The heavy hit to balance-sheet assets that some companies could absorb if the Financial Accounting Standards Board’s proposed pension rules go into effect might force them to renegotiate loan covenants and hurt their access to capital markets, a pension actuary thinks.
By the end of this year, the first phase of FASB’s proposed overhaul of retiree benefits accounting would require companies to record their pension plans’ “funded status” — assets minus liabilities — on their balance sheets. Previously, plan sponsors’ needed only to record paid-up pension costs in the footnotes of their financial statements.
The result could wipe out a company’s entire net worth, forcing some to grapple with lenders on the terms of their loans or else fall into default, John Ehrhardt, a principal with Milliman, an actuarial-consulting firm, suggested at a seminar releasing the results of the firm’s annual pension funding study.
The study, which looked at 100 big U.S. corporations that sponsor defined-benefit pension plans, found that if FASB’s proposed rules had been in place for 2005, the pre-tax charge to shareholder equity would have been $222.2 billion more than it ended up being.
The proposed rules, along with the pension-reform legislation currently being mulled in Congress and the start of Baby Boom retirement, mark this year as a turning point for plan sponsors, according to Milliman. Yet 2006 follows a fairly decent year for the generally gloomy world of pension funding.
In 2005, for instance, the average investment return on assets was 11.3 percent, marking the third straight year when actual returns beat out expected ones, according to Milliman’s study of 100 big U.S. corporations that sponsor defined-benefit pension plans. That helped spawn a slight improvement in the plans’ funded status, which rose from a cumulative deficit of $110 billion at the end of 2004 to a $96 billion shortfall for 2005.
The three years of better-than-expected returns, however, go only part of the way toward wiping out the big unanticipated investment losses companies suffered during 2001 and 2002—losses that are still dragging down plan earnings, Ehrhardt pointed out. Thus, from 2000 through 2005, the annual expected rate of return (9 percent) was almost double the actual rate of return companies experienced (4.8 percent).
Even the brighter investment picture in 2005 was tempered somewhat by liability losses. Those losses were triggered by a drop in the discount rates used to gauge plan liabilities to a median of 5.5 percent last year from 5.75 percent in 2004. Indeed the rates, which are pegged to AA-rated corporate bonds, have been dropping over the last five years from a peak of 7.5 percent in 2000.
But with interest rates up 40 to 50 basis points in the first quarter, the trend of plummeting discount rates could be broken this year, according to Milliman. Nevertheless, the unclear fate of the pension bill — which is likely to have something to say about discount rates — and FASB’s looming accounting rules could cause many companies to freeze their plans.
Ehrhardt, however, sees an increased use of defined-benefits by corporations seeking to cope with the retirement needs of a rapidly aging workforce. He cited the case of a client that had frozen its plan when it was in financial distress, only to unfreeze it when things got better about five years later. “I’d like to see some global warming and see some of those frozen plans thaw out,” the pension actuary said, acknowledging that he wasn’t entirely without self-interest on that point.