Don't forget these five pension fundamentals

Because SFAS 158 has become effective for fiscal years ending after Dec. 15, 2006, it won't be long until annual reports start arriving with re-measured and reclassified defined-benefit pension liabilities or assets on the balance sheet. The revised amounts will generally be much larger, capturing items that were formerly disclosed in the footnotes, but that now must be recognized. Furthermore, the reporting will done in a single net item, and not, as before, in multiple components spread across the balance sheet.Although SFAS 158 will be shining a spotlight on funded status, we think a great many people won't understand what that information means, or doesn't mean. We also think many managers won't know what to do about their situation. To help out, we present five key fundamental - but generally unappreciated - truths about pension funding.

1. THE LIABILITY IS A TARGET

One fundamental truth is that the pension liability is a target, while the pension fund is a cannon that must be aimed, loaded and ready to fire when the liability comes due. Unlike bonds and notes that have specific due dates, a pension liability aggregates short-, intermediate- and long-term future cash flows and produces a stealthy target that is constantly shifting and changing. Likewise, the pension fund aggregates short-, intermediate- and long-term assets to help ensure that benefits will be paid. This cannon requires continual resighting to keep its fix on the liability's future position.

Because the Financial Accounting Standards Board decided to offset these two elements, many will misconstrue the reported net liabilities, primarily by thinking that being underfunded is necessarily a bad situation.

The oft-unacknowledged fact is that the asset and liability balances represent two distinct present values focused on the same nebulous future cash flows. The liability balance is the present value of all future benefit payments discounted at the market interest rate for pension settlements. According to what we've seen, the median pension discount rate for the S&P 500 is around 6 percent, while expected pension fund return rates typically range between 8 percent and 9 percent. As a result, a plan may be underfunded in the traditional sense (by having a present value of the benefit obligation in excess of the market value of the plan assets) but still be adequately funded.

That seeming paradox will arise if there is enough time before settlement to allow the smaller but faster-growing plan assets to catch up to the initially larger but slower-growing benefit obligation. If you remember your compound interest math, the lower discount rate for the liability produces a higher present value, while the higher discount rate for the assets produces a lower present value, despite the fact that the two amounts should converge in the future. (In addition to using the higher return rate to catch up to the liability balance, management also has the discretion to accelerate or retard its contributions according to its cash deployment strategy.)

Therefore, we expect most pension plans to be underfunded, but there is no automatic need for alarm. Strategy calls for both the liability and the assets to be moving toward the same future amount such that they need to merge only when the cash flows must occur. This relationship between the present values doesn't necessarily justify having an underfunded plan, but a deficit may arise even though everything is well under control. The issue is whether the degree of underfunding seems appropriate under the circumstances. We say more on this point later.

2. THEY'RE BOTH BELL CURVES

Financial accounting has always had an unfortunate fixation on spurious precision, such that financial statements report assets and liabilities at single amounts, often with multiple digits. This fixation means that balance-sheet measures of pension assets and liabilities are only single points taken from two different bell-shaped curves.

The liability measure is a single point on a highly dispersed curve because of many possible benefit cash flows as shaped by work lives, mortality, future salaries and alternative terms for paying benefits. When the actuary finishes, the result is a spuriously precise number that cannot completely represent the underlying amount. Similarly, the balance sheet's asset valuation is only a single point on another bell-shaped curve, because the reported market value is for only one day on a continuum of many years of working toward confluence when the payments have to be made.

Thus, SFAS 158 requires one single point in one bell curve to be subtracted from another single point in another bell curve, with the difference reported as if it, too, is a single point. Indeed, that recognized difference is likely to be too imprecise to be useful for projecting the future.

Our warning here calls for people to not focus on that single point, but to comprehend the dynamics of both amounts. Therefore, it behooves managers to provide sufficient measures of past amounts to allow users to observe and evaluate trends. If the difference is closing, for example, users and management can deduce that the power of the exponent is working toward catching up any underfunded deficit. On the other hand, if the difference is spreading, watch out.

WAIT, THERE'S MORE!

Although it could be fine to be underfunded, three other factors may drive management to close a funding gap.

3. DON'T FORGET DEDUCTIBILITY

Because DB pension contributions are deductible for the employer, it is usually wise to harvest the immediate return provided by the tax savings. For example, the final federal tax bracket is 35 percent, which means that contributing $1 million produces an instant savings of $350,000, which is an awfully good return for one year. Deductibility should compel managers to achieve maximum funding, instead of the minimum. It's well worth borrowing to earn a return of that scale.

4. DON'T FORGET TAX DEFERRAL

Similarly, the fund's investment income adds to the employer's pretax income, but is sheltered from tax until it's paid out, and then it's taxed to the employees. This fundamental truth should encourage managers to fully fund, instead of investing the minimum and paying higher taxes on income earned with the uncontributed assets. It can be difficult to earn an after-tax return on those investments that will exceed the fund's pretax return. Here, then, is another compelling reason for full funding, even overfunding.

5. DON'T FORGET THE SHAREHOLDER

We thank Dr. Jeremy Gold, a consulting actuary in New York, for helping us understand this next point.

Specifically, when sophisticated investors are building portfolios, they need to assess the relative risks and returns of security issuers and their industries. They try to maximize their own results through judicious selections based on clear ideas about the risk/return tradeoff for each company's stock.

Here's the rub: Many DB pension funds are essentially large unregulated mutual funds, which means that they may differ from the risk/return tradeoff produced by the employer's main business and make it more difficult to assess the stock's suitability for a portfolio. Another complicating factor is the lack of public information about a fund's specific holdings, such that investors cannot easily assess its risks and returns. This arrangement effectively forces investors to buy two investments, one of which is an unknown pig in a poke.

The fix here is simple, as Dr. Gold has explained patiently for years: Employers should fund pension plans with high-quality debt instruments that have risks and returns that mimic and neutralize the risks and costs of the pension liability. This arrangement promotes market efficiency by causing the risk and return of the employer's stock to more directly reflect its industry and its managers' skills.

THE FUND-AMENTALS

So, there will be mixed signals when employers report net DB pension liabilities on their balance sheets. Underfunding isn't necessarily bad because of the target and cannon effect with differing discount rates. In addition, the amount of underfunding isn't as precise as the balance sheet measure will suggest.

Moreover, there are some very good reasons for management to maximize its funding to reap tax benefits while not diversifying into equity investments, so that their shareholders can manage their own portfolios more efficiently.

Like most things, pension funding is more complex than it appears at first glance, and the new pension numbers on balance sheets will be worth more than a casual look.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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