A “Perfect Storm” of Circumstances Batters Corporate Pension PlansPublished: February 12, 2003 in Knowledge@Wharton
In 1985, the Financial Accounting Standards Board (FASB) looked at defined-benefit pension accounting issues and issued Statement No. 87, Employers’ Accounting for Pensions. Back then, the FASB noted, “Measuring cost and reporting liabilities resulting from defined benefit pension plans have been sources of accounting controversy for many years.”
Now, nearly two decades later, they’re still controversial as companies like General Motors, IBM and others rack up billions of dollars in under-funded defined benefit pension plan liabilities. Questions raised about accounting for pension funds have prompted some Wharton faculty and other experts to ask if rules promulgated by the FASB, as well as the Internal Revenue Code itself, may have played a significant part in the strife.
A defined benefit plan is generally based on a formula indicating the exact benefit that a qualified employee can expect upon retiring. Unlike some other pension funds, the payout to a retiree under a defined benefit plan is generally not dependent on the return of the invested funds, which means that the sponsoring company is usually liable for any shortfall between the amount needed to meet the plan’s obligations and the amount available to meet them
In contrast, a defined contribution plan, such as a 401(k), only addresses the amount of money that will be contributed, and has not generated the same kind of debate. In a defined contribution plan, an employee can generally defer an agreed-upon part of his or her salary—subject to legal and other restrictions—into a tax-advantaged plan. Although the employer may match all or part of the employee contribution, it is the employee who typically bears the risk of investment loss.
Promises are at the heart of the defined-benefit controversy—specifically the promise, on the part of companies (known as sponsors), to pay certain benefits to qualified retirees. Using net present value and other calculations, actuaries typically advise the sponsor-companies on the amount of assets (usually investments) they will need in the current period to meet future pension liability obligations. The liabilities, of course, are based on the number of plan participants, their age and other factors, while the dollar value of the necessary fund assets are based on such factors as the expected rate of return.
According to Olivia S. Mitchell, Wharton professor of Insurance and Risk Management and executive director of the Wharton/University of Pennsylania Pension Research Council, a “perfect storm” of circumstances is battering the value of corporate pension plans and the ability of sponsors to fund them.
“To begin with, many corporate pension funds are heavily invested in the stock market, and the weaknesses we’ve seen there over the last two years have trimmed an average of 10-15% from U.S. pension plan portfolios,” she observes. “Low interest rates are also having a particularly painful effect on defined benefit pension plans, since accounting rules such as the FASB’s statement No. 87 (FAS 87) require these plan liabilities to be valued using current interest rates. As a result, companies sponsoring defined benefit pension plans have seen their plan liabilities grow rapidly as interest rates have dropped, much like bond prices rise as interest rates fall.”
Mitchell explains that this problem may have been exacerbated in some cases by the use of optimistic discount rates. “Under FAS 87, companies and their actuaries have some leeway in determining the discount rate used in valuing pension liabilities. And in some cases, unrealistic values may have been applied. Going forward, any company using an assumption of nine percent or higher will probably get a hard look from the SEC.”
She points out that the third issue that drags down pension-plan funding is the fact that some pension plan sponsors are simply not turning a profit. “This is a big problem in the automotive, steel, and airline industries,” she says. “Even as the parent company slips into the red, it’s facing under-funded pension plan expenses running into billions of dollars.”
As examples, she notes that the United Airlines pension plan is short-funded by $4 billion, while the airline industry as a whole has under-funded liabilities totaling an estimated $19 billion. “In the automotive sector, General Motors Corporation had to contribute $2 billion to its pension last year, and it may have to contribute between $14 billion to $17 billion through 2007,” she adds.
Can companies continue to take these hits? Mitchell thinks the pension fund crisis could exacerbate the long-term shift away from traditional defined benefit plans, and could spark additional concerns.
Overseas for example, England has adopted Financial Reporting Standard No. 17, which requires companies to value their pension funds at market values – the mark-to-market approach – instead of historic values. Additionally, the British Accounting Standards Board is reportedly trying to convince the International Accounting Standards Board (IASB) to adopt a similar requirement.
“The bottom-line impact has been that many large companies in Europe have eliminated their defined benefit pensions. Increasingly, companies are moving toward a 401(k) type of plan, which has become very popular in the U.S. over the last two decades,” Mitchell observes. “While this can shield a plan sponsor from under-funding risk, it does shift the capital market risk to employees who, like their counterparts in the U.S., worry about their own future.”
In response, she says, there is growing demand for investment products with built-in guarantees, such as annuities or stable value funds. “In Germany, for instance, defined contribution plans must offer a guarantee of principal, while pension plans in Chile are required to offer a guaranteed rate of return. These are appealing to risk-averse plan participants, but the tradeoff for such guarantees can be a lower rate of return.”
In the U.S., a recent survey conducted by Deloitte & Touche covered 80 mid-sized and large companies: 40% of respondents say their pension expenses will rise by more than 50% in 2003. Another 20% expect increases of 26-50% while 16% of respondents see expenses growing between 11% and 25%.
According to the survey, the “enormous funding squeeze” is driving more than four out of ten companies to either make or consider making fundamental changes to their defined benefit plans. The survey notes that 12% “have already decided on changes and 31% are evaluating possible alternatives,” including profit-sharing plans.
“Companies that change their pension plans solely because of stock-market volatility and the current higher expenses could be making a serious mistake,” says David Hilko, practice leader of the employee benefits group for Deloitte & Touche’s Chicago office. “Recruiting and retention strategies should drive benefits.”
“Changes now won’t fix the funding issue,” Hilko adds. “The companies still must make up these major shortfalls under IRS rules. What’s more, benefit expenses often rise in the short term when companies switch plans, which would simply add to the current expense crisis.”
What is the solution? Continuing her “Perfect Storm” analogy, Mitchell notes that a 10-15% bump upwards in stock markets and a modest increase in interest rates could mean “smooth sailing” for defined benefit plans, and for plan sponsors’ perceptions of these retirement plans.
Meanwhile though, the problem may extend beyond the direct effects of the stock market’s ups and downs. Wharton accounting professor Wayne R. Guay notes that reporting guidelines often do not accurately reflect changes in the value of pension-plan assets. “Current generally accepted accounting principles distort the amount of pension expense (or income) that’s recognized in the income statement,” he says. “Accounting for pension plan assets and liabilities is treated in a very odd manner, and could benefit from some changes.”
Guay notes that the current treatment, through a variety of technical maneuvers, requires companies to defer a portion of current-period pension-related gain or loss, leading to results that are effectively “smoothed” on a year-to-year basis.
“The ‘smoothing’ in pension accounting comes from the fact that pension plan expense will be too high following unusually strong stock market performance—since only part of the excess of actual return on assets over the expected rate of return can be recognized; and will be too low following poor stock market performance, since only a portion of the “loss” of expected rate of return over actual can be recognized,” he explains. “Right now we are in a period of unusually poor performance. In the late 1990s, we were in a period of unusually good performance.”
Guay compares the core issue, reporting treatment, to questions raised about another controversy—accounting for stock options—and says, “If analysts and others take the time to carefully read the footnotes, they’ll discover what’s going on. If they don’t, then they’ll be surprised.”
The FASB, he adds, generally thinks that disclosing information in footnotes is often “inferior” to reporting this information directly in the income statement and on the balance sheet. “Many academics are not convinced about these differences,” says Guay. “I think the point is just that the costs imposed on businesses and accounting standard setters due to overhauling pension accounting may well exceed the informational benefits of moving the information from the footnotes into the financial statements.”
As the accounting industry moves toward global-based standards, one might think that FASB would take a keen interest in the mark-to-market approach that the IASB had adopted. But according to Pat Durbin, a FASB practice fellow, the organization is not about to be rushed into such a review.
“During the past year we’ve heard some rumblings about pension-fund accounting from various parties,” he notes. But in December, although some staff members suggested adding pensions and other post retirement issues to FASB’s agenda, the Board declined. “Board members asked the staff to solicit more definitive commentary on just what the issues are, and what the focus should be. It is definitely a backdrop to international convergence, but pension accounting is not on the Board’s short list.”