Pension Dissension

Companies generally pride themselves on being forward-looking, but many are balking at the idea of looking ahead to future pension obligations and affixing a firm price tag on today's balance sheet. That has emerged as the biggest, but by no means only, bone of contention as companies, the Financial Accounting Standards Board, Congress, the Securities and Exchange Commission, and others grapple with pension-accounting reform.

Most CFOs appear ready to accept the concept that future pension obligations should be reflected on today's balance sheet — 87 percent agreed with that statement in an April survey conducted by Grant Thornton. But if the devil is in the details, so too is the ire, and CFOs say that the manner in which FASB proposes to address the issue is unworkable.

"The medicine may kill the patient," says Alan B. Graf Jr., executive vice president and CFO of FedEx Corp. "We agree with everyone else that the pension rules are complicated and convoluted, and we fully support improvements. But this proposal isn't it."

FASB is championing a two-phase project that would provide guidance for gauging annual pension expenses on the income statement and disclose plan assets and liabilities on the balance sheet and in footnotes. The goal is to make plan information more useful to investors, creditors, and plan participants. As FASB puts it, "Existing standards on employers' accounting for defined benefit postretirement plans fail to produce...faithful and understandable financial statements."

In Phase One of the project, FASB proposes that pension-plan surpluses or deficits currently contained in the financial-statement footnotes be moved instead onto the balance sheet. If FASB makes no changes to its proposal, companies with fiscal years ending after December 15, 2006, will be the first ones affected. Phase Two, a joint initiative with the International Accounting Standards Board that will delve more deeply into pension accounting, is likely to take several years to reach fruition.

That's just as well, because Phase One is causing plenty of jitters. A study by Mercer Human Resource Consulting of the 235 letters received by FASB during the public-comment period on the proposed pension rules found that unfavorable comments outpaced favorable comments 4-to-1. At a June roundtable, FASB board members and the SEC's top accountant faced a barrage of criticisms from companies and actuaries.

Future Tense
At the heart of the matter is a debate over the projected benefit obligation (PBO), a method of determining a company's pension liability by projecting salary increases and other costs far into the future. Many companies, says Jim Verlautz, a principal with Mercer, "have difficulty reconciling an unfunded PBO in the balance sheet with the concept of a liability."

Not without reason. The PBO, as the present value of the future benefit payments accrued to date, includes expected future salary increases (highly relevant, since many pensions are based on how much an employee earns in his or her final year[s] with the company) that would be earned only if the employee continues to render future service to the company. "I simply do not understand why future pay increases would be a current liability on the balance sheet, since they haven't occurred yet," says Graf. "Sure, they're a potential future obligation, but you don't put potential future obligations on a balance sheet today. We're not allowed to consider future earnings in the [pension] trust to offset the pension pay increases. I seriously question the whole way FASB is calculating liability."

"There is a fundamental mismatch here," agrees Mark Harrison, executive vice president and CFO of Allina Hospitals & Clinics, a Minneapolis-based not-for-profit health-care system with $2.2 billion in revenues. "Incorporating salary increases in the PBO as a future liability is not matched by an offsetting asset. We have to take into account this future liability, but don't get to record the future assets associated with having those employees."

Calling the PBO a current liability on the balance sheet also gives pause to actuaries. "How do you measure this precisely?" asks John Ehrhardt, a principal and consulting actuary in the New York office of Milliman. "Salary-increase assumptions depend on lots of things, like inflation and how things are going at the company. To extrapolate from that to figure out future salary expenses and say this is a current liability doesn't make any sense."

Many companies advocate instead the use of a metric known as ABO (accumulated benefit obligations), which doesn't require estimates of future obligations. Some proponents of this approach agree that it can sometimes miss the mark due to complexities posed by lump-sum payments or stock-option expenses that may be embedded in cash-balance plans, but argue that those flaws pale in comparison to a system based on estimating future liabilities. Scott Taub, the SEC's chief accountant, countered at the June roundtable that the SEC is "concerned by people's unwillingness to use estimates" and added, "We're certainly not looking for each number to be 100 percent exact when you book numbers into your financial statements."

But even a modicum of inexactitude can produce some very skewed numbers when factored over many years, companies say. Both Allina and FedEx have studied the sensitivity of pension estimates. "A change of 1 percent in the discount rate used to determine the present value of the PBO would increase or decrease the PBO by $41 million," says Harrison, "introducing significant volatility into the financial statements based on future assumptions." Graf's numbers are equally sobering. "Just one basis point in a discount rate changes our expense calculations by $2.5 million," he says.

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