Stock Market Sensitivity to U.K. Firms' Pension Discounting Assumptions

New U.K. pension accounting regulations significantly increase the exposure of the balance sheets of U.K. firms to volatilities in pension fund valuations. We examine whether the abnormal returns of firms that voluntarily used market-based pension discount rates are significantly different from the abnormal returns of industry-matched pair samples of firms that retained traditional cost-based valuation assumptions during the period surrounding the release of the related exposure draft. We also examine the interest rate sensitivity of stock price returns over the 4-year period before and after the announcement date. Consistent with our hypotheses, U.K. stock price returns incorporate the effect of unexpected interest rate changes on sources of pension earnings for firms that voluntarily switched to market-based assumptions but do not incorporate these effects for firms that did not switch. These results suggest that unexpected changes in interest rates have a differential effect on a firm's sources of pension, financial, and core earnings.