When funding defined, benefit pension plans, firms are required by Federal law to place their sponsored assets into a trust. Any analysis of the sponsor’s stock needs to recognize that stock returns reflect the performance operational and pension plan assets. Insights from such analysis can often be enhanced if the pension returns are extracted from the overall returns. As a result, such insights can improve both the firm’s external and internal analysis. If, for instance, an investment analyst desires to evaluate the market’s perception of a firm’s competitive nature, , removal of the pension returns could sharpen the analyst’s understanding of the performance vis- a-vis its competitors. Likewise, focusing on the firm’s operations could provide a more rational basis towards proper incentive compensation. The analytical problems stemming from a valuation that combines different asset groups into one stock price are particularly problematic in the case of defined benefit pension plans. In general, pension assets are comprised of a well-diversified portfolio of publicly traded securities. A close approximation of the portfolio held by a firm’s pension fund could be readily gathered and held by other pension funds. The operational assets on the other hand, define the firm’s business, competitors, and customers. Pertaining to its operational assets, the firm’s management team distinguishes itself from its competitors through sound articulation and implementation of competitive strategies.. In addition, management’s decisions can modify to a certain degree (at a specific level) the firm’s industry affiliation. Moreover, in contrast to pension assets, operational assets tend to be rather illiquid and difficult to value since the strongest part of a firm can be comprised of attributes not reflected in the financial statements (i.e.,customer loyalty and innovative capabilities).

Successfully “removing” the return on pension assets from market returns depends upon whether and how the market impounds pension returns in equity valuation. Since the latter part of the 1970s, the economic ownership of pension assets had not been resolved. Some had thought that the assets belongingto the employees were completely separate from the firm’s equity valuation, while others considered the association of the firm’s assets to its economic fortunes. A series of studies conducted by the likes of Oldfield, (1977), Feldstein and Seligman(1981), Daley (1984), Landsman (1986), Barth, Beaver, and Landsman (1992), Coronado and Sharpe (2003), and Franzoni and Marin (2006) had reasoned that the value of the pension assets is reflected in the value of the firm’s common stock. The relationship is statistically significant and economically substantive with results suggesting that pension plan assets are valued on a one-to-one basis with the operating assets of the firm. The findings suggest that the returns on pension assets are impounded into equity returns. The empirics of the valuation studies are generally consistent with the idea that US$1 of pension assets corresponds to US$1 of market value. However, the 1:1 relationship overstates theoretical expectations. Black (1980) had posited that the returns on pension assets would be impounded into the stock price on an after tax-basis because of the tax deductibility of the pension contribution. Because the sponsoring firm can deduct the contribution from taxable income, only the after- tax proportion (1- tax rate) of corporate cash is required to create $1 in the pension plan. Consequently, US$1 of returns produced by pension assets should impact the market value of the firm’s stock by US$1(1 - marginal tax rate). Bulow, Morck, and Summers (1987) had argued that US$1 of pension returns may have US$1 of equity value because the contributions to pension funds are constrained at the liability level. In this paper, we assume that pension returns are reduced by the tax rate when they are impounded into the stock’s return. If the 1:1 relationship holds for a given firm, our analysis of the impact would qualitatively apply, but the proportions would change. Both Corronado and Sharpe (2003), as well as Franzoni and Marin (2006), have challenged the effectiveness of the market’s impounding. Neither study had explicitly evaluated the returns of pension assets, but instead, had evaluated the net pension liability. Corronado and Sharpe had found that the market’s valuation tended to rely more on the accounting aspect of the pension rather than that of the economic view. Franzoni and Marin’s results did not support the broad claims of Corronado and Sharpe; they had found that the stock market did not incorporate pension-related, future cash flow information for severely underfunded plans. Zion (2002) had found that effective impounding is hindered by cumbersome and often time non-economic accounting representations. The outcry from the financial community regarding defined benefit reporting resulted in the promulgation of Financial Accounting Standard 158 in September 2006 (Financial Accounting Standards Board, 2006). Being that FAS 158 addresses many of the issues that may have impeded the economic interpretation of pension results, the likelihood of the capital markets correctly impounding the pension performance is enhanced, going forward. Jin, Merton, Bodie (2006) (JMB) had provided an additional support for the equity market’s impounding pension valuations, but had differed from the prior studies in two ways. Firstly, the authors had focused on the relationship between the systematic risk of the firm’s stock returns (instead of the firm’s market value) and the systematic risk of the pension plan. Secondly, JMB characterized their study as “dynamic,” wherein their variables were based on changes instead of levels. JMB had found that the beta of the firm’s stock was influenced by the beta of the pension assets. The impact was theoretically and statistically significant. Like JMB, this paper specifically seeks to examine the dynamic returns of pension funds, but differs from JMB and other studies in that the focus strictly lies on the performance of pension assets without netting the impact of pension liabilities. The rationale is that pension liabilities stem from operational costs (i.e., the salaries of employees). Funding these liabilities before payments are due through the contribution to the pension fund is distinct from the firm’s operations, albeit, legally required. In addition, the returns on the pension assets are much more subject to the sponsor’s specific investment policy, whereas changes in the economic value of pension liabilities stem more from economy-wide changes in interest rates. In sum, we argue that pension returns are the component of pension plans that most confound the interpretation of how the equity market perceives the firm’s operational performance. Moreover, the focus on pension returns allows for greater interpretation of the funding decision. We structured the model to enable a measurement of the firm’s performance as if the pension was funded strictly on a pay-as-you-go basis.

Panel of Table 2 provides the returns on the firm’s common stock, while Panel B highlights the returns on the pension assets.. Panel C (net core returns) shows the implied returns on the stock with the pension returns removed. Stock returns were obtained from CRSP, while pension returns were taken from the 10-K reports of the respective firms. However, disaggregating the pension returns from the overall stock returns required assumptions about what is impounded by the stock market. As discussed in the literature review, our model assumes each US$1 of pension returns increases the market value of the firm by US$0.65, given the 35 percent Federal income tax rate.

systematic risk of the stock using a regression between the stock’s annual returns and the annual returns for the Standard & Poors 500 index return over the 1992- 2004 time period. Beta is typically computed using monthly returns; however, this analysis uses annual returns because pension returns are only reported annually. In order to isolate the influence of pension assets in equity returns, our model of the firm is as follows:

M V f = M V ca + M V pa

The conflict between risk measures stems from the inter-company correlations of pension returns and net core returns. Even though volatility assesses the returns of an asset as an independent set of numbers, many analysts find that a metric measuring how the security relates to a broader portfolio is more relevant. Another view, especially relevant from a portfolio manager’s perspective, concerns the volatility of a representation of the industry as a whole. We construct an “Integrated Oil and Gas” portfolio with equal weights in each security, and then compute the portfolio return.We then analyze the portfolio, pension, and net core return. The return for this portfolio is the arithmetic average of the four returns for each year. Table 4 provides the returns for an equally weighted portfolio for each year. The “Diversification Reduction” column compares the average standard deviation for the four oil companies ((SDHES+SDCVX+SDXOM +SDCOP)/4) with the standard deviation of the portfolio. The percentage difference stems from the portfolio returns being less than perfectly correlated. Because the pension funds are typically well diversified, the relative comparison of the resultswith the diversification impact of combining pension returns being much smaller, is logical. But the degree of difference is surprising. Pension fund diversification only reduces the standard deviation of 10.90% for the average of the four pension standard deviations to 10.11% for the portfolio of four pension funds, and a reduction in volatility of 7.25% ([10.90% - 10.11%/10.90% = 7.25%). On the other hand, the portfolio reduction for the net core returns is over 26%, with the average net core’s standard deviation being 15.60% and the portfolio of net core return’s having a standard deviation of only 11.52 percent, where (15.60%-11.52%)/15.60% = 26.16 percent. The reduction in standard deviation presented above stems from the degree of diversification, serving as a reminder to the basic principles of modern portfolio theory. As Table 5 demonstrates, the correlations among pension returns are much higher than the correlation among net core assets, explaining the diversification difference between the two portfolio combinations. Table 5 presents the correlations across all components.

combinations of the four firms of only 45.6 percent, whereas the correlation among pension assets is 91.6 percent. Even though pension assets have no direct industry affiliation, their performance appears to increase the similarity in the equity market behavior across firms. In other words, the pension assets increase the correlations among the firms from 45.62 percent to 46.88 percent. Pension assets exaggerate the apparent industry affiliation, even though pension assets, in fact, diminish any industry-specific interrelationship. The bottom panel in Table 5 includes the correlations between the pension returns and the net core returns, as well as the correlations between the pension returns and the stock returns. Note that the correlations are always greater for the pension to stock relationship because the stock return includes the pension return. Authors like Haugen(1989) and Jin, Merton, & Bodie (2006) suggest that firms may integrate pension asset allocation into overall firm risk management. The advantage to minimizing the correlation between net core returns and pension returns is that the firm is less likely to experience poor performance from operations when the pension assets are performing poorly. HES, by far, has the lowest correlation. If the relationship from the past holds into the future, HES would have less of a chance in facing binding constraints from being forced to make up for poor pension performance.

While the demonstration was applied to healthy firms with the assumption that shareholders were the sole beneficiaries of pension performance, the model could be widely applied. Neither creditors (for firms at risk of default) nor employees (who would increase claims on retirement income if the pension performed well, Jin, Merton, & Bodie (1996)) were assumed to play a role in this analysis. For firms with some prospect of other claimants on pension assets, the model would be modified to estimate the likelihood of diminished impact of pension returns on stock returns. As discussed, pension assets may confuse the understanding of industry- specific impacts, by increasing the inter-firm correlation, but not for industry-specific events. Such insight is likely to prove useful for external analysts in their attempts to understand the firm’s competitive position going forward. More specifically, a clear understanding of the role of pension returns would help industry-based long- short decisions for hedge funds to interpret the net result of changes in oil prices. For internal analysts, extracting pension returns could help in the assessment of the market’s interpretation of the effectiveness of competitive strategy. Knowledge of the net core assets’ risk factors should enable management to select pension assets that have low sensitivity to firm/industry-specific or firm- specific risk factors (Haugen (1989); Jin, Merton, and Bodie (2006)). Managing pension assets to minimize correlation with the net core assets would diminish the probability that the firm would experience a “double-down” or poor performance from both asset groups simultaneously. Evidence of such management should appear in low correlation between pension returns and net core returns (Table 5). In addition, pension plans can be readily compared within the industry. For example, XOM’s pension has clearly outperformed its competitors in the industry, but only by assuming greater risk, both in terms of beta and standard deviation (Table 2). Comparing pension performance in the context of competitors may allow a rethinking of how the firm wishes to address asset allocation and funding levels. For human resource compensation decisions, compensation plans based on stock performance are clearly impacted by the presence, size, and performance of pension funds. Extracting the pension results from the stock returns would have improved the compensation basis for COB by 42 basis points and CVX by 32 basis points (Table 3). Net core results may or may not have generated greater returns. However, it seems likely that employee options would tend to have more value if based on the more volatile net core returns instead of the sponsor’s stock return.

Author statement: Brooks Marshall (E-mail: marshasb@jmu.edu) is the submitting author. He is a professor of finance at the James Madison University.