Companies' fuzziness on pension funds fails to add up

October 27, 2002|By JAY HANCOCK

EASTMAN KODAK reported a net profit last year of $76 million.

Except its operations really didn't earn that much.

A recorded increase of about $170 million in Kodak's pension investments turned what would have been a net loss into an official profit for shareholders.

Except the pension plan doesn't belong to shareholders. It belongs to employees and retirees. Accounting rules allow corporations to add gains in pension reserves to the bottom line, nevertheless.

Except Kodak didn't have gains in its pension reserves. It had a loss last year, as did many other pension funds, as the stock market dropped. But, like other companies, Kodak can use gains from previous years and blithe assumptions about the future to prop up current-year results.

Thus, the $170 million pension gain. Thus, the $76 million profit.

Armed with this information, you are ready to become a Wall Street analyst and answer the question, "How much is Kodak's stock worth?"

Beats me, and the worry in some circles is that fuzzy pension accounting at many big companies will mean continued problems for stocks.

A growing number of analysts have embraced the view that there were three kinds of corporate American book-cooking over the last decade.

The first, outright fraud, was illegal. The other two, optimistic accounting for the cost of executive pay and pension obligations, were legal but maybe even more obfuscatory than the stuff that's against the law.

Consider that in 2000, reported net earnings for Standard & Poor's index of 500 big companies reached an all-time high of $50 a share,

Of these "profits," $3 a share came from fictitious, fraudulent accounting, according to Robert D. Arnott of First Quadrant, an investment advisory firm. Additional padding of $6 a share was generated by the failure of most companies to record executive stock options as an expense.

And the fattest profit bolster of all - $8 a share - stemmed from unwarranted, sunny expectations on pension performance, according to First Quadrant.

The rules for pension accounting, which hinge on life expectancy, future interest rates, stock performance, work force levels, expected salary increases and the moons of Jupiter (kidding!), make the human genome project look simple and are not suitable for detailing in a family newspaper.

Suffice it to say that the leeway they allow for puffing up profit results is considerable but not unlimited, and many signs suggest that the limits are being reached and investors are taking notice.

For one thing, if the stock market continues to do badly, companies won't be able to use historic pension-investment gains and outlandish assumptions about the future to boost their earnings. All by itself, that mars the outlook.

Computer giant IBM, for example, said two weeks ago that it might reduce its official expectations for pension-investment results, which are currently between 5 percent and 10 percent annually for different plans.

Last year, paper pension gains added $1.4 billion to IBM's reported profit, even though the company's pension investments lost 6 percent of their value last year, according to Baltimore's Jack T. Ciesielski, publisher of The Analyst's Accounting Observer.

At some point, many companies will probably have to contribute cash and take charges against earnings to bail out their pension pools. That's another hit.

David Zion, an analyst at Credit Suisse First Boston, calculates that the typical rate of expected long-term return on pension investments for big companies is 9.2 percent, which strikes him and many others as ridiculous.

The longer pension returns limp along without achieving 9 percent, the more apparent will be the emperor's nakedness and the more frequent will be forced cash infusions away from shareholders and into corporate pension funds.

Zion figures almost half the companies in the S&P 500 had under-funded pension plans last year, although Kodak was not one. And he expects S&P 500 companies collectively to book a net pension expense next year of $15 billion. Talk about off-balance-sheet liabilities! IBM has said pension top-offs could cost it $700 million next year.

A quick recovery in stocks could make all of this less worrisome, and one hopes the accounting authorities will tighten the rules to prevent future distortions. But if stocks stay in the dumps, pensions might demonstrate another, signal lesson in how financial bubbles collapse.

Consider: IBM's pension fund owns shares in Ford. Ford's pension fund owns shares in IBM. Ford will, and IBM may, have to take charges against earnings and inject extra millions into their retirees' investment pools.

Which could hurt the value of IBM and Ford stocks. Which would hurt each other's pension funds. Which could require new cash infusions. And so forth.

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