Human Capital & Careers

Smoothing Operators

FASB's Robert Herz and IASB's David Tweedie give senators a lesson in how companies can report pension-related gains in years when they've actually...
David KatzJune 15, 2006

Never has the practice of smoothing pension results suffered the deft skewering it did on Wednesday, when the world’s two most powerful accounting standards-setters testified before the Senate Banking Committee.

Tweedie Speaks

The IASB chairman on pension smoothing.

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Responding to the questions of senators worried that tougher accounting standards might drive employers to quit offering pensions altogether, International Accounting Standards Board chairman Sir David Tweedie and Financial Accounting Standards Board chairman Robert Herz poked rhetorical holes in the current system of reporting the assets and liabilities of retirement plans.

The actuarial assumptions companies use to soften the blows of their pension obligations over time might create more of a risk to corporate financials than more transparent accounting, they suggested during the hearing, which focused on FASB’s proposed standard for employer accounting of defined-benefit plans.

In a Scottish brogue that eventually punctuated his punch line, Tweedie ridiculed the opacity of current pension accounting with an example of how smoothing works. “To put it very simply: if we had a pension fund which had assets of $40 million and liabilities of $40 million, and the assets fell by $10 million, you would have a deficit of $10 million. That is not how they’re generally shown. What happens is, we have smoothing mechanisms,” he said.

Under those mechanisms, Tweedie went on, “some of that deficit will be market noise; we measure that at 10 percent of whatever is the higher, liabilities or assets. And liabilities are the higher at 40. We take 4 million off the deficit of 10. We then spread that deficit of 10 million over the active working lives of the employees, say 10 years, and you end up with a deficit shown in the accounts of $600,000. Now, as I’ve often said, explain that one to your grandmother.”

Without missing a beat, the IASB chairman went himself one better: “You may as well take the $10 million and divide it by the cube root of the number of miles to the moon and multiply it by your shoe size. It doesn’t mean a thing.”

Herz seemed more moderate on the overall issue of smoothing, declaring that whether the practice should be eliminated is still a subject for debate. Like Tweedie, however, he was sharply critical of corporate use of an assumed rate of return in calculating the future returns of pension assets.

That assumption helped cause Corporate America’s current pension-underfunding woes, according to the FASB chairman. To prove his point, Herz cited the hypothetical case of a large company with $1 billion in its pension plan invested 60 percent in stocks and 40 percent in bonds. Under current accounting rules, the company could assume a long-term rate of return on its assets of, say, 8 percent.

Assuming an 8 percent return on the $1 billion, the company could report pension-related earnings of $80 million for that year. But if the plan’s assets actually tumbled by $200 million — a typical loss for many pensions in 2001–2002, for example — the difference between the assumed and actual results would be $280 million.

Yet the corporation could spread the reporting of the $280 million difference over 20 or more years, subtracting $14 million a year from its expected pension investment return. Thus, in the year the company might report assumed pension-related earnings of $80 million, “you would net-report pension income that year of $66 million, even though your pension plan went down by $200 million,” explained Herz.

The reasoning behind such calculations was that, over time, negative results would balance out positive ones. “But of course what we found was that, in a number of companies and industries, they did not even out. They went over a cliff,” the FASB chairman said.

Seemingly surprised by the testimony of the two men about the practice of smoothing, Banking Committee chairman Richard Shelby asked Herz how many corporations actually engaged in it. “Everybody does it,” answered Herz. “They don’t have to, but everybody does.”

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