in actuarial assumptions, which is significantly larger than the previous three years. 11 Finally, the funded status improved due to both plan amendments and plan freezes, although only the change due to plan amendments is statistically significant. [Insert Table 2] Table 2, panel B reports the average funded status over the period 2003 to 2006 for the sub-sample of 355 companies with postretirement plans (as well as pension plans). The Employee Retirement Income Security Act of 1974 (ERISA) established minimum funding requirements for pension plans, which is why all companies have a substantial amount of pension plan assets. In contrast, only a small portion of the postretirement plans are funded. Similar to pension plans, there was an improvement in the funded status in 2006 (increase of $62 million) and at least a portion of this improvement is related to a $41 million increase in the funded status on average due to changes in actuarial assumptions. In addition, many postretirement plans were amended 18

21 over the period 2003 to 2006 to reduce benefits and cap rising healthcare costs. This is reflected in the increase in the funded status each year due to amendments, with the largest average increase of $68 million in Table 3 reports the distribution of discount rates (panel A), rates of compensation increase (panel B), and the initial health care cost trend rate (panel C) over the period 2003 to 2006 for all sample companies. In 2006, the median discount rate increased from 5.65% to 5.86% and the discount rate also increased across all percentiles. The median rate of compensation increase has remained steady at 4% over the sample time-frame. The rate of compensation increase in all percentiles (10 th, 25 th, 75 th, and 90 th ) decreased over the period 2003 to 2005 and then increased in Finally, the median healthcare cost trend rate has declined over time from 10% in 2003 to 9% in 2006, and has also declined across all percentiles. [Insert Table 3] Table 4 reports the distribution of the mean changes in the assumptions across companies for the pre-sfas 158 period ( ) and the post-sfas 158 period (2006). The sample is broken down into companies with low, medium, and high levels of debt (panel A), unrecorded retirement assets or liabilities (panel B), actual return on retirement plan assets (panel C), and small, medium, and large companies (panel D). Because many postretirement plans are unfunded, there is not much distribution in the return on postretirement plans and nothing is presented for the change in the initial healthcare trend rate in panel C. In 2006, the discount rate increased on average and this increase was higher for companies with high levels of debt (0.21 vs. 0.18) and companies with the smallest return on pension plan assets (0.22 vs. 0.17). Although the magnitude of the increase in the discount rate is small, it can still have a large impact on the PBO. In addition, the change in the initial healthcare cost trend decreased on average in both the period before and after SFAS 158, and the decrease was the largest for companies with high levels of debt in 2006 (- 0.41) and highest unrecorded liabilities (-0.36; low category in panel B). 19

22 [Insert Table 4] Regression results for changes in the funded status of defined benefit pension plans The results from estimating model (1) for all sample companies with pension plans are reported in Table 5. Columns (1) and (2) report the results for the total change in the funded status ((ΔFS_PEN_TOT it ). The first column reports the results with no interaction terms and the second column reports the results of the expanded model that includes interaction terms to test whether the post-sfas 158 time period is different. The results for the change in the funded status due to changes in actuarial assumptions (ΔFS_PEN_ACT it ) and plan amendments (ΔFS_PEN_AMD it ) are reported in columns (3) and (4), and (5) and (6), respectively. [Insert Table 5] Columns (1) and (2) report a positive and significant relation between the total change in the pension plan funded status and the market return (MKTRET it ). At least a portion of the change in the funded status can be explained by changes in market conditions. The variable controlling for expected growth or decline in the size of the retirement plan (ΔEMP it ) is negatively related to ΔFS_PEN_TOT it (p<0.01). As the number of employees decreases, the funded status of the pension plan improves, perhaps because the retirement obligation is lower. Finally, there is a positive relation between ΔFS_PEN_TOT it and DURATION it (p<0.01). This relation is not surprising as many companies have a high duration due to freezing or reducing plan benefits and you would expect to see a corresponding increase to the pension plan funded status. Contrary to expectations, in the pre-sfas 158 sample period there is a negative relation between ΔFS_PEN_TOT it and DEBT it-1 (p<0.05) and a positive relation between ΔFS_PEN_TOT it and ΔNW it (p<0.01). This is consistent with companies having better financial prospects, as seen by lower debt and higher net worth, increasing funding to the pension plan. However, if the reasons for the change in the funded status are considered, it is apparent that this is not the only 20

23 explanation. The results in columns (3) and (4) show that the negative relation with DEBT it-1 and the positive relation with ΔNW it are present when the dependent variable is the change in the funded status due to changes in actuarial assumptions (ΔFS_PEN_ACT it ). In the pre-sfas 158 time-period when the entire retirement obligation was not on the balance sheet, other incentives may have taken precedence over debt contracting incentives. For example, companies with high rates of collective bargaining use more financial leverage to improve union negotiating positions (Matsa 2010) and D Souza et al. (2001) find that more unionized companies were more likely to adopt SFAS 106 immediately as the larger retirement obligation gave the company bargaining power in future labor negotiations. The negative relation between DEBT it-1 and the change in the funded status in the pre-sfas 158 time period is consistent with the findings in these studies. As reported in columns (2), (4), and (6), the coefficient on the DEBT it-1 *FAS158 interaction variable is positive and significant when the dependent variable is total changes in the funded status (p<0.01), actuarial changes (p<0.01), and changes due to amendments (p<0.05). After the adoption of SFAS 158, companies with high levels of debt at the beginning of the year are more likely to have an increase in the pension plan funded status due to both changes in actuarial assumptions and amendments to the pension plan. This supports hypothesis 1a; companies with debt contracting incentives had a larger improvement in the funded status of the pension plan after they were required to move pension assets and liabilities from the footnotes to the balance sheet. In addition, supporting hypothesis 2a, the coefficient on the UNREC_PEN it- 1*FAS158 interaction variable is negative and significant (p<0.01) when the dependent variable is total changes in the funded status, actuarial changes, and changes due to amendments. This variable is negative if there is an unrecorded pension liability, and the negative coefficient indicates that companies with a higher unrecorded pension liability tend to have increases in the pension funded status in the following year due to both changes in actuarial assumptions and plan amendments. Finally, the negative coefficient on the SIZE it *FAS158 interaction variable (p<0.01) 21

24 supports hypothesis 4a. Smaller companies had a larger increase in the total pension funded status and the portion of the change in the funded status due to actuarial assumptions. Regression results for changes in the funded status of other postretirement plans The results from estimating model (2) for the subsample of companies with postretirement plans are reported in Table 6. Columns (1) and (2) report the results for the total change in the funded status ((ΔFS_OPEB_TOT it ). The first column reports the results with no interaction terms and the second column reports the results of the expanded model that includes interaction terms to test whether the post-sfas 158 time period is different. The results for the change in the funded status due to changes in actuarial assumptions (ΔFS_OPEB_ACT it ) and plan amendments (ΔFS_PEN_AMD it ) are reported in columns (3) and (4), and (5) and (6), respectively. [Insert Table 6] As expected, there is a positive and significant relation between the variable controlling for the effect of the Medicare Prescription Drug, Improvement and Modernization Act (MEDACT it ) and both the total change in the postretirement plan funded status (ΔFS_OPEB_TOT it ) and the portion of the change due to changes in actuarial assumptions (ΔFS_OPEB_ACT it ). Similar to the results with pension plans, the change in the number of employees (ΔEMP it ) is negatively related to ΔFS_OPEB_TOT it (p<0.01). In contrast to the results with pension plans, the relation between the change in the postretirement plan funded status and market returns (MKTRET it ) is not statistically significant. This is not surprising as many of these plans are unfunded. For the entire sample period, columns (1) and (2) report a positive relation between DEBT it-1 and ΔFS_OPEB_TOT it (p<0.01) and a negative relation between UNREC_OPEB it-1 and ΔFS_OPEB_TOT it (p<0.01). It can be seen from columns (5) and (6) that this relation is due to changes in the funded status due to plan amendments, which is consistent with the findings of 22