COST OF EQUITY CAPITAL AND UNDERSTATED PENSION LIABILITIES

Abstract

Pension discount rates have a powerful effect on the size of reported defined benefit corporate pension liabilities because of the long-term nature of projected benefit obligations. Firms often choose pension discount rates that are above the guideline long-term Treasury, AAA-grade, and AA-grade corporate bond yields. We assess the sizes of understated pension liabilities relative to these benchmark interest rates and relate them to individual firms’ implied cost of equity. We find that firms with large understated pension liabilities have a higher implied cost of equity after taking into account standard control variables and other pension information such as funded status and mandatory contributions.