Human Capital & Careers

Defined Benefits, Loose Accounting

For years, corporate earnings -- and hence corporate share prices -- have been bolstered by gains from corporate pension plans. That's likely to end.
David KatzMay 20, 2002

Doing a story on defined-benefit pension plans is a lot like going to a museum of natural history. The word “relic” seems to come up an awful lot.

With good reason, too. For the most part, defined-benefit plans are relics — dusty vestiges of a bygone era when unions were able to negotiate plum retirement plans from employers. Under a defined-benefit setup, a plan sponsor guarantees a specific payout to plan participants. By contrast, defined-contribution schemes — 401(k) plans, for instance — only require employers to guarantee the kick-in, not the payout.

Generally, plan sponsors have found it much easier to guarantee contributions than investment gains. Indeed, over the past two decades, defined-benefit plans have been supplanted by less-onerous defined- contribution plans as the retirement scheme of choice among most employers.

Despite this steady decline in popularity, a fair amount of old-guard companies still operate defined-benefit plans. And many of those companies have benefited mightily from their antiquated defined-benefit plans.

How? Thanks to the magic of pension accounting, defined-benefit plan sponsors are able to treat gains on plan investments as earnings. Given the bull market of the late nineties, that added income has substantially boosted income for many publicly traded corporations.

But expect most of those paper gains to vanish — and soon. For one thing, the bear economy has made the bullish forecasts of the investment returns of many plans look downright Pollyanna.

Moreover, analysts and auditors are beginning to take a dim view of companies that repeatedly use their pension plans to inflate earnings. As reported last week, Standard & Poor’s excluded pension-generated earnings from its much trumpeted “core earnings” metric. S&P’s new earnings gauge is designed to show the true financial performance of a business — and not bookkeeping gains.

Adding injury to insult: S&P’s new earnings metric treats pension payouts as a cost. That’s a big shift from GAAP accounting.

In the coming months, S&P plans to plug its core earnings calculation into its massive database. The rating agency’s newfangled treatment of pension plans will no doubt help lower the earnings of many companies listed on its indices.

Can’t Touch This

But despite the pain, at least one retirement-plan consultant says finance chiefs would do well to follow Standard & Poor’s lead in placing less stress on pension-related income numbers.

“CFOs should be managing their companies to do what their company does and [use the] pension to attract and retain employees,” says John Ehrhardt, a principle and consulting actuary with Milliman USA. “They should look at what their operating earnings look like without the pension plans — and be managing to that number.”

Gains in pension assets, of course, have never really ended up in corporate coffers. “It’s really a negative expense that looks like profits,” he says.

Under GAAP accounting, corporations can take credit on their financial statements for an anticipated gain on pension investments once benefits payments and administrative costs are accounted for. Under GAAP, that excess can be counted toward net income. On the balance sheet, a positive return can appear as an asset or a diminished liability.

But while a defined-benefit plan surplus is a corporate asset, it’s an asst that’s damned near impossible to liquidate. Indeed, surplus pension assets are held in trust funds that corporations can tap only to pay benefits.

The only way a plan sponsor can gain pocket excess pension income is by unraveling the plan — and distributing the benefits via annuities or similar vehicles. That, of course, would mean paying substantial taxes on the money that remains after the benefits are distributed. Says Ehrhardt: “They can’t access that surplus in any tax-efficient method.”

Smooth Operators

Rather than unraveling over-funded plans, companies have used pension investment gains to make up for plummeting corporate revenues. Indeed, thanks to widespread use of asset-smoothing techniques, many plan sponsors have been able to bask in the glow of the nineties bull market long after that boom went bust. (Under FAS 87, companies can spread pension gains and losses over a five-year period, or a shorter timetable.)

Thus, even though the total surplus assets of the pension plans of 50 of the biggest U.S. corporations dropped by $100 billion in 2001, the income of those plans actually rose $4 billion (from $92 billion to $96 billion), according to a survey of the plans by Milliman USA. The firm reckons that at least 22 of those companies use asset-smoothing techniques.

The problem for many of these companies: Their giddy growth projections for their pension investments now look hopelessly out of reach. Even in 2000, when the stock market justified optimism, corporations were overly buoyant in their projections. On average, employers predicted that their pension plans investments would yield a 9.38 percent return, or more than $51 billion. As it turned out, the actual return was slightly less impressive–around $14 billion.

What’s more, it seems experience was a poor teacher. Despite missing their 2000 investment targets by a country mile, corporate forecasters forged ahead and bumped up their predicted pension plan returns for 2001. For that year, plan sponsors forecast their pension plan investments would generate a 9.39 percent return.

They were wrong. Rather than clocking a 9.39 percent investment return, plan sponsors got clocked, losing $36 million on their investments. For the two years, plan sponsors were off by $90 billion in their investment forecasts.

As a result, the pension plans of 28 of the companies surveyed in the Milliman USA study recorded deficits in 2001, with nine showing deficits of more than $1 billion. General Motors, for instance, saw its $7 billion 1999 pension surplus turn into a $9 billion deficit by 2001 — the biggest deficit by far among the companies surveyed.

To be sure, some corporations pension plans were so overfunded that the investment losses, while huge, didn’t cut that close to the bone. While Verizon saw more than half its pension-plan surplus vanish in 2001, that still left the company with a $12 billion surfeit.

“This isn’t a story about benefits not being there,” concedes Ehrhardt, noting that the plans of the companies surveyed still cumulatively sport an $18 billion surplus. But next year, he cautions, some companies will have to inject cash into their plans.

Scylla and Charybdis

This year, CFOs will no doubt feel pressure to slash aggressive pension forecasts.

Such a move will involve considerable pain, however. Lowering the return assumptions could leave a big hole in corporate income statements. In 2001, for instance, cutting the expected rate of return on pension plan investments by one percentage point would have depleted corporate earnings by $5.7 billion, according to the Milliman study.

Nevertheless, if plan sponsors again come in with sky-high forecasts, that may lead auditors and investors to “question all the numbers” on a company’s financial statements, says Ehrhardt.

That’s not a happy scenario for any finance chief — particular a CFO who pushes the bookkeeping envelope. As Ehrhardt notes, some finance chiefs will want to avoid any suggestion “that their companies are milking the pension plan to sweeten the bottom line.”

Even if they are.