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http://www.forbes.com/2002/12/10/cz_em_1210pension.htmlhttp://www.forbes.com/2002/12/10/cz_em_1210pension.html
Pension Panic
Elizabeth MacDonald, 12.10.02, 7:00 AM ET
NEW YORK - When stocks turn south, then the bogeymen start coming out of the woodwork. One of the biggest items spooking Wall Street today is pension accounting.
Most all of the major investment houses--including Bear Stearns (nyse: BSC - news - people ), Goldman Sachs (nyse: GS - news - people ) and Morgan Stanley (nyse: MWD - news - people )--have issued reports filled with earnings warnings about this thorny topic.
The issue is this: Under accounting rules, a profitable company can boost its reported earnings dramatically by using gains from its employee pension plan. That is, if a pension plan has a rise in assets that exceeds the increase in future benefit costs in any given year, that difference is loaded into the company's income statement as a profit.
Trouble is, companies can easily manipulate their expected returns on pension assets to inflate their bottom lines with non-cash, paper gains. The manipulations occur in a company's assumptions about future portfolio returns. The bigger the rate of return, the less money has to be in the bank now to fund future pension payouts.
Not surprisingly, some companies assume long-term returns based on their wildest dreams. Despite the market downturn, lots of companies still say their plans will return 10% or even higher. That's a fool's game.
Trevor Harris, an accounting expert who consults for Morgan Stanley, says the operating income of the S&P 500 companies last year was overstated by an average of 7.2%, up from 5.3% in 2000. And what could get the market really scared, Harris notes, is that pension gains will contribute less in 2002 and 2003, starving the bottom lines. Indeed, while the S&P 500 expected their pension plans to return on average 9.2% in 2001, they actually had an average loss of 6.9%.
Given all that, analysts and investors are increasingly sweating the details about pension accounting, which is loaded with more bells and whistles than a Macy's Christmas window.
It's time for everyone to relax and take a deep breath. We got answers from Jack Ciesielski, an accounting expert who runs the Analysts Accounting Observer newsletter in Baltimore, for the most commonly asked questions about pension accounting.
Forbes: What's the right long-term earnings assumption that companies should use for their pension plans?
J.C.: The rates are probably high for plans that are invested in equities. But it's notoriously hard to tell from the financial statements what a plan's investments are, as there's no required disclosure of asset composition. But getting back to the question: You'd have to know the future of the stock market to be certain if a company is doing it right. At least take a look at the rates in use by the players and draw conclusions about their reasonableness. Put it this way: If single-digit returns in the equity markets are expected to be the norm in the future, a reported double-digit expected return rate is unreasonable.
Are some companies more likely to tinker with the assumed rate of return on assets than others?
Certainly some companies have more to lose if they must drop their expected rates of return. One approach to looking for reasonableness would be to take into account how sensitive a company's earnings are to pension costs: The more significant the pension costs are to earnings, the more a firm might resist lowering its expected rate of return because it would immediately smack earnings. To get a rough estimate of the impact of a firm's operating income for a following year, multiply the ending fair value of plan assets by expected decreases in the expected earnings rate--say, half a percent to a couple percentage points. Multiply the result by one minus the tax rate and you have an idea of the impact on net income. If it's a troubling amount, then the firm might resist a reality check on its expected rate of return.
What have companies been using for their expected long-term returns on assets?
For the Russell 1000, about 59% were using rates ranging from 9% to 10%, and a median of 9.25%. That might not be too reasonable at all if there's a blend of other assets than equities that bear lower return expectations in the combined reported expected return. One could also argue persuasively that such an expected rate might be high just for equities alone. Amkor Technology (nasdaq: AMKR - news - people ) has been using a 12% expected rate; Weyerhaeuser (nyse: WY - news - people ) was using 11%. Meanwhile, Dentsply International (nasdaq: XRAY - news - people ) was using 5%. Indeed, just 24% of the companies in this index had expected returns lower than 9%.
Where is the pension cost shown in the income statement? There's one in the footnotes, but it's nowhere to be found on the income statement.
That's because pension costs are sprinkled throughout the income statement. Just as labor costs are loaded into either cost of goods sold or selling, general and administrative expenses, so is the pension cost. Take note: The figure shown in the footnotes is a net pension cost, not an expense. It's an expense when charged to earnings, but some of it might very well be a cost and stored somewhere on the balance sheet. There's not much one can do to figure out how much of the reported pension cost is tied up on the balance sheet at year-end. No such disclosures are required.
A company says it has more retirees than it does active workers. Does that make it likely to tank?
It may go under for other reasons, but it might actually make sense that it has more retirees than active workers. Consider that companies with defined benefit pension plans are often in industries that are labor intensive but also where great strides have been made in automation and downsizing. It would stand to reason that the number of retirees relate to an era when there was more labor content in the firm's products than in the present. If the firm has been laying off employees and substituting machines for labor, it would make sense there are fewer employees now than retirees. It also means fewer employees to enter the retiree fold.
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