It's hard to believe we can write another column about pensions and the bad GAAP applied to them, but here we are again, beating the same old drum. In addition, there is a new drum in the Pension Protection Act of 2006.While we're putting this column together, the market is continuing its sliding and bouncing, and the government is doling out money left and right (and in between) to bail out insurers, mega-banks, regional banks, investment banks, depositors, money funds, brokerage houses, and who knows what else.
What we haven't heard anybody talk about are defined-benefit pension plans, like those maintained by Chevron, General Motors and General Electric, to name a few. To say the least, they are being squeezed by the strong decline in equity securities combined with the Federal Reserve's policy of keeping interest rates low. The rest of the story is that these employers' financials won't clearly reveal just how bad things are getting.
Two things are of concern.
One is the mandatory catch-up funding requirements of the PPA, and the other is the incredibly sorry state of GAAP, specifically features that banish market losses completely away from employers' income statements. Both issues have arisen because of intense political maneuvering and an underlying assumption of market stability and growth.
In May 2007, the Journal of Accountancy published our article, "Perfect Storm Prompts Changes in Pension Accounting" in which we referred to what had seemed like a once-in-a-lifetime combination of declining interest rates and falling stock prices and the difficulties they produced for employers with defined-benefit pension plans. Little did we (or anyone else, for that matter) realize that even worse times were just around the corner.
According to numbers we found, the prime rate at Oct. 1, 2008, was at 5 percent, compared to 7.75 percent a year before and 8.25 percent two years earlier. What does this mean for pensions? Because the projected benefit obligation and health care obligation are estimated with present values of predicted future cash flows, this decline in market interest rates will cause the estimates to jump markedly. For example, assume a $50,000 annual payment stream for 15 years: At 7.75 percent, the present value is about $435,000; at 5 percent, it jumps up to $519,000. The result is a 20 percent increase in the liability.
On the other hand, security values have plummeted, as everyone knows. As we are writing, the Dow is back and forth in the 8,000-9,000 range. As of Dec. 31, 2007, the measurement date for many companies, the index was at 13,264, which puts the decline at about 30 percent to 40 percent.
This pincer effect has been dramatic. If these shifts were applied to a company with, say, a $1 billion liability that was fully funded with equity holdings at the end of 2007, it would have a $1.2 billion liability (plus any new service costs and interest, less any paid benefits) while the fund could have dropped to $600 million. Astoundingly, it would have swung from being fully funded to being only 50 percent funded. The situation would be even worse if the pension fund had been invested in any mortgage-backed bonds, and we suspect a great many were in that boat.
WAIT, THERE'S MORE ...
There's more to this nightmare.
In a fit of confidence in the capital markets, Congress passed the PPA in August 2006, apparently assuming that nothing bad could happen. Among other things, it requires defined-benefit plans to be fully funded. If they're not, the employer must implement a plan to close the deficit over seven years. The contributions are to include interest to make up for the delay. For our example, that sudden $600 million shortfall must be funded to the tune of $100 million-plus per year for seven years (at 5 percent interest), all at a time when the employer is facing declining sales, profits and cash flows. That money will have to come from somewhere, possibly (and ironically) from laying off current employees to pay people who no longer work.
With surprising foresight, Congress also created a provision for waivers that temporarily excuse a company from the funding requirement, but with strings attached. When you see the numbers below, you'll understand why it doesn't take a great prognosticator to predict that lots of managers will line up to get them.
It's worth looking at some real companies to assess how deeply they have been squeezed by the pincers of climbing liabilities and crashing assets. We tried, but it's insanely difficult to figure out what is happening.
At the heart of that difficulty are convoluted accounting standards that create a secret code that only real experts can untangle. The convolution is intensified by managers' tendency to obfuscate, hiding behind legalese and disclosing no more than the bare minimum mandated by FASB. A third factor is the absence of detailed quarterly reports. There's just no public information that fully reveals the true state of affairs.
In the face of this non-transparency, we produced pro forma numbers projecting the squeeze the pincers may have put on the ending-2007 financial position. We caution readers against considering them to be predictions of what will be reported for 2008, because we've not been able to account for all events that have occurred.
Our model is simple: Increase the reported liability measure by 5 percent to reflect the decline in discount rates and decrease the plan assets by applying a 30 percent drop in the portion invested in equity securities. Although these assumptions aren't outlandish, the results are disturbing.
* Chevron: At the end of 2007, combined PBO and health care plan assets were $12 billion and the debt was $16 billion with a net liability of $4 billion. Applying the pincer model cranks the liability up by about $1 billion and drops the assets by about $3 billion, doubling the net liability to $8 billion. That's not too bad, until you realize just how much money that is!
* General Motors: At the end of 2007, plan assets were $133 billion and the debt was $173 billion with a net liability of $40 billion. A 5 percent increase in the liability is $9 billion. The asset loss implied by a 30 percent decline in equity securities is $13 billion. The combined amount is about $22 billion. As a matter of scale, GM's 2007 reported loss was $39 billion and its reported operating cash flow was only $8 billion.
* General Electric: This previously venerated company ended 2007 with plan assets of $69 billion and the debt was $65 billion with a net overfunded asset of $4 billion. Applying a 5 percent growth factor to the debt produces an increase of about $3 billion, while taking away 30 percent of the equity portion of the assets yields a decline of about $11 billion. Under these assumptions, that nifty $4 billion surplus is turned into a $10 billion net liability. That $14 billion net decline is about two thirds of the company's reported net income for 2007, so it's not to be sniffed at.
Beyond any doubt, the pincers created P-bombs that have already gone off. But the explosions are yet to be heard and you won't find them lighting up income statements because of bad accounting standards. After all, the main goals of SFAS 87 were to dish gobbledygook out to the capital markets while keeping truly useful information away from them.
The dumbest thing of all substitutes the expected return on the plan assets for the actual return when calculating annual pension cost. Take GE, for example: The company disclosed an expected long-term return rate in 2007 of 8.5 percent; given the fund balance, a $6 billion expected return would be used to compute the 2008 pension cost, instead of what will likely turn out to be a multi-billion-dollar loss. That's a many-billion-dollar swing in reported earnings toward the high side based solely on bad accounting.
To all who hope the worst is behind us, don't ignore that faint but growing tick ... tick ... tick ... .
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 firstname.lastname@example.org.
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