Funding Fun House

Detractors say current accounting lets companies distort the picture they present of pension plan performance.

Still, if losses continue, companies will be forced to make two years’ worth of cash contributions at the same time. Furthermore, complaints are growing that pension accounting has allowed companies to delay recognition of poor investment results. According to a recent study by actuarial firm Milliman USA, 50 of the largest U.S. companies counted roughly $54 billion of pension fund gains as profits last year, when they actually lost almost $36 billion. “If you used the same accounting for the operations side that is used on pension funds, you would be put in jail,” asserts Kra.

Mild Deflation

Such complaints are now gaining currency, with heavyweights from Warren Buffett to Sen. Tom Harkin (D-Iowa) weighing in. The chief criticism is that investment-return assumptions are too high and inflate earnings or hide losses. The average company uses a rate of 9.2 percent, according to the CSFB report. Buffett’s company, Berkshire Hathaway, uses a return of only 6.5 percent.

But it’s pressure like the proposal from California state controller Kathleen Connell that really gets the attention of finance executives. “[The inflated assumptions are] an accounting gimmick that needs to be cleansed out,” she says. Connell has called on the state’s two giant public pension plans, the California Public Employees’ Retirement System and the California State Teachers’ Retirement System, to stop investing in companies that use overly optimistic fund projections, and she says they are now considering the return rates in their investment decisions.

David Zion, an analyst at CSFB, says the pressure to be conservative is likely to have a greater impact as companies review their assumptions this year. “I expect that they will come down about 50 to 100 basis points at many companies,” he says. The move will be costly. CSFB estimates that a mere 50 basis-point reduction will result in an aggregate increase in pension costs of $5 billion for the S&P 500.

IBM, for instance, announced during an October conference call that the IT giant would reduce its expected rate of return from 9.5 percent in 2002 to between 8 percent and 8.5 percent this year. “We believe that this will affect the income statement by roughly $700 million next year,” said CFO John Joyce during the call.

While reality checks like IBM’s will help, many analysts contend that more-fundamental reform of the pension accounting system is needed. “The current accounting can be misleading because of the smoothing methods,” says Zion. “What investors want to see is the economic reality of the pension plan reflected on the financial statements.”

To that end, Zion proposes marking pension plan gains and losses at fair market value rather than using assumptions and then amortizing the difference over several years. And while he admits it would create wild swings in earnings and make the bottom line less useful, he thinks it would be better than the current system. “Volatility is not necessarily a bad thing, unless it’s hidden,” he cautions. At the very least, Zion argues that more pension information needs to be disclosed. He thinks a company’s pension funding status should be on its balance sheet on a net basis along with more information on the plan’s asset allocation. Zion also wants to see the effect of pension losses and gains on earnings isolated from operating income. “In most instances you don’t know where it goes,” he says. “It could hit any line where the company puts labor costs.”

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