Under the rule US accounting rule FAS 87, a company with a defined benefit (DB) pension plan can ‘assume’ a certain rate of return on the assets in which the plan invests. The assumption is usually based on a five-year moving average of recent annual returns, but the Financial Accounting Standard Board (FASB) makes no explicit requirement to reveal what methodology is used, asking only that the approach be consistent over time. If pension returns are realised above the assumed rate, companies may accrue the excess returns directly to earnings over the average life of a pension plan. If returns fall short of the assumed return, the loss does not have to be realised right away, but again, can be accrued. This system of spreading gains and losses over up to 15 years is named ‘smoothing’.
More and more Wall Street analysts and other financial professionals are pointing out that ‘smoothing’ obfuscates true operating earnings and are calling for a change, especially after the last three downmarket years have started affecting seriously DB pension plans and their corporate sponsors. While the stock market was sky-rocketing in the 1990s, US companies used the excess performances to boost their bottom line and also raised their assumed rate of returns: nowadays the average is an annual 9.25%, according to Ryan Labs Inc, a New York-based quantitative firm. If the assumed rate were lower – for example 6.5%, the “fair” rate according to Warren Buffett – it would mean for a company to contribute more to its DB plan in order to make it funded enough to match its liabilities. Robert Arnott, chief executive officer of Pasadena-based investment manager First Quadrant LP, in a recent academic paper writes: “In 2000 and 2001 earnings from the S&P 1500 totalled $524bn (E484bn) and $252bn, respectively, with P/E ratios of 25 and 46 times earnings. If pension return assumptions had been dropped by 3%, then reported earnings would have been $474bn and $202bn, respectively, and the year-end P/E ratios would have been 28 and 58 times earnings. Today’s P/E ratio would rise from 60 to 80 times current depressed earnings”.
Some politicians believe FAS 87 is misleading. Representative Robert Matsui, a California Democrat, in a letter to FASB wrote that current accounting rules “create the potential for overstatement of corporate earnings and create incentives to corporations to over-invest pension plan assets in stocks”.
Because of so many critics, FASB is planning to reconsider FAS 87. But any reform will encounter the hostility of most actuaries and most corporate executives who defend the rule, including some important institutional investors eg, John Biggs, former chairman and chief executive officer of TIAA-CREF (the $260bn pension system for university teachers) and a trustee of the International Accounting Standards Committee Foundation (IASCF). He explained to IPE that he favours status quo, asking only for more disclosure on balance sheets. “Smoothing is fair,” says Biggs, “as you don’t want financial markets’ volatility to affect corporate operations. The problem is that some companies assume a 6% rate of returns, others assume a 10% rate or even higher. I think 9% should be OK if the assets are invested in stocks, because you have to take into account a certain risk premium in the long term.”
A similar idea, pushed by other investors, is to improve the frequency of information and get quarterly, rather than annual, disclosure of pension plans’ effects on corporate performance, possibly shown on the income statement itself.
A radical solution – proposed among the others by Lawrence Bader, former consulting actuary with Mercer and Salomon Brothers, who is now retired, is instead to value pension plans separately from operating businesses, their value being the pension assets minus the pension liabilities. According to the new system, pension assets should be considered as a common investment portfolio and valued at their market prices; while pension liabilities should be valued using the market discount rates for debt with similar creditworthiness. The whole matter should be seen from the point of view of an investor who buys stock in a company: “He acquires a proportionate share of the company’s pension surplus or deficit,” writes Bader in an article for the American Academy of Actuaries’ magazine.
The price he pays should reflect the price at which the relevant assets and liabilities would currently trade by themselves. When a buyer and seller transact at an off-market price, one party earns an unwarranted profit at the expense of the other”.
Eric Klieber, associate principal with Buck Consultants in Cleveland, disagrees completely. “Unlike most debt,” Klieber replies to Bader, “pension liabilities afford companies considerable flexibility in making payments on a tax-favoured basis”. On the assets side of the problem, Klieber stresses that “rational people invest in equities in the expectation of higher returns over long time period than other types of investment and rational people will take this expectation into account when valuing pension liabilities funded by equities”.
A big battle has just started.