Pension plan funding and stock market efficiency. The Journal of Finance, forthcoming

As a consequence of the recent bear stock market, the aggregate funding level of defined ben-efit pension plans has tremendously deteriorated. A relevant issue is whether the market value of the firms sponsoring these plans reflects information about their pension liabilities. In sharp contrast to earlier studies, this paper presents evidence indicating that the market significantly overvalues firms with severely underfunded pension plans. We show that these companies earn lower stock returns than firms with healthier pension plans, and the underperformance persists for at least five years after the first emergence of the large underfunding. Moreover, the low returns are not explained by risk, return momentum, earnings momentum, or accruals. For this reason, we conclude that we have identified an additional layer of mispricing. We propose an explanation where investors do not anticipate the impact of the pension liability on future earnings and cash flows, and they are surprised when the negative implications of underfunding finally materialize. Consistent with this view, we provide significant evidence of market surprises for severely underfunded firms. Finally, these firms have poor operating performance, and the