Death to Smoothing

A tough regulatory environment is another nail in the coffin for defined-benefit plans.

On Deck at FASB

At FASB, a drive toward convergence with international accounting standards is putting pension accounting under review. While nothing is on its agenda yet, the board could embark on a major pension project as early as 2006, according to FASB practice fellow Gerard O’Callaghan. One possibility is that the SEC would press FASB to eliminate techniques that smooth fluctuations in pension investments, forcing companies to square their assumed returns with actual returns. Critics have long charged that smoothing provides a screen for obscuring the true condition of pension assets, since only the variance between actual and expected returns must be reported. An effort last year to ameliorate the concerns through increased disclosure has met with mixed reviews, and most analysts say they still need more pension information.

The prospect of marking stock assets to market value at the end of every year or every quarter is a fearsome one, however, because of the volatility it would introduce into income. Without smoothing, changes in the stock market “could totally dominate earnings at some companies,” says John Ehrhardt, a principal at actuarial firm Milliman. At GM, for example, which has the country’s largest pension plan, “you’d be investing in an equity mutual fund that sold cars on the side, rather than an automaker,” he says.

And then there are the massive swings in the market such a move could trigger. Nearly half of the managers at major pension funds surveyed said that if smoothing were abolished, they would reallocate an average 9 percent of their assets away from equities and into fixed income to reduce volatility. A swing like that could suck anywhere from $250 billion to $600 billion out of the stock market, according to analyses by Goldman Sachs and Morgan Stanley.

Such an accounting change could also cause more employers to simply freeze their plans. In the United Kingdom, nearly half of the companies on the FTSE 100 stock index have dropped their plans since the United Kingdom began requiring pension assets to be marked to market in 2002.

The good news for employers is that smoothing seems to be safe for at least the next year. Such a change isn’t on FASB’s agenda as a stand-alone item, according to O’Callaghan. When it does appear, he says, international standard setters will consider both the current FAS 87 standard that governs U.S. companies and the nascent International Accounting Standard (IAS) 19, which does not allow for smoothing to the extent that FAS 87 does. “I expect it will be a project in which everything is open to reconsideration,” he says.

Some observers are less hopeful that FASB will have equal say. “The one sure casualty [in international convergence] is asset smoothing,” says Ehrhardt, since “everyone’s assuming [the final rule] is going to go more toward the IAS route than the current FASB one.”

Can Congress Help?

A little help from Congress on pension funding requirements could certainly buffer the effects of accounting reform on companies, whatever the changes turn out to be. “The bells have been ringing pretty hard for three or four years now for fundamental reform,” says Kevin Wagner, an actuary with Watson Wyatt in Southfield, Michigan. “Accounting can smooth everything out over time, but funding is a cash issue, here and now.”

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