Pensions: $400 billion hole to reduce U.S. corporate earnings

An issue that has received scant acknowledgment in the media is the likely hole in pension funds books resulting from the recent rout in shares. Pension funds must invest the money they receive today in order to provide pensioners funds tomorrow. The problem is that pension funds have been overestimating the likely returns for years and now that we have hit a rough patch in the economy this poor actuarial accounting is about to catch up with them.

Volatile markets have saddled U.S. companies with a $409 billion deficit on pension plans, reversing a $60 billion surplus a year earlier, and will cut into earnings in 2009, consulting firm Mercer said.

As of December 31, pension plans among members of the Standard & Poor’s 1500 had $1.21 trillion of assets and $1.62 trillion of liabilities, Mercer said in a report released on Wednesday. At the end of 2007, pension plan assets totaled $1.66 trillion and liabilities totaled about $1.6 trillion, Mercer said.

The S&P 1500 is a broad portfolio representing large-cap, mid-cap and small-cap segments of the U.S. equity markets.

The shortfall suggests that more companies will have to pump cash into their pension plans to ensure they can meet their commitments to retirees.

Mercer estimated pension expenses will increase to about $70 billion this year from $10 billion in 2008, reducing overall profitability by about 8 percent.

“The decline in funded status will be capitalized and reflected in corporate balance sheets for many companies,” Adrian Hartshorn, a member of Mercer’s financial strategy group, said in a statement.

He said this will reduce balance sheet strength and could affect companies’ ability to make capital expenses, meet loan covenants and preserve their credit ratings.

Edward here. The fact is that pension funds have systematically used excessive projected returns in order to avoid paying into the fund. In fact, pension funds have been a large source of earnings for most companies.

How does this work? Say, you are an international company called American-British Consolidated. Each year, your workers contribute $100 million to their pension plan. In return, they are guaranteed a certain payout for life. This is called a defined benefit plan — something companies now loathe because they are on the hook for payouts. So they increasingly switch to defined benefit plans, or so called 401K’s.

Now, under Generally Accepted Accounting Principles (GAAP), one must calculate an estimated payout schedule and its net present value after subtracting the employees’ $100 million contributions All of this is complicated and requires assumptions on average life expectancy as well as average pension fund return.

Here’s the thing: if you run the numbers and they come too far short, you MUST cough up more money right now, today, to make the fund whole. What to do? Make optimistic assumptions, silly. If the fund returns 10%, that makes a future payout much less onerous than if the fund returns 7.5%. Everyone knows that.

Only during bear markets do these tactics come to light. Witness the following proposal from 2001 during the last bear market, still accessible on General Electric’s site (I have bolded the most important bits):

The Communications Workers of America Pension Fund, 501 Third Street, N.W., Washington, D.C. 20001-2797 has notified GE that it intends to submit the following proposal at this year’s meeting:

“Resolved that the stockholders request that the Board of Directors take the steps necessary to adopt a policy that future executive compensation will be determined without regard to any pension fund income, so that the compensation of senior executives will be more closely linked to their performance in managing the business.

“Supporting Statement: Accounting rules require the Company to include gains on the assets in its pension fund in calculations of income, even though no money is transferred to the Company. This distorts the principle of pay for performance because the Company relies on net earnings and earnings growth in determining the compensation of executives.

GE reported $1.7 billion in pension income in 2000. According to a recent study by Credit Suisse First Boston (CSFB), this is the second largest amount reported of all companies in the S&P 500. This pension income amounted to 9.4% of GE’s reported pre-tax income for the year.

“While the impact of earnings calculations may vary, GE’s top five executives were given cash bonus awards of $23.7 million in 2000. They were given restricted stock units worth $89 million. They were given long-term incentive awards contingent on financial performance over a three year period, and were paid $58 million pursuant to the contingent awards that were made in 1997. In addition, they were given options with a potentially realizable value of $422 million if future earnings permit GE stock to appreciate at an annual rate of 10 percent over the option term.

“Executive compensation ought to be based on performance. It should not be distorted by ‘pension income,’ because that item of income does not represent money the Company has actually received, and does not reflect the operational performance of either the Company or its executives.

“As Business Week reported on August 13, 2001, when companies ‘are inflating earnings with income from pension plan assets, … their [reported] results look better than what’s really happening with their business.’ For this reason, a Morgan Stanley Dean Witter report declares that ‘net gains from pension assets do not deserve the same valuation … as true operating income.’

“A related concern, according to The Wall Street Journal (June 25, 2001), is the possibility ‘that companies can use pension accounting to manage their earnings by changing assumptions to boost the amount of pension income that can be factored into operating income.’ According to Business Week, ‘Companies can not only play around with the expected rate of return on assets but also with the value of the assets themselves.’ They can also boost pension income at the expense of employees and retirees by reducing anticipated benefits or withholding improved benefits.

“CSFB identifies several companies that ‘increased their expected rates of return on plan assets in 2000 even though their actual returns on plan assets declined.’ While such increases may well be an appropriate exercise of discretion, the proposed policy would reduce any temptation that senior executives may have to ‘use pension accounting to manage earnings’ for the purpose of increasing their own compensation.”

Your Board of Directors recommends a vote AGAINST this proposal.
This proposal requests the Board to make future executive compensation determinations without regard to reported pension fund income, purportedly to link more closely executive compensation to business performance. As discussed in the Compensation Committee Report at pages 16-19 (Compensation Committee Report), executive compensation is already closely linked to the performance of internal business units and to the appreciation of GE stock – which in turn is linked to GE’s overall business performance. Because your Board believes that senior executive compensation is already closely linked to business performance, and therefore to the long-term interests of the share owners, your Board believes this proposal is unnecessary and recommends a vote against the proposal.

Now, here’s the great thing about pension accounting. If your numbers are good enough, not only do you avoid a shortfall, you actually receive a windfall profit. Just as shortfalls must be topped up, windfalls must also be recorded and fall proportionately to the bottom line of the company. You will notice, however, these are phantom profits because they are non-cash items.

At issue with GE in 2001 was the fact that General Electric received nearly 10% of its earnings from fictitious, non-cash based net contributions from its pension fund. These profits boosted the bottom line and helped executives make a lot of money as their pay was directly and indirectly linked to the company’s profit. Some shareholders did not like this, so they issued the proposal quoted above. Of course, as you saw, the Board of Directors recommended shareholders vote against the proposal. So, the proposal failed.

Now that we have seen another massive drop in market returns, proposals like this are likely to resurface — especially given the $400 billion shortfall that Mercer foresees. We shall see if these new proposals have any more success than the ones in 2001 and 2002.

U.S. companies face $409 billion pension deficit: study – Reuters
Share Owner Proposal No. 6 – GE Annual Report 2001

  1. Dudley Heer says

    Re: Pension Accounting. It seems to me that any non-cash income from inckuding pension fund investment gains in a company'y net income should be subtracted out in the flow of funds statement as well as disclosed in the income statement. Thus, a cash flow analysis would make the correct adjustment, cash flow being the only correct way to look at a company's results. If this information is not shown, then the auditor must be questioned as to why not as should management as this would not be full disclosure.

  2. Edward Harrison says

    Dudley, all public companies produce a cash flow statement. And the pension numbers including investment return assumptions are all on display for everyone to see in the annual report. However, that doesn't mean that compensation plans are matched to cash flow. They are generally based on net income. And when looking at the pension fund return estimates, I remember looking back through annual reports from the early 1990s and comparing them to early this decade during the last bear market. There was a considerable lift in assumptions. Was this another pro-cyclical factor that will come unstuck. it seems so.

  3. Dudley Heer says

    Mr. Harrison, I think you missed my point. To do a correct cash flow calculation and the claims on that cash requires the use of both the income statement and the the flow of funds statement are used and making adjustments deemed appropriate, i.e. eliminating nonrecurring items. Obviously, the pension information is in the footnotes and just as obvious managements play games with the assumptions and the accounting. However, that was not my point nor did I have anything to say about compensation which is not germane to whether or not you can determine the extent that pension gains are in earnings and that they should be removed when looking at a company's results. Of course, management wants them included so they can receive higher compensation. But, if the analyst is doing his/her job she will take that into account. The problem is determining the extent or percentage pension gains are a part of income. The best way to look at a company's results is to do a cash flow analysis which removes all the dubious items like pension gains and gives the analyst the clearest picture possible of a company's financial performance.

    1. Edward Harrison says

      I think we are on the same page then; it is an investment analyst’s job to take all available information in assessing a company. I now this is the common habit on Wall Street, especially when you are talking about industries with large amounts of CAPEX. In order to get a sense of real value one needs to look at the cash flow and subtract the maintenance CAPEX in order to come up with the free cash flow. Doing so is standard practice.

      But that does not diminish from the fact that management is not incentivized by free cash flow. Their pay is usually connected to net income. And most equity analysts publish net income estimates that are tracked as baselines for whether a company ‘beat” estimates. that is a problem because it leads to fudging the numbers to make earnings.

      And just so you know, there is actually considerable leeway in even how the cash flow statement is presented.

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