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Death to Smoothing

A tough regulatory environment is another nail in the coffin for defined-benefit plans.
Alix Stuart, CFO Magazine
February 22, 2005

Like Sisyphus, who was condemned to roll a rock up a hill each day only to watch it roll back down again, pension plan sponsors can't seem to make any progress. They poured record amounts of cash into their plans — an estimated $40 billion in 2004 on top of contributions of more than $70 billion in 2003 — to comply with federally mandated minimum funding levels, but mediocre stock market returns, persistently low interest rates, and ballooning retiree populations mean plans are in little better shape than they were in 2002. Now changes to accounting rules could compound the problem, if techniques to smooth volatility in pension obligations are eliminated, as some have threatened. As if that weren't enough, the Securities and Exchange Commission is examining whether some companies toyed with pension plan assumptions to game financial results.

In October, six companies — Boeing, Delphi, Ford, General Motors, Navistar, and Northwest Airlines — announced that the SEC had asked them to provide more information about how they calculate their pension and other retiree-benefit obligations. The commission was seeking data on such assumptions as expected rates of return on assets, discount rates, and projected health-care cost increases.

With no apparent trigger for the timing of the investigation, the corporate world is buzzing with speculation about how and why the companies were chosen. The six under investigation were not those with the highest or even the most erratic rate-of-return assumptions. GM and Delphi, for example, held assumptions steady at 10 percent from 2000 to 2002, and dropped them to 9 percent in 2003. Honeywell, Pfizer, and Delta — companies that are not under investigation — did the same.

"Is it that the assumptions were so outlandish? I'm not so sure about that," says Jack Ciesielski, editor of Analysts' Accounting Observer. In fact, a recent report commissioned by the Committee on Investment of Employee Benefit Assets (CIEBA) put the actual median annualized asset returns for large corporate pension funds at 9.4 percent from 1993 to the end of 2003, higher than the average 8.8 percent return that companies assumed.

Although the SEC was characteristically circumspect about the course of its investigation, its aim is clear. "Among other things, we're looking to see if companies have reverse-engineered the rates to get to a certain financial result," says Kenneth Lench, an assistant director in the SEC's enforcement division. Emphasizing that none of the companies is suspected of any particular wrongdoing, Lench says that "several factors," including the size of the pension plans and other postemployment obligations, went into the selection of the six companies. Since even a small change in rates can have a huge impact on income, he says, "this is an area where we see potentially significant risks, and that's why we're taking a look at it."

Such risks are hardly news to most investors. The vagaries of pension accounting and its impact on income have been well publicized since the market downturn of 2001, and the SEC has been addressing the issue in public speeches and private comment letters ever since. However, with issues of pension reform coming to a head at both the Financial Accounting Standards Board, which governs pension accounting, and Congress, which sets funding and payout requirements, plan sponsors fear that pensions will be less likely to receive the favorable treatment from regulators and legislators they need to stay viable. Even worse, public pressure could force new rules that increase the weight of the plans on firms' balance sheets and income statements.

On Deck at FASB
At FASB, a drive toward convergence with international accounting standards is putting pension accounting under review. While nothing is on its agenda yet, the board could embark on a major pension project as early as 2006, according to FASB practice fellow Gerard O'Callaghan. One possibility is that the SEC would press FASB to eliminate techniques that smooth fluctuations in pension investments, forcing companies to square their assumed returns with actual returns. Critics have long charged that smoothing provides a screen for obscuring the true condition of pension assets, since only the variance between actual and expected returns must be reported. An effort last year to ameliorate the concerns through increased disclosure has met with mixed reviews, and most analysts say they still need more pension information.

The prospect of marking stock assets to market value at the end of every year or every quarter is a fearsome one, however, because of the volatility it would introduce into income. Without smoothing, changes in the stock market "could totally dominate earnings at some companies," says John Ehrhardt, a principal at actuarial firm Milliman. At GM, for example, which has the country's largest pension plan, "you'd be investing in an equity mutual fund that sold cars on the side, rather than an automaker," he says.

And then there are the massive swings in the market such a move could trigger. Nearly half of the managers at major pension funds surveyed said that if smoothing were abolished, they would reallocate an average 9 percent of their assets away from equities and into fixed income to reduce volatility. A swing like that could suck anywhere from $250 billion to $600 billion out of the stock market, according to analyses by Goldman Sachs and Morgan Stanley.

Such an accounting change could also cause more employers to simply freeze their plans. In the United Kingdom, nearly half of the companies on the FTSE 100 stock index have dropped their plans since the United Kingdom began requiring pension assets to be marked to market in 2002.

The good news for employers is that smoothing seems to be safe for at least the next year. Such a change isn't on FASB's agenda as a stand-alone item, according to O'Callaghan. When it does appear, he says, international standard setters will consider both the current FAS 87 standard that governs U.S. companies and the nascent International Accounting Standard (IAS) 19, which does not allow for smoothing to the extent that FAS 87 does. "I expect it will be a project in which everything is open to reconsideration," he says.

Some observers are less hopeful that FASB will have equal say. "The one sure casualty [in international convergence] is asset smoothing," says Ehrhardt, since "everyone's assuming [the final rule] is going to go more toward the IAS route than the current FASB one."

Can Congress Help?
A little help from Congress on pension funding requirements could certainly buffer the effects of accounting reform on companies, whatever the changes turn out to be. "The bells have been ringing pretty hard for three or four years now for fundamental reform," says Kevin Wagner, an actuary with Watson Wyatt in Southfield, Michigan. "Accounting can smooth everything out over time, but funding is a cash issue, here and now."

The recent revelation of the dire financial straits in which the Pension Benefit Guaranty Corp. (PBGC) has found itself (see "The Domino Effect") may in fact be one of the best hopes to galvanize a cleanup of the current patchwork of Employee Retirement Income Security Act rules, which contain both loopholes and nooses for pension plan sponsors. Companies are still allowed to let underfunded plans ride on funding credits that accrued during the years they were overfunded, for example, but they get no incentive for cushioning their plans with added cash due to a ceiling on tax deductions for contributions.

A number of bills are expected to address pension-related issues. The interest rates upon which both long-term and lump-sum liabilities are calculated and the degree to which those liabilities must be covered are likely to be addressed in some form or another. Lobbyists are also pushing hard for a stamp of approval on cash-balance plans that would protect firms from employee lawsuits.

Meanwhile, the interest rates used to calculate lump-sum payouts to retirees do not match up with those used to calculate the same amounts when they are considered as annuities — and the debate over how to replace the defunct 30-year Treasury bond rate for such calculations is still raging, with last year's Pension Funding Equity Act set to expire at the end of the year. "It's crucial that we have a permanent solution to the temporary fix that Congress enacted to replace the 30-year Treasury rate," argues Bill Heitmann, senior vice president of finance at Bedminster, New Jersey-based Verizon Communications Inc., who says Verizon favors using a blended corporate rate. "We need to have certainty [to determine] our pension obligations," he adds.

But a permanent solution is an unlikely outcome. "We'll most likely get another temporary reform measure," says Aliya Wong, director of pension policy at the U.S. Chamber of Commerce. This would make long-term planning for pension funding all the harder.

The difference between economic and political ideals may be stark, however. Wagner and other actuaries would like to see a system in which healthy companies could keep their plans funded to a lower degree than the current minimums, allowing them more leeway in conserving cash until closer to the time when the obligations come due. "If a company is very healthy, it may not need to have its plans as well funded as those that are unhealthy, because it has the financial wherewithal to make contributions when necessary," says Wagner.

Yet politicians are far more comfortable with the idea of requiring more money in the bank, rather than less. "Congress should require companies to fully fund their plans," said Rep. John Boehner (R-Ohio) in a speech before the American Benefits Council. Boehner, chairman of the Committee on Education and the Workforce, wants to change laws that allow companies to skip pension payments when minimum funding levels are met.

The best-case scenario for plan sponsors, then, is likely to be a higher ceiling on the level of tax-deductible contributions a company could make in a given year, which could be helpful in future years when companies have more to contribute. "Companies should be given more latitude as to when they can fund their plans on a tax-effective basis," says Heitmann. "That would create alignment between a company's ability to fund and its long-term need to fund the plan."

Given the intricacies of pension reform, the SEC investigations may ultimately be the least of pension sponsors' worries. No one is expecting the SEC to start setting rates of return, or even mandating methodologies. Instead, the probe is likely to have its intended effect if the commission prompts sponsors "to take a good look at their own assumptions," says Ciesielski. Adds Brian Lane, a partner at Gibson, Dunn & Crutcher LLP in Washington, D.C., and a former SEC official: "I would guess that most companies are going to be able to explain their assumptions to the satisfaction of the SEC. I don't expect we'll see many enforcement cases."

But clearly, without some attention from regulators, there is little hope that keeping corporate pensions from crushing the rest of the corporation will get any easier. As it stands now, the best bet for plan sponsors is to hope for good stock market returns and higher interest rates.

Alix Nyberg is a contributing editor of CFO.

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