One of the many things that make investors sweat is the state of corporate pensions and other post-retirement benefit plans. How well are they funded? Are there enough assets available in the plan, or must the employer satisfy obligations?Investors aren't the only ones who sweat. Employees and retirees are also concerned. Their futures hang on the numbers, and the numbers can get pretty big, especially the red ones - possibly $600 billion in all, according to the Government Accountability Office.
Concerned that financial statements could be more transparent and useful with regard to pensions and other post-employment benefits, the Financial Accounting Standards Board has taken on a project that is likely to prove as controversial as it is complex.
"We've been monitoring this for several years, because what we've been hearing directly and indirectly from a lot of financial statement users was that the current reporting model was not satisfying their needs," said FASB project manager Peter Proestakes. "Their main concern was that statements based on Statement 87 and 106 did not result in a true depiction of the costs for providing, and the economic status of, post-retirement benefit plans."
FASB Statements 87, Employers' Accounting for Pensions, and 106, Employers' Accounting for Post-Retirement Benefits Other than Pensions, are the current standards. They relegate substantial information on pensions to the footnotes of financial statements.
The eventual standard that the board hopes to issue by the end of 2006 will not resolve the country's retirement benefit problems, but it should help companies, investors, employees, retirees and others understand the financial weight of funded and unfunded defined-benefit and post-retirement plans.
Project manager Proestakes called the project "comprehensive," and said that the board will reconsider "many, if not all, of the issues that it considered when it first developed the accounting standards," as well as new developments in business, such as new plan designs that have evolved out of changes in demographics, and greater employee mobility.
FASB plans to approach the project in two phases. The first will seek a way to recognize in the balance sheet the funded or unfunded status of defined-benefit and other post-retirement plans measured as the difference between the fair value of plan assets and the current measure of the benefit obligation incurred for past employee service. Any additional gains or losses to be recognized would be reported in other comprehensive income.
"The amount of net benefit cost recognized in earnings will not change during the first phase of the project," said Proestakes.
While the first phase would not change the measurement of pensions and other benefits, Rebecca McEnally, CFA Institute vice president of advocacy, said that the change may have a significant impact on airlines, manufacturers of heavy equipment, and other companies that have been pleading bankruptcy because of excessive pension fund liabilities.
"A number of the companies currently in bankruptcy argue, in essence, that they can't keep their pension and OPEB promises to their employees, and that they must be relieved of the obligations," McEnally said. "Unfortunately, the information about the problems was not in the primary financial statements where it belonged, but relegated to the notes to the statements. So, should the board choose to move forward on the staff's recommendation, this would bring a sharp light to focus on the problems in some companies."
The second phase, far more technical, will address a broad array of related issues, such as the recognition and display in earnings and other comprehensive income of the various elements that affect the cost of providing benefits, the best measurement of the obligation under plans with lump-sum settlement options, whether more guidance is needed regarding measurement assumptions, and whether post-retirement benefit trusts should be consolidated by the plan sponsor.
The second phase may do away with or modify permitted "smoothing devices" that companies use to reduce the effect of short-term volatility on long-term liabilities. Companies accomplish this by presenting underfunded plans partially on the balance sheet and partially off.
"Investors often have two views of a company as it relates to these types of long-term arrangements," Proestakes said. "One view wants to see the volatility that exists in the marketplace in the financial statement. But at the same time, because the cash flows relating to post-retirement benefits have such a long duration, they want to be able to clearly identify that volatility separately from the other parts of the business."
The accounting team at Bear Stearns supports FASB's decision to take on pension accounting. They predicted, however, that the project will be the most controversial that FASB has ever taken on, hotter even than the decade-long project on share-based compensation. That project brought the board to the brink of congressional action that threatened to overturn the board's decision, not to mention its independence as a private-sector standard-setter.
A quasi-social issue
Bear Stearns estimates that 2004 aggregate net liabilities of OPEB - principally retiree health care - on the balance sheets of S&P 500 companies would have been $128 billion higher under the likely Phase 1 treatment than the recorded 2004 liability, and believes that the impact on pension obligations could be similar.
While a FASB ruling on pensions might affect securities markets, a more serious impact could go beyond market stability and return on investment.
"I think there may be concerns that companies, in reaction to more volatility showing up on their income statements and balance sheets, might continue pulling back from defined-benefit pension plans," said Bear Stearns accounting analyst and senior managing director Janet Pegg. "This could continue the trend of not offering them to new employees or scaling them back, or terminating plans, all depending on the exact circumstances."
Pegg said that the possibility of such accelerated withdrawal from pension plans raises the accounting question to a "quasi-social issue."
"Given that pensions and OPEB issues affect politically powerful constituencies," Pegg said, "the Bear Stearns team believes that there will be a large opposition base in Congress that will unite to attempt to block this project."
McEnally said that, theoretically, moving these liabilities to the balance sheet will not impact markets, because investors have already considered the information that was in financial statement footnotes.
But theories are one thing, stock markets another.
"To the extent that the information wasn't factored into investors' decision-making because it may have been out of sight to them, then their decisions may have been sub-optimal," McEnally said. "Companies would have appeared to have less debt (leverage), may have appeared to have lower costs of production, and to be more profitable. Their long-term solvency may have appeared to be stronger. In short, the pricing of such companies' securities may have been biased to the optimistic side, in some cases severely so."
McEnally thinks that the brighter light on the status of pension funding will ultimately affect the way corporate managers make fund decisions.
"It is one of the market conundrums that although managers knew full well what the economic condition of plans was before [moving them to the balance sheet], until this was pulled into the sharp focus of daylight, they could have ignored it in their own decision-making. This is especially true where the worst effects of the promises lay some years in the future, long after they would be gone from management. Managers may tend, for example, to dampen the volatility in the numbers by changing the types of investments in the plan asset trust accounting, better matching the term of the liabilities with the term of the assets, for example."
Proestakes said that the first phase of the project is not technically difficult and that a final statement could be issued by the end of 2006. The second phase, however, will be substantially more complicated and controversial. He expects it to take "at least several years" to complete.
The International Accounting Standards Board has expressed interest in amending its standards on these same issues. The two boards are now exploring the best way to work toward converging their standards. Recently the two have worked on concurrent projects to arrive at similar conclusions, but it is also possible that the international board will wait to see the results of the U.S. effort before proceeding with its own project with the likely intention of producing a similar standard.
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