How to Tell If Your Company's Pension Plan is Sinking
from
September/October 2003
by Randy Myers
Many defined-benefit pension plans have been hit by a perfect storm of lower stock prices, which reduced their assets, and sharply declining interest rates, which bumped up the present value of their future retiree benefits. So many plans that once seemed dramatically overfunded now turn out to be dramatically short. As a result, the plans’ sponsors—the employers, since these are not 401(k) retirement accounts, for which employees are responsible—are having to cough up real cash to cover the difference. Make that very real cash. The 360 or so companies in the Standard & Poor’s 500 index that sponsor such plans came up short by some $216 billion last year, the first shortfall since 1993, when it was a modest $10 billion.
The scary news for anyone monitoring these figures—and board members should be—is that bad as they are, they don’t reflect the whole problem. U.S. pension accounting is a notoriously perverse art that at times allows a company to book pension income when the fund is actually experiencing losses, to show pension-related assets on the balance sheet without recording underfunded plans as a liability, and to base the whole ball of wax on a series of forecasts about future plan performance that may be wildly out of step with reality.
The Financial Accounting Standards Board, which governs accounting practices in the U.S., announced earlier this year that it was launching a study of perceived deficiencies in how companies carry their pension assets and liabilities on their books. In other words, the FASB wants more transparency. The board planned to come out with a draft of how it would like these disclosures made by late 2003.
Obviously, directors—especially those on the audit committee, who are responsible for the accuracy of a company’s books—should not wait for the FASB’s recommendations. Instead, they should find out just how healthy their company’s pension plan really is. “Board members should absolutely be aware of the risks involved in these plans,” says Jerry Spigal, a principal and pension consultant at the benefit consulting firm Towers Perrin. Here are some good places to start:
Is the plan overfunded or underfunded?
All discussions of pension plan health begin here. Fortunately, companies are required to report their funding status, even if only in the fine print. Go to the “notes to the financial statements” section of your company’s latest 10-K filing and look for the note that addresses pension or retirement plan issues. You should find a table listing the plan’s “benefit obligation at year end” and the “value of plan assets at year end,” followed by a line that nets the two under the label “funded status.” If the projected benefit obligation, or PBO, is less than the value of plan assets, the plan is overfunded; if it is more, the plan is underfunded. Basic math, but important.
Are the plan’s “expected return” assumptions realistic?
At the beginning of each year, accounting rules require plan sponsors to project what they’ll earn on their pension investments over the long term, which means 10 or more years. This figure is called the expected return, and it’s important because, as we’ll see shortly, it has a direct impact on how much pension-related profit or loss companies can claim on their income statements. Plan sponsors typically don’t change this number very often; for those in the S&P 500, the median expected return was 9.2% from 1997 to 2001. Last year it was cut back to 8.8%. If your company has raised its expected rate of return in the last year or so, most pension specialists would view this as overly aggressive—a sign of potential trouble. There might be a legitimate explanation, but make sure you know what it is.
Don’t be fooled by robust pension income.
One of the more perverse aspects of current pension accounting is that it allows companies that are losing money on their pension investments to record pension income on their income statements. The fiction ties into the expected return that companies set out for their pension plans at the beginning of each year. Suppose, for example, that a company expects to earn 8.8% on its $1 billion in pension assets next year, which makes the expected return $88 million. Let’s say its expenses, excluding pension payouts, total $4 million. The company nets those figures and reports pension plan income of $84 million. But what if the plan actually loses 8.8% on its investments? No matter. The company ignores actual performance and still reports $84 million in pension income. The key thing for board members to understand is that pension income on the financial statement says little about the true health of the plan.
Doublecheck the discount rate.
Plan sponsors must calculate the present value of their future projected benefit obligation by using a discount rate that accounting rules say should be roughly equal to the yield on high-quality corporate bonds. The higher this rate, the lower the present value of the obligation and the less money that needs to be in the pension pot to cover future payouts. Since companies don’t have much leeway in setting their discount rate, it’s uncommon to find extreme outliers, but numbers do vary. If they’re off by much, directors should demand an explanation.
Are assumptions about employee pay raises too optimistic?
Another important assumption factored into annual pension costs is the projected growth in employee compensation rates. The lower the salary inflation rate is, the lower the pension benefit obligation will be and the higher the plan’s funded status will appear. This number is reported in the footnotes to the financial statement, along with the plan’s expected return and discount rate, and board members should be sure that it makes sense. Says David Zion, an accounting analyst with the investment bank Credit Suisse First Boston: “If the salary inflation rate [for pension calculations] is 2%, and you’re always hearing management complain that salaries are jumping 5% or 6%, you should want to know where the disconnect is coming from.”
Board members who conclude that their pension plan is in funding trouble have limited recourse in seeing that it gets set right. Where required by the IRS, the sponsoring company must make contributions to the plan in the form of either cash or other assets, such as debt securities—or even company stock, so long as the total amount of that stock doesn’t exceed 10% of plan assets.
Companies that don’t have the cash flow to support additional contributions to their plans may have to consider more dramatic measures. Sometimes a company must go to the markets to raise the needed cash. General Motors recently did just that, announcing in June that it will borrow $13 billion—the largest bond issue by a U.S. company in history—to reduce a $19.3 billion shortfall in its pension funding. Another choice is to cut back future benefits, which would reduce the projected benefit obligation. This would anger the company’s workforce, of course, but perhaps not so much as outright termination of the plan. Terminating right now would be costly anyway, says Towers Perrin’s Jerry Spigal, since the plan would have to buy annuities to cover future benefits. Those annuities, at today’s low interest rates, would be expensive.
