Accounting Choice, Economic Environment and Employee Demographics

Abstract

The accounting for defined benefit pension and postretirement benefit plans requires substantial managerial judgment and therefore allows for managerial discretion in the choice of plan assumptions. Previous research has shown that firms tend to increase their assumed discount rates to minimize their Projected Benefit Obligation (PBO) and the magnitude of the increase is negatively related to the duration (time to maturity) of the firm’s pension liabilities, since the impact on the PBO is greater (smaller) the longer (shorter) the duration. Ultimately, the duration of the firm’s plan is a function of the characteristics of the firm’s current workforce relative to its retirees. This paper investigates whether cross-sectional differences in the duration of firms’ plans are related to the firms’ discount rate choices. Specifically, when interest rates are low, firms whose pension plans have short durations may be motivated to lower their discount rates (rather than increase them), since a lower discount rate will decrease their pension expense. We find that for shorter duration firms, duration is positively related to the discount rate. These results, which are contrary to the findings in prior research, are especially relevant in the present climate of low interest rates and more firms freezing their defined benefit pension plans, thereby shortening the duration of their obligations.