More questions than answers
How deep will the changes to the pension accounting rules go? How will they affect companies’ financial strategies? Will they trigger the termination of defined benefit (DB) plans in the private sector? These are just a few of the questions haunting the US pension funds’ industry after the Financial Accounting Standards Board (FASB) announced it had added “a project to its agenda to reconsider guidance in statement no. 87, employers’ accounting for pensions” in order to “improve the reporting of pensions and other post-retirement benefit plans in the financial statements by making information more useful and transparent for investors, creditors, employees, retirees, and other users”.
About the decision, made on 10 November, Credit Suisse First Boston (CSFB) analyst David Zion, says: “With both companies and unions complaining about a potential rule change, it could make the expensing of stock options seem like a walk in the park.” This comparison is alarming, because when the FASB finally ruled that options must be expensed, many companies moved to other forms of compensation abandoning options.
Maybe this time will be different. “Perhaps this is a good moment to implement changes of the pension accounting rules,” says Ronald J Ryan, chief financial architect and founder of Ryan ALM. “On one hand it is true that pension funds are currently a drag on companies’ earnings, and if their assets must be expensed according to a mark-to-market value that would add a lot of volatility to companies’ balance sheets. But on the other hand, let’s consider liabilities: from today’s record low level, interest rates will probably go up, at least that is everybody’s bet. That means that pension liabilities cannot grow much from this point. On the contrary, they can experience a negative growth. So companies can have a situation where assets’ growth is a winner and volatility is good.” A perfect combination, one may think, to adjust during a transition, which will last for a while.
“Although this is the board’s highest priority, given the complexity of the task and the ultimate goal of international convergence, this project will take at least three years to complete,” writes Merrill Lynch analyst Gordon Latter in his report about the FASB agenda. Phase one will last all next year and should be based on the recommendations of the 15 June 2005 SEC staff report about improving balance sheet transparency. “The first phase seeks to address the fact that under current accounting standards, important information about the financial status of a company’s plan is reported in the footnotes, but not in the basic financial statements,” the FASB statement says. “Accordingly, this phase will seek to improve transparency by requiring that the funded or unfunded status of DB and other post-retirement benefit plans, measured as the difference between the fair value of plan assets and the current measure of the benefit obligation incurred for past employee service, are recognised in the balance sheet.”
Phase two will affect all aspects of accounting for pension obligations including: “how to best recognise and display in earnings and other comprehensive income the various elements that affect the cost of providing post-retirement benefits; how to best measure the obligation, in particular the obligations under plans with lump-sum settlement options; whether more or different guidance should be provided regarding measurement assumptions; whether post-retirement benefit trusts should be consolidated by the plan sponsor.”
Latter says: “The ultimate goal is mark-to-market. Board members feel strongly that smoothing is public enemy number one and the real economic liability needs to be recognised. As such, FASB will continue to move the project in the direction of the UK standard (FRS17).” Or in the direction of Europe’s IAS 19. FASB chairman Robert Herz has agreed that there should be a worldwide convergence of pension accounting rules.
‘Smoothing’ is the practice amortising over an extended period the difference between forecasted returns on pension assets and actual returns. “Assumptions used by companies to calculate expected returns and future liabilities vary widely,” says Neri Bukspan, managing director and chief accountant with S&P’s credit market services. In the end, financial reports may be inconsistent among peer companies.” If smoothing is abolished, according to S&P research, “one practical consequence that cannot be ignored is that some companies would pursue much more conservative investment strategies in their pension plans, for example, by reducing the holdings of equities in the funding mix in an effort to minimise earnings volatility. Ultimately, this would likely translate into reduced portfolio earnings, to the detriment of many plans.”