BPEA | 2003 No. 1

Did Pension Plan Accounting Contribute to a Stock Market Bubble?

Julia Lynn Coronado and
Julia Lynn Coronado Board of Governors of the Federal Reserve System
Steven A. Sharpe
Steven A. Sharpe Board of Governors of the Federal Reserve System

2003, No. 1

During the 1990s the assets of corporate defined-benefit (DB) pension
plans ballooned as a result of the booming stock market. Because of
accounting rules for DB plans put in place in 1986, this robust growth
provided a substantial, although stealthy, boost to the profits reported by
sponsoring corporations. In particular, the extraordinary returns earned on
pension assets flowed to the bottom line on corporate income statements
through lower net pension cost accruals included in general corporate
These developments may have misled many investors about the value
of corporate equities, because pension cost accruals provide a fairly convoluted
signal of the underlying value of net pension assets, in two ways.
First, the accounting rules allow firms to smooth the effect of volatility
in asset returns in calculating net pension expense; this smoothing both
hides the variation inherent in the realizations of risky returns and tends
to make current accruals of pension cost a stale measure of a pension
plan’s net asset value. Second, the net costs of financing outstanding
pension liabilities are effectively understated when pension sponsors
assume a future rate of return on plan assets that far exceeds the discount
rate they use to calculate the present value of plan obligations. In effect,
the costs associated with providing a pension plan to employees are offset on the sponsoring firm’s financial statements by a smoothed and inflated
stream of income flowing from the pension portfolio.