Pension games: Accounting illusion hides woes
Reuters, 01.07.03, 2:44 PM ET
forbes.com
By Deepa Babington
NEW YORK, Jan 7 (Reuters) - The stock market just wrapped up its third straight year of losses, but when it comes to pension accounting, that reality has yet to catch up with much of corporate America.
Many companies are feeding their bottom line by assuming their pension assets will grow by at least 10 percent in the future, even though the stock market slump shows few signs of abating.
The practice is receiving increasing scrutiny as investors fret over whether companies are using aggressive estimates to pump up earnings.
That's because complex accounting rules require companies to book pension income based on estimates rather than actual losses or gains. As a result, the higher a company forecasts its return on pension plans, the higher its earnings, irrespective of how the pension assets really perform.
At the start of 2002, companies in the Standard & Poor's 500 <.SPX> on average estimated that their pension assets -- the bulk of which are invested in the stock market -- would post lofty returns of 9.3 percent, according to a study by Merrill Lynch.
Some analysts say investors should start getting nervous and question expected return rates above 8 percent or 9 percent since the market is not likely to produce such returns over the long term without the help of another bubble.
"Investors should get worried, first of all, when they see companies with high expected rates of return -- it flies in the face of the move toward more conservative accounting and suggests the company is reaching for earnings," said David Hawkins, an accounting consultant with Merrill Lynch.
LONG-TERM MODEL
Companies and other analysts, on the other hand, argue that these estimates are based on long-term models and are not meant to change with year-to-year fluctuations in the stock market.
"This rate is generally chosen not to look back at what's happened over the last year or two; it's meant to be looking forward from now on, what say is reasonable average long-term rate of return," said Larry Sher, director of research at Buck Consultants, an actuarial consulting firm and unit of Mellon Financial Corp. (nyse: MEL - news - people)
Take, for example, US Bancorp (nyse: USB - news - people), which forecast an 11.6 percent expected return in 2001, making it one of those with the highest assumptions in the S&P 500. It then revised that estimate to 11.9 percent for the first two quarters of 2002, before lowering it to 9.9 percent for the last two quarters of the year. It expects to continue using a 9.9 percent return this year, a spokesman said.
The company defends those estimates by saying that it has a better chance of earning such returns over the long term because its pension plan is fully invested in the stock market.
Timber products company Weyerhaeuser Co. (nyse: WY - news - people), which assumed an 11 percent rate of return in 2001, says it is reducing that estimate to 10.5 percent for 2002, but counters that it has one of the highest-performing pension funds in the U.S. -- averaging about 18 percent annually.
Critics, such as Merrill's Hawkins, however, argue that companies aren't likely to repeat double-digit returns of the past decade without another bubble similar to the tech boom of the late 1990s -- an unlikely prospect at the moment.
Plus, UBS Warburg's accounting analyst David Bianco says assumptions over 7 percent or 7.5 percent are optimistic, even accounting for the long-term argument that companies offer.
That's because on average, pension portfolios have 60 percent of their assets tied up in the stock market while the rest are usually locked up in debt or other assets that generate even lower returns.
PENSION BOON
Either way, a wave of the pension wand has transformed many losses into profits.
Verizon Communications (nyse: VZ - news - people), for example. booked $1.32 billion in pretax pension income in 2001, even though its pension plan actually lost $3.06 billion in that period. A company spokesman says that its plan is fully funded and that the difference between actual and estimated returns will be smoothed out over several years, as required by accounting rules. It also plans to lower its assumptions for 2003.
Indeed, S&P 500 companies collectively booked $104 billion in pension income in 2001, even though they actually lost $90 billion in the period, Credit Suisse First Boston estimates.
By the same token, pension plans easily surpassed their estimated returns during the bull market of the 1990s. In 1999, companies in the S&P 500 on average estimated returns of 9.01 percent, even though they posted returns of 17 percent, according to Bear Stearns.
International Business Machines Corp. (nyse: IBM - news - people), for example, notes in its 2001 annual report that since 1986 its actual returns exceeded its projected returns by $5.3 billion. In 2001, the company's pension plans lost $2.41 billion, despite projecting returns of $1.45 billion.
If these differences seems mind-boggling, blame pension accounting rules and bullish estimates.
U.S. accounting rules deliberately require that companies estimate how their pension assets will perform over the next 10 or 20 years, and then base pension costs on that estimate rather than actual returns. The rules were designed this way to prevent earnings from swinging sharply each year because of a rise or fall in pension assets -- which belong to retirees and not the companies.
However, the rules give companies plenty of discretion in coming up with their assumptions. As a result, companies have been able to rack up impressive gains on their profit statements, even though their pension assets have shrunk and returned losses.
Right now, even though the market remains sour, companies remain reluctant to pull back those estimates
Despite a rough 2002, the median assumption on expected returns is expected to fall only to about 9 percent or an average of 8.78 percent in 2002, according to a survey of 162 companies by Buck Consultants. Watson Wyatt, another consulting firm, says it expects rates to fall 33 basis points in 2003. |
