Corporations ought to get real about pension assets

April 10, 2005|By JAY HANCOCK

WE'VE CLEANED up the illegal fraud of hidden liabilities, capitalized expenses and fake revenue that blinded Enron or WorldCom shareholders.

We've fixed the legal chicanery that let companies keep millions in executive pay from cutting into their reported profits. This year, public corporations must start deducting stock-option expenses on their income statements if they don't already do it.

Two down, one to go. The final frontier of dubious financial reporting by big publicly traded corporations, many believe, is in pension accounting.

"It's not illegal. It's not immoral. But it's wrong," Vanguard Group founder John C. Bogle says of the current method of pension reporting.

Credit Suisse First Boston's David Zion writes in a recent report that "we may be approaching a tipping point" in pension reform that could prompt not only accounting-overhaul proposals this year, but also stricter funding requirements.

Despite the stock market's recovery the past two years, which improved corporate pension-fund reserves, Bogle and many others believe U.S. companies are still substantially understating future pension expenses, largely by overestimating expected returns on pension investments.

And if they're understating pension obligations, they're overstating profits.

The 500 big companies in Standard & Poor's best-known stock index collectively earned $55 a share in 2003. But about $2 of that came from aggressive pension assumptions and might not have been profit at all, according to research by UBS Investment Research.

And that's an average figure for all of the companies. For some individual companies, the degree of potential earnings exaggeration would have been more substantial.

Last fall, the Securities and Exchange Commission disclosed that it was examining pension accounting at several companies. It declined to identify them, but news outfits reported that Ford, General Motors, Navistar, Boeing, Delphi and Northwest Airlines were part of the inquiry.

Those companies have huge pension obligations, and some have made very optimistic assumptions about how their pension-fund assets will appreciate to meet those obligations.

Until 2003, for example, GM, which acknowledges long-term pension liabilities of $87 billion (five times the company's stock-market value!), assumed for bookkeeping purposes that its pension reserves would appreciate by 10 percent a year.

It reduced the assumption to 9 percent. That might still be too generous, especially because a third of GM's pension assets are invested in bonds, which pay low interest these days and will lose value if overall interest rates rise.

Many companies have cut pension-return assumptions. Black & Decker went from a 9.75 percent expected return for its U.S. pension plans in 1999 to 8.75 percent now. Baltimore's Provident Bankshares' expected return shrank from 9.5 percent in 2002 to 8.5 percent. Constellation Energy has held steady at 9 percent at least since 1998.

Vanguard's Bogle thinks even 9 percent is "ridiculous."

Even though pension assets have gained about that much over the past decade, he scoffs at the idea that such performance can continue. Stock gains are tied to dividends, corporate profits and increases in earnings multiples, he says, and when you put them together "a reasonable assumption is a return of 7 percent to 8 percent."

And that's just for stocks. U.S. pension funds are 29 percent in bonds, according to First Boston, for which Bogle believes a 5 percent return is realistic.

If he's right, many companies are substantially overstating profits because seemingly small changes in expected pension returns can require big contributions from current earnings. Even a reduction of 1 percent in the pension-return assumptions for the S&P 500 companies would increase their collective costs by $12 billion, chopping earnings by almost 2 percent, Zion calculates.

But reform might go much further than whittling expected returns. Zion believes accounting authorities might propose a drastic overhaul in which pension assets and liabilities are placed on corporate financial statements, and in which techniques to "smooth" jerks in pension-asset returns - such as those seen in the stock downdraft of 2000-2002 - are scrapped.

Such treatment, which Zion calculates would have cut S&P 500 earnings by an amazing two-thirds in 2001 and 2002, would certainly prompt many companies to reduce or scrap corporate pension plans, just as better accounting is prompting them to reduce stock option grants.

That's another reason not to meddle with Social Security, which increasingly looks like the only guaranteed retirement benefit that will be around in 50 years.

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