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Moody's: An Obligation Is a Debt

Posted by Tim Reason | CFO.com | US

January 26, 2006 8:09 AM ET

I had heard whispers of this from a banker source of mine, but now it's official: Moody's is going to start considering pension underfunding to be the functional equivalent of debt and has developed a model to calculate just how much of a liability it represents.

I won't pretend to have even looked at the model � I got this about 20 minutes ago � but it raises interesting questions. After all, pension underfunding does not translate directly into default risk (indeed, I'd guess this will widen the gulf between Moody's credit ratings and Moody's KMV scores). And bottom line, this could further complicate life for companies seeking the proper balance of debt and equity, or the so-called "efficient frontier," because now it gets harder to compare two companies with BBB- ratings if one has a defined-benefit plan and one does not.

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I do not think it will necessarily be harder to compare a company with a defined benefit plan to one without, as inherently a company with a defined benefit plan does have the potential for substantially higher costs in the long term, as at some point in time they are going to have to fund those obligations. Obviously, much of the liability will be in the future, so a short term lender may not be as concerned, but in the long term a company without a defined benefit plan has less risk than one with a under funded benefit plan all other things being equal.

Posted by Steve Ruffini | January 26, 2006 06:27pm

The debate about counting pension obligations as debt is remarkable for the number of participants who won't call a spade a spade. In economic terms, pension obligations are debt just as plainly as long-term leases and insurance company reserves. Their ultimate payment is not optional -- companies that can't or won't pay them go broke. That they can be hard to quantify is no excuse for not starting -- footnotes cover a multitude of sins.

We customarily account for them differently purely because, when a number of years ago it became clear how dangerous unrecognized pension obligations were, it was considered too much of a shock to the system if everyone accounted for them all at once. Now the transition accounting has become quasi-permanent. But any CFO who believes his pension liability is only what the rules currently make him recognize is living in a dream world.

The fact is that a company stuck with an unfunded pension obligation is at greater long-term risk than one that is not; perhaps more importantly in the short term, its cost structure will be higher than its unburdened competitor -- a fact that users of financial statements need to know to assess its viability. In addition, not funding pension obligations as they accrue distorts the cost of producing revenue and overstates profit. Bad information like that produces bad decisions all around. The sooner we stop accepting bad answers because we don't like what the good answer tells us, the better off we'll be.

Posted by Mary Cannon Veed | January 27, 2006 11:34am


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