With uncharacteristic decisiveness, the Financial Accounting Standards Board acted quickly last November to create a new major project. In doing so, it responded to growing alarm about the critical state of defined-benefit pension and other post-retirement benefit plans, and burgeoning criticism of the low quality of reported information about those plans.The crisis
The crisis has been growing for the last five years, characterized by frequently huge funding deficits, such that the collateral in the benefit trusts is inadequate. The immediate causes include low returns on fund investments, while liabilities have ballooned. The obligations have grown for at least three reasons: unwise benefit increases in lieu of current raises; inevitable compounding interest over decades; and lower market interest rates that raised the present values of the expected future cash payments.
Ironically, most employers actually had overfunded defined-benefit plans just a few years ago. Now they're unbelievably under water, a fact that perfectly illustrates the downside cost of trying to shield employees and retirees from risk by promising them defined benefits. OPEB plans are even more worrisome because essentially every company manages them on a pay-as-you-go basis.
Do employees and their representatives really understand that their benefits are entirely dependent on their employers' future success?
We don't think so.
So, how bad is the crisis? Trust us, it's pretty bad. As we've reported here before, the top four employers with DB and OPEB plans had a combined net off-balance-sheet liability of around $135 billion at the end of 2004. (We expect the situation to be no better when 2005 10-Ks are released.)
Real pressure is being felt by the Pension Benefit Guaranty Corp., which has gone from break-even to a $30 billion deficit as it has assumed liabilities for struggling industries. Delphi and General Motors could make this number even more staggering all by themselves.
Bad GAAP
More observers are coming to understand that the seeds of the crisis were planted a couple of decades ago, when FASB issued its compromised SFAS 87 covering pension plans, soon followed by SFAS 106, which applied the same flawed practices to OPEB plans. These standards haven't been up to the dual tasks of informing the public and holding management accountable for its actions. They certainly did not provide the early warnings that were needed five years ago when investment returns flattened and interest rates began falling.
Specifically, these standards have two failings. The first is their off-balance-sheet presentations of plan assets and obligations. Because these items were tucked away, pretty much out of sight, managers seem to have left them pretty much untended. The second is the blatant smoothing of annual costs that has kept most real value changes from affecting earnings per share.
Even while managers pumped up benefits and watched liability measures skyrocket, GAAP financial statements deferred those costs and losses, based on naive hopes that they would be offset in the future by revenues and gains. The accounting sleight of hand includes reporting expected asset returns instead of actual results, a scheme that is impossible to justify when the purpose of reporting is telling financial statement users what is really going on.
Not long ago, we referred to this practice as nothing better than "sanctioned fraud."
FASB acts quickly
Since shortly after its November decision, FASB has publicly described its plans with unusual fervor and specificity. The key component of those plans is breaking the project into what we call Phase 1 and Phase 2.
Phase 2 will be tougher, because it will put all issues on the table, with many possibilities for change. It will be contentious and politically difficult, especially because it will be conducted with the International Accounting Standards Board. There is little doubt that the process will take years.
Unfortunately, there is also little doubt that the result will include more compromises that prevent complete transparency. But we're leaving this phase for later columns.
Phase 1 - One small step
FASB's description of Phase 1 has been both candid and optimistic, and we appreciate both attitudes. Candor is evident in the justification for the project's narrow scope, which is designed to allow certain issues to be ducked to avoid bogging it down. The timetable is optimistic, because it anticipated an exposure draft in March, the final standard in September, and an effective date that would put the new accounting results in calendar year 2006 financial statements.
While we admire ambition, we associate the board's approach with Neil Armstrong's words from the lunar surface: "That's one small step for [a] man, one giant leap for mankind." Phase 1 is only a small step, because all it would do is put a net asset or liability on employers' balance sheets, while leaving intact deeply flawed income measures. While debt-to-equity ratios may be more complete, earnings will still be polluted by deferrals and predictions, instead of forthrightly reflecting what actually happens.
Nevertheless, in light of the immense crisis, any improvement in balance sheets should be considered good for financial reporting quality. At the very least, it will force managers to assume full responsibility for the elephantine assets and liabilities that they have pretended are not in the room.
What Phase 1 will do
FASB intends to require that managers recognize a net asset or liability for each of its defined-benefit and OPEB plans. All plans with net assets will be aggregated, as will all plans with net liabilities, but they will not be offset against each other. The board will not reconsider measurement issues in Phase 1, so the assets will be measured at market value, while the liabilities will be measured using predicted future salaries and benefits. The consequence will generally be increased amounts of reported debt with declines in reported debt/equity ratios.
The proposal will eliminate today's spurious balance sheet presentation of a prepaid or accrued cost equal to the cumulative difference between past costs and contributions, while also getting rid of the always-baffling practices involving the minimum liability.
Another key feature will abolish the off-the-books treatment of prior service costs, deferred gains and losses for unexpected asset returns, and actuarial gains and losses on the liability. Instead of being hidden away in memo accounts, these items will be included in "other comprehensive income" in the equity section.
The board expects today's annual cost calculation to come through Phase 1 unchanged, including deferrals, prior service cost amortization and corridor amortization. Because managers still fear volatile reports so much that they want to cover up the truth, the board is postponing this battle so that it can focus on at least fixing up the balance sheet.
FASB also anticipates that footnote disclosure of pension and OPEB situations will become more complete and accessible. We certainly hope so, because the current presentation is nearly impenetrable to all but the most resolute and persistent analysts.
Better than nothing?
We tend to shy away from using the "It's better than nothing" rationale for progress. If best practices are known and technically feasible, they ought to be implemented. In this case, there are no technical barriers to putting gross assets and liabilities on the balance sheet, and there are no technical barriers to reporting a volatile annual cost.
Rather, objections will arise solely from fears that transparent reporting will reveal the truth that has been so distorted by GAAP reporting. Those complaints are superficial, disingenuous and unjustified in today's capital markets. The fact is that sophisticated market participants already understand the true situation. For those who don't, it's about time they were let in on the truth.
Don't get us wrong - we're all for Phase 1, and we hope it's implemented according to the board's ambitious timetable. Our more fervent hope is that absolutely no one will consider this stopgap effort to be good enough.
The world still needs a giant leap that elevates truth-telling to the first position. Anything less is only a small step.
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.
