Big Baths and Pension Accounting
According to "Rewriting Pension History" by Michael Rapoport (Wall Street Journal, March 9, 2011, several large multinational corporations are changing the way they report retirement plan numbers. The goal is to stop smoothing losses and gains and instead have current year earnings reflect the full extent of what is owed (or available as a surplus).
Cynics might describe this strategy as a "big bath" approach. Report pain all at once and therefore be able to report higher earnings the following year. On a more benign note, companies may simply want to provide more transparency to their investors, especially at a time when lots of questions are being asked about the costs associated with providing retirement benefits to current and past employees.
Assuming good intentions, recognizing the pension deficit (surplus) in the year in which it occurred may still not provide accurate information about the true economic costs associated with servicing a traditional pension plan. There are many reasons why a comparison of the non-smoothed pension gain or loss for two or more companies could differ, sometimes dramatically. Consider the following.
- Reported numbers that are based on accrual accounting do not necessarily reflect the actual cash flowing out (in) the door. Investors will still have to assess whether the sponsor can readily access cash to meet its pension obligations and at what cost.
- Assumptions about factors such as wage hikes, cost of living adjustments, mortality, return on assets and risk exposure given a particular asset allocation mix can and do vary across companies. Unless a prospective or existing investor can assess whether underlying assumptions make sense, it is difficult to know if reported numbers are too low or too high, relative to economic reality.
- A year-by-year analysis of reported earnings is going to be hard to render without making some adjustments to past financial statements. Hopefully companies that use current accounting methodology for their 2010 books will provide sufficient information for investors to be able to compare "apples to apples."
- Actuarial numbers used for compliance with the Pension Protection Act of 2006 could still vary, perhaps materially, from reported current year numbers, causing confusion for investors and creditors as to which number is "right."
- For those companies that are infusing their defined benefit plans with massive amounts of cash, it would be helpful to understand how enterprise value is impacted as a result since that cash cannot be used for product development, dividend payments and so on.
- For those executives who receive earnings-linked compensation, there are questions about how their respective bonuses will be computed in the year of the big bath versus the following years. The concern for investors is that executive compensation might be too "generous" later on due to this year's accounting decision versus a growth in operating earnings.
As described in "The Plan That Didn't Bark" by Susan Mangiero (CFA Magazine, March/April 2008), quantity is not the same thing as quality. Investors may be provided new and arguably more information about pensions and still be in the dark about the true encumbrance associated with an underfunded plan.
The same "clear as mud" dilemma that confronts investors of ERISA plan sponsors likewise applies to public pension and health care plans. According to Dr. Michael Kraten, an accounting professor with Providence College and president of Enterprise Management Corporation, "There are no requirements in the MD&A sections of the annual reports of the health plans to disclose and/or discuss detailed 'churn rates' of the subscriber base, 'turnover rates' of the provider base or the quality of care 'outcomes data' of the network itself."
More than a few individuals have called for a separate financial report for each retirement and health care benefit plan sponsored by a particular company or government. There are distinct advantages of that approach as long as uniform reporting standards are used and the accounting numbers are as close as possible to economic losses (gains). On the flip side, treating the benefit plans as separate and distinct makes it difficult, perhaps impossible, for a firm to manage risks across the enterprise.
That's a significant discussion for another day...
