Institutional Asset Allocation

My comments about institutional asset allocation, along with those made by Mr. Ron Ryan (CEO, Ryan ALM) and Lynn Connolly (Principal, Harbor Peak, LLC), were well received on January 8, 2014. Part of a joint program that was sponsored by the Quantitative Work Alliance for Applied Finance, Education and Wisdom ("QWAFAFEW") and the Professional Risk Managers' International Association ("PRMIA"), our audience of investment professionals added to the lively debate about topics such as strategic versus tactical asset allocation, fees, role of the pension consultant and the likely capital market impact due to the implementation of strategies such as liability-driven investing ("LDI") and/or pension risk transfers ("PRT"). 

With the size of the U.S. retirement market at $20 trillion and counting, big money is at stake. Bad asset allocation decisions can lead to a cascade of economic woes. It is no surprise that fiduciary breach allegations in the form of ERISA lawsuits are increasingly focused on questions about the appropriateness of a given asset allocation mix and whether an investment consultant or financial advisor has helped or hindered the way that pension monies are allocated. Noteworthy is that scrutiny about the efficacy of the asset allocation process and resulting money mix can, and has been, applied to both defined benefit and defined contribution plans. Keep in mind that asset allocation decisions are likewise central to assessing popular financially engineered products such as target date funds. Accounting issues and how changing rules influence asset allocation decisions are yet another topic that we will tackle in coming months.

Click to access Susan Mangiero's asset allocation slides, distributed to members of the January 8 audience, and meant to peturb a discussion about this always essential topic. Interested readers can check out "Frequently Asked Questions About Target Date or Lifecycle Funds" (Investment Company Institute) and "Annual Survey of Large Pension Funds and Public Pension Reserve Funds: Report on pension funds' long-term investments" (OECD, October 2013).

If you have a specific question about asset allocation and/or the procedural process associated with asset-liability management, send an email to me.

Benefits Accounting Legerdemain

Accounting has been on my mind a lot these last few days. A colleague recently asked me to review his pitch deck for a prospective attorney client. We ended up spending time in discussing a slide about pension accounting. I suggested that he move the focus away from accounting-driven balance sheet risk and instead discuss the economic implications of an underfunded plan. Let's leave aside for now that we could have a lengthy and complex discussion about how to properly measure a shortfall - whether for a defined benefit plan or a defined contribution plan. Instead, I would like to reiterate that economic numbers are seldom the same as accounting numbers.

Let me repeat.

Economic numbers are not necessarily the same as accounting numbers. That's not to say that one is bad and the other is good. So much depends on the objective at hand. If I am a risk manager and need to plan for adequate cash on hand, a historical accounting number is not sufficient. Furthermore, accounting numbers can be based on a set of rules or driven by a collection of principles.  I will likewise leave a discussion of the merits of Generally Accepted Accounting Principles ("GAAP"), non-GAAP reporting, international accounting standards and hybrid approaches for another day. Until then, interested readers can check out "Principles vs Objectives-Based Accounting Systems," excerpted from "2012 Current Developments Update: Accounting & Financial Reporting" by Steven C. Fustolo, In a similar vein, if you would like to get a snippet of the concept that actuarial numbers are not necessarily the same as economic numbers, you can read "Will the Real Pension Deficit Please Stand Up?" by Susan Mangiero (June 22, 2006). While written before the Pension Protection Act of 2006 was signed into law by President George W. Bush on August 17, 2006, the notion about actuarial representations versus economic reality remains valid today. Complicating things is that actuarial numbers themselves can vary by virtue of inputs and model selection but I digress.

The important message is that one needs to understand how numbers are assembled, what they represent and, just as critical for proper decision-making, what they do not include. Moreover, it is essential to understand that accounting numbers can vary across countries, across sectors such as private versus public and over time.

Consider a November 11, 2013 statement from Fitch Ratings, Ltd. that predicts a likely jump in reported defined benefit plan provisions for 2013 as the result of a revised standard known as International Accounting Standard ("IAS") 19 on Employee Benefits. Authors of "German Corporates Most Affected by Pension Accounting" - John Boulton, Alex Griffiths and Cynthia Chan - write that "as there would be no change to the economics of a company's pension obligation, the new rules should not change our analysis or ratings." However, if an investor is comparing financial statements for a German company with a non-German competitor that utilizes a different way to create year-end and quarterly data, it will be necessary to make adjustments. Otherwise, the financial statement user is unable to make an evaluation on an apples-to-apples basis. In addition, it is important that the accounting numbers be converted to metrics that allow the investor to evaluate required cash flow, anticipated impact on debt service and other types of economic risks that are associated with the sponsor's offering of a benefit plan(s).

Another recent example of allowable story-telling about benefits that merits further analysis comes courtesy of Gretchen Morgenson. In "Earnings, but Without the Bad Stuff" (November 9, 2013), this New York Times muckraker describes the use of Regulation G by Twitter to present a second set of operating results "through the eyes of management" by lopping off $79 million stock-based compensation expense for Q1 through Q3 2013. She cites Jack T. Ciesielski, publisher of The Analyst's Accounting Observer, as saying that 'When they back out stock-based compensation they're basically saying that management is working for free...And we know that's not the case." Click to download the final amendment to the Twitter prospectus and visit the section entitled "Reconciliation of Net Loss to Adjusted EBITDA." You will see that, for the first nine months of 2013, a net loss of roughly $133.852 million is the top line. Then $79.170 million is added back, along with $77.670 million for depreciation and amortization expense. Another $6.203 million is added back for interest and other expense. Adding back $1.494 million as a provision for income taxes results in an Adjusted EBITDA of $30.685 million.

For all of the investors that include pension funds, endowments, foundations and family offices with allocations to organizations that are large shareholders of the now public 140-character communications company, they may want to ask about how different numbers were parsed. According to the Washington Post (November 6, 2013), Twitter's major shareholders include Benchmark Capital, JPMorgan and Rizvi Traverse.

Economic Indicators to Include Focus on Pensions

In what most people would call a significant announcement, the U.S. Bureau of Economic Analysis ("BEA") will begin measuring economic growth this summer by taking pension finance into account. According to its March 2013 announcement, BEA will record defined benefit plan transactions on an accrual accounting basis. This entity, part of the U.S. Department of Commerce, will now include a pension plan subsector in the national income and product accounts ("NIPAs"). As much as possible, the BEA will "provide estimates of the current receipts, current expenditures, and cash flow for the subsector." The intended changes contrast with the current method of including information about disbursements and earnings of pension plans as participants' personal items and using a cash basis for reporting.

The goal of enhancing transparency about employer-provided defined benefit retirement plans is laudable. However, in reading the fine print, one wonders if the opposite will occur and users of post-implementation data will be more confused. For one thing, the BEA states that it will adopt an accumulated benefit obligation ("ABO") for "both privately sponsored and state and local government sponsored plans" and use a projected benefit obligation ("PBO") for federal government plans. This means that you will never be able to compare all defined benefit plans with a single set of rules. Second, the BEA describes a discount rate assumption that "will be based on the AAA corporate bond rate published by the Federal Reserve Board." Since debt issued by the U.S. is no longer rated AAA and recent regulations allow for temporary funding relief for corporate pension plans, how will BEA numbers compare and contrast with financial accounting numbers over time? Third, since certain data is not available prior to 2000, the BEA will extrapolate to generate "normal costs" for past years. Will their method of extrapolation allow for an accurate "apples to apples" assessment of historical pension earnings and costs? In the plus column, applying the same discount rate for private pension plans versus state and local offerings will help to better assess the economic viability for each sector.

Should the Public Employee Pension Transparency Act move forward, disclosures will be based on the BEA approach. Understanding what BEA numbers do or do not show will therefore be a critical exercise for policy-makers, investors and participants.

For a detailed discussion of these intended changes on the part of the BEA, read "Preview of the 2013 Comprehensive Revision of the National Income and Product Accounts: Changes in Definitions and Presentations," BEA, March 2013. Click to read about advantages of passing the Public Employee Pension Transparency Act. Click here to read criticisms of this proposed rule. On April 23, 2013, the U.S. Senate received a version of the Public Employee Pension Transparency Act in the form of S. 779. This proffered legislation cites a staggering $5.170 trillion in pension liabilities of the 50 states combined. It is no wonder that numerous individuals want a true tally of what is owed.

New PCAOB Report Finds Pension Valuation Numbers Wanting

According to a new report just published by the Public Company Accounting Oversight Board ("PCAOB"), valuation of pension plan assets was one of the audit areas with "deficiencies attributable to failures to identify and test controls." Given the importance of having proper pension valuations carried out by knowledgeable and experienced persons, it is no surprise that this oversight organization devoted an entire section of its findings to the topic of valuation of pension plans assets. The problems they found include the following:

  • Insufficient testing of controls over how pension plan assets are valued;
  • Testing of controls that were imprecise and therefore did not allow for an assessment of the risk of material misstatement by plan auditors;
  • Failure to properly test the valuation of pension plan assets; and/or
  • Relying on management or the person(s) who performed the reviews without seeking an independent assessment as to why "variances from other evidential matter" were occurring.

In response to these findings, a prominent ERISA attorney commented that the cited deficiencies were not surprising and that valuation problems will continue to grow for those retirement plans that are allocating more money to "hard to value" funds.

In his 2011 speech before the AICPA National Conference, Jason K. Plourde with the Office of the Chief Accountant, U.S. Securities and Exchange Commission ("SEC"), talked at length about the role of pricing services and how securities that are not actively traded should be valued. He suggested that management "may need to perform different procedures and controls when considering the information from pricing services regarding the fair value of financial instruments..."

Concerns about how best to value pension plan assets and regularly test methodologies and controls related to said valuations took center stage in 2008 when the ERISA Advisory Council working group on "Hard to Value Assets" met to discuss how best to improve things. This blogger - Dr. Susan Mangiero - testified on the topic of "hard to value assets," emphasizing that poor valuations lead to a cascade of problems. For one thing, inflated valuations translate into higher fees paid by ERISA pension plans. Second, incorrect valuations make it difficult to properly review and revise any of the items listed below, each of which are critical to proper fund management such as:

  • Asset allocation;
  • Exposure to a particular sector or fund manager;
  • Fee benchmarking for appropriateness of compensation paid to a manager;
  • Type and size of hedges;
  • Hiring and termination of an asset manager(s);
  • Regulatory funding ratio and related cash financing; and
  • Cost of pension plan de-risking for some or all of current defined benefit plan participants.

If you missed reading Dr. Susan Mangiero's September 11, 2008 testimony before the ERISA Advisory Council Working Group, click to read about "hard to value" assets in the context of ERISA fiduciary duties and pension risk management.

With more pension plans reporting large scale deficits, don't be shocked if further questions are asked about the integrity of asset and liability valuation numbers.

Retirement Townhall Adds to Debate on Pension Accounting

In "New reporting trend may ultimately put pain in rearview mirror" (Retirement Townhall, March 23, 2011), Milliman Inc. executive Bart Pushaw cites "Big Baths and Pension Accounting" by Susan Mangiero (March 9, 2011) and "Rewriting Pension History" by Michael Rapoport (Wall Street Journal, March 9, 2011) in his discussion about pension plan reporting reform. Specifically, Pushaw talks about the convergence of U.S. Generally Accepted Accounting Principles ("GAAP") with international standards and the likelihood that plan sponsors' earnings "would be automatically increased, and expenses decreased, for future years" because of accelerated "hits" when performance is poor. He adds that a move towards more realistic representation of the funding status of a particular defined benefit plan will encourage the use of liability driven investing ("LDI") as a way to "avoid the significant mark-to-market hits that are expected in the future."

Pension Rate of Return Reality

According to its March 15, 2011 press release, the Board of Administration for the California Public Employees' Retirement System ("CalPERS") votes to maintain its current per annum discount rate assumption of 7.75 percent. Citing its actuary's take that maintaining the "discount rate at its current level is prudent and reasonable" and its long-term investment posture, this giant pension system justifies the status quo.

A few months ago, CalPERS "slightly decreased the allocation for traditional bonds and shifted the funds to inflation-protected bonds and commodities to reduce volatility risk." Its historical and projected analysis suggests an average gross (net) annual return of 7.95 (7.80) percent for the next several decades. Prior to 2004, CalPERS states that it had assumed an annual discount rate of 8.25 percent.

Not everyone agrees that defined benefit plan rates of returns should hover around the magic eight percent that has been long used for determining funding status. St. Petersburg Times reporter Sydney P. Freedberg describes the dilemma in "Experts say Florida overstates future pension returns" (March 21, 2011). If states assume a rate that is overly optimistic, reported IOUs will be smaller as a result on paper but not in reality. At some point, real money will be required to write checks to beneficiaries. On the flip side, the use of a more likely rate of return will balloon unfunded liabilities, forcing economic and political change right away.

The larger the funding gap (and assuming no changes in contributions), the more likely it is that traditional pension plan decision-makers will steer money towards higher risk investments, in anticipation of higher returns. This may be a valid strategy AS LONG AS new risks are properly identified, measured and managed. Otherwise, the situation could become even worse as out of control risk-taking leads to more and larger portfolio losses down the road.

As described in "Will the Real Pension Deficit Please Stand Up?" by Dr. Susan Mangiero, CFA, FRM (June 22, 2006), the American Academy of Actuaries writes in its July 2004 primer on pension fund accounting and funding that "Amounts calculated under pension funding rules are completely different than those calculated for pension accounting, and one must be careful not to mix the two topics."

The important issue continues to be how long it will take before plan participants, sponsors, shareholders and taxpayers get the real scoop on what is owed, when and by whom.

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...

Bill Gates Talks About Public Pensions

Business Insider journalist John Ellis summarizes Bill Gates' remarks at the TED conference on March 3, 2011 about public pension plans. Apparently, the founder of Microsoft is concerned that ailing state budgets will impair their ability to fund public education. His take on mounting IOUs is that much more needs to be done to structurally address the issues instead of "building budgets on tricks - selling off assets, creative accounting and fictions, like assuming that pension fund investments will produce much higher gains than anyone should reasonably expect."

Note to Readers:

Congress Wants Public Plan Transparency

According to a press release dated February 9, 2011, U.S. Congressman Devin Nunes and U.S. Senator Richard Burr are about to force their peers to focus on public pension fund finances. While the House gets the Public Employees Pension Transparency Act this week, a version for the United States Senate is expected in a few days. The goals of this proposed legislation are several:

  • Provide one set of financial statements (and underlying assumptions) for state and municipal plans to the U.S. Secretary of the Treasury that are based on prevailing accounting methods, even if flawed.
  • Report a second set of financial statements that reflect the level of liabilities for each reporting entity as determined according to a uniform set of rules. "These guidelines will include more realistic discount rates, as well as controls to assure assets are counted using a reasonable estimate of fair market value."
  • Penalize non-compliant government units by withholding federal subsidies of state and local debt and nixing federal tax-exempt status for their bonds.

According to "US House Republicans Rule Out Federal Bailouts For States" by Andrew Ackerman (Wall Street Journal, February 9, 2011), today's Congressional discussion about the state of public employee benefit plans made it clear that states and/or municipalities seeking refuge from their funding problems will not get a federal bailout.

Unless struggling government plan sponsors rescind benefits and/or increase local tax revenue and/or take on a lot more investment risk, they are going to feel immense pain in the coming years. The bad news is not spread out equally. A table that describes the "Public Pension Crisis" and is based on "Public Pension Promises: How Big Are They and What Are They Worth" by Professors Robert Novy-Marx and Joshua D. Rauh projects that Oklahoma, Louisiana, Illinois, New Jersey, Connecticut, Arkansas, West Virginia, Kentucky, Hawaii and Indiana will exhaust their funding first.

The vicious cycle begins. If municipal bond investors view these issuers as higher risk, their respective cost of money will go up. More expensive debt service will exacerbate the overall problems, irregardless of which accounting rules are used for reporting. Taxpayers will get more upset and possibly vote with their feet, moving to what they perceive as fiscally sound cities, towns and states. Yet another falling domino, a shrinking tax base will mean fewer available dollars to pay bills, widening the money gap.

According to "Bond Rating Drop Ignites Pension Fight" by Lisa Fleisher and Jeannette Neumann (Wall Street Journal, February 9, 2011), the Garden State is now on the receiving end of a ratings downgrade and "is one of the seven lowest-rated states in the country." They report that New Jersey missed a $3.1 billion pension payment and could well have been a factor in the drop from AA to AA-.

I hate to say "I told you so" AGAIN but I wrote about the political impact of pension funding in the mid 2000's since it was obvious even then that there were large problems afoot. If you missed it, read "Tea Party Redux" State Pensions in Turmoil" by Susan Mangiero (July 27, 2006) and note that the term "tea party" has nothing to do with the party or movement of late.

Watch carefully as to how these plans change their asset allocations. Already there is a significant move towards investing in funds and instruments with an expectation of higher returns. That's not a problem as long as a robust risk management process in put in place or improved upon if it exists already. My forthcoming book on this topic will elaborate on the potential dangers of taking on too much risk.

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Dr. Susan Mangiero to Keynote Audit World 2009

I have the great pleasure of being one of two keynote speakers as part of Audit World 2009. My speech, entitled "Navigating the Auditor Hot Zone: Helping Investors Through Volatile Financial Markets," will include case studies from the trenches with respect to prudent process, hard-to-value investing, modeling and much more.

Always important, auditors are increasingly finding themselve in a position of providing pro-active guidance to their clients about complex rules and markets alike. It's no surprise then that institutional investors tell us that what, when and how auditors opine is of critical importance. Lack of uniformity in what auditors advise is a stated concern. On the flip side, auditors worry that pensions, endowments and foundations are asking too much of them, forcing an uncomfortable situation that blurs oversight with execution of essential duties.

Please join me for what should be an exciting and topical event. Sponsors of Audit World 2009, the MIS Training Institute, have put together a "case study-driven, information-rich program in four defined tracks: Financial Services, Non-Financial Services, Manufacturing and Best Practices."

Click to download the conference brochure for Audit World 2009 from September 15 through 17, 2009 in Boston, Massachusetts. If you register before August 29, 2009, you are entitled to a 10% discount off the regular conference fee.To take advantage of this special discount, you must contact MIS Training Institute’s Customer Service and reference the following priority code when registering: AW09/PRM. The discount offer cannot be used in conjunction with any other discount offer or on previous registrations. Contact the MIS Training Institute by telephoning 508-879-7999 or sending an email to mis@misti.com.

Private Equity and Derivatives - Double Whammy or Blissful Combo?

According to the U.S. Government Accountability Office, nearly 4 out of 10 surveyed pension plans say they allocate monies to private equity. Allowing that some managers have turned in acceptable returns, respondents also cited numerous "challenges and risks beyond those posed by traditional investments." Valuation and limited transparency are two issues cited in "Defined Benefit Pension Plans: Guidance Needed to Better Information Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity" (GAO-08-692, August 14, 2008).

 

To shed light on some of the intricacies associated with private equity investments, I authored a case study for the February 2009 issue of PEI Manager, a private equity and venture capital focused publication. The bottom line is that institutions that invest in private equity funds are directly impacted by their portfolio companies' use of derivatives.

 

"Swapping out" by Dr. Susan Mangiero, an Accredited Valuation Analyst and CFA charterholder, is reproduced below. Email Ms. Jennifer Harris, Associate Editor - PEI Manager, for permission to reprint the case study.

 

                                                                       * * * * * *

 

THE CHALLENGE:

 

Private Equity Holdings (“PEH”) is required by its charter to avoid companies that use derivative financial instruments to speculate. In reviewing numbers for FAS 157 reporting purposes, a PEH managing partner notices that one of its portfolio companies, ABC Incorporated (“ABC”), recently included a FAS 133 entry for a $20 million interest rate swap hedge. During a call to the company to query about how the swap is being used, the PEH managing partner is informed that its counterparty is Global Bank Limited (“Global”). Not only has Global just reported a $30 billion loss due to poor valuation of its structured product portfolio, it posted no collateral in favor of ABC while ABC was required to pledge $2 million in U.S. Treasury Bills in order to protect Global in the event that ABC could not make its contractual swap payments to Global. Not being too familiar with derivative instrument pricing and default risk analysis, PEH hires an expert to investigate whether the swaps reflect a hedge versus a market bet and to further assess how PEH should adjust the valuation of its equity stake in ABC. What does the expert need to look at and how should she arrive at an appropriate conclusion?

 

SUSAN MANGIERO'S ANSWER:

 

This fact situation, ripped from the headlines, raises several important valuation questions, including, but not limited to the following:

 

  • Notwithstanding FAS 133 numbers, is the company exposed to changes in interest rates that could adversely impact cash flow, liquidity and net income?
  • Was the swap correctly valued?
  • How might ABC be impacted by Global’s deteriorating health?
  • What adjustments, if any, should PEH make to its initial valuation of ABC equity?

There are several critical issues here, all of which could seriously hamper the fortunes of both ABC shareholders and PEH investors. An inaccurate valuation of the swap leads to a flawed accounting representation for ABC and may lull treasury staff into thinking that the hedge offers full protection against unexpected moves in interest rates. PEH may report a bad FAS 157 number which in turn could lead to flawed asset allocation decisions made by institutional limited partners or the overpayment of performance fees to PEH. A poorly constructed hedge (in economic versus accounting terms) that exposes ABC to negative market conditions could force PEH to violate its prohibition against speculative trades being executed by portfolio companies. If Global does not meet its swap obligations and/or files for bankruptcy protection, ABC may not be able to recover its collateral quickly or could lose it altogether, depending on its standing vis-à-vis other creditors.

 

Swap pricing models can differ depending on the complexity of the transaction. However, for standard fixed to LIBOR swaps, the secondary market is large ($111 trillion, according to the Bank for International Settlements). Active trading makes it easy to readily obtain prices for various maturity interest rate swaps with quotes reflecting the discounting of future projected fixed and floating swap payment amounts. In contrast, the assessment of credit worthiness varies, sometimes considerably, across banks. Unfortunately for ABC, even if they posted more collateral than should have been required, the fact remains that they have no immediate recourse in the event that Global’s distress prevents the bank from paying what it owes to ABC. If Global defaults, ABC will then have to decide on a course of action that could include any or all of the following:

 

  • Enter into a second interest rate swap to replace Global at a now higher fixed rate
  • Attempt to sell the initial swap in the open market and consider another way to hedge against rising interest rates though few will be willing to accept the Global risk
  • Take legal action to reclaim its collateral
  • Write down the value of the swap on its books

There is no ideal situation. The expert will necessarily have to ask ABC what they plan to do in the event of swap non-performance and how it is expected to impact its cash flow, cost of money (which in turn affects capital budget decisions), balance sheet, dividend payments and interest coverage. Once that scenario analysis is conducted, both the expert and PEH will be able to quantify how much of an adjustment downward they will need to make for both accounting and performance reporting purposes.

Hard to Value Assets: Hide and Seek Creates Stir for Investors

As this blogger has long maintained, what you see is not necessarily what you get and what you don't see could come back to bite you. It is therefore troublesome to think that billions of dollars of assets are likely to be classified as Level 3 or the international equivalent of FAS 157 "hard to value" items.

According to "Financial groups' problem assets hit $610bn" (December 10, 2008), a significant trend is already underway for banks to move securities to third tier status. Financial Times reporters Aline van Duyn and Francesco Guerrera cite a Standard & Poor's study that shows an increase in illiquid assets by more than 15 percent from Q2-2008. Difficulty in finding buyers for mortgage-backed securities and collateralized debt obligations accounts in part for the increase. Somewhat alarming, the article adds that "level-three assets are many times bigger than the market cap of the banks."

In "Running the Fund: Alternative Realities" (November 2008), PlanSponsor reporter Judy Ward quotes me extensively on the topic of valuation of "hard to value" assets from the investment fiduciary perspective. As regular readers will recall, the U.S. Department of Labor has made no secret that it would like to see pension decision-makers do a good job of vetting valuation numbers that are provided by its asset managers.

Litigation, sub-par asset allocation, anemic risk management, overpayment of fees and eventual losses due to hidden economic pot-holes are just a few of the possible nasties when valuation process is ignored. If true that banks themselves are struggling as to how properly classify a holding(s), how will plan sponsors need to respond? As I said to Ward, The number is important, but it is more important to know why that valuation number is what it is, and if the factors that contributed to that valuation number are likely to change. People take a sense of false security from that one number."

If regulatory filing statistics portend more recategorizations to "hard to value" status, there will be an awful lot of nervous pension decision-makers, deciding what to do next.

Editor's Note: Click to read a "Summary of Statement No. 157," provided by the Financial Accounting Standards Board. Wall Street Journal reporter Mark Gongloff provides a nice overview of the FAS 157 hierarchy, defining Level 3 assets as those for which inputs are not directly observable. See "A FAS 157 Primer" (November 15, 2007.)

Pension Plan Metrics - What's Wrong With This Picture?

In a November 12, 2008 letter to Congress, the American Institute of Certified Public Accountants ("AICPA") and 300 plan sponsors and pension associations urge new legislation that would help employers avoid "huge, countercyclical contributions," for credit crisis induced losses. The authors' stated rationale is that monies diverted to support defined benefit plans could instead be used for "current job retention, job creation and needed business investments." The letter suggests that, worse yet, employers may be forced to freeze plans altogether unless the Pension Protection Act of 2006 is modified to allow "full smoothing of unexpected losses." Click to read the letter.

One of the letter writers, Watson Wyatt, criticizes the averaging method which, unlike smoothing, does not include projected returns as part of the determination of market values. According to this consultancy's website, "averaged assets cannot exceed (or trail) current market value by more than 10 percent. Prior rules allowed for 20 percent. When asset values drop sharply as they have in recent months, this tight limit around market value creates considerable funding challenges for pension plan sponsors." Finally, the Pension Protection Act of 2006 accelerates replenishment of "underfunded" plans, putting pressure on employers to pony up cash at the same time that they are unlikely to be flush.

While this blogger fully empathizes with the economic pain that can occur when "artificial" reports force real change (i.e. rating downgrade, higher cost of capital, cash squeeze, share price hits, etc), I think Joe and Sally Retiree are still left in the dark as to the financial soundness of their retirement plan. This knowledge gap about which numbers are the right numbers is something we've addressed here before. (See "Will the Real Pension Deficit Please Stand Up?" June 22, 2006.) Global accounting imperatives, national laws and regulatory urgencies add to the confusion about pension metrics - which ones deserve attention and which ones are outright "bad" representations of a plan's ability to send checks every month, made more so when they result in expensive consequences.

This entire debate reminds me of a great line in the 2008 HBO movie entitled "Recount." In this small screen version of uncertainty related to the 2000 U.S. presidential election (remember hanging chads?), the Kevin Spacey character turns to his colleague at one point and says, with great frustration, how he wishes he just knew who won.

In the same vein, one asks - "What is the truth?" Understandably, plan sponsors are upset at having to outlay cash contributions "forced" by the Pension Protection Act of 2006, FAS 158 and/or other "cannot ignore" dictates but should they not counter with a robust solution that gets to economic reality? Should retirees be worried that all or some published numbers lead astray or assume instead that pension decision-makers have it under control?

According to best-selling business author and leadership guru, Warren Bennis, "We have more information now than we can use, and less knowledge and understanding than we need. Indeed, we seem to collect information because we have the ability to do so, but we are so busy collecting it that we haven't devised a means of using it. The true measure of any society is not what it knows but what it does with what it knows."

I raise my hand for reporting rules that (a) reflect the sponsor's true ability to pay, now and later on (b) avoid confusion (i.e. too many regulations can result in conflicting data points or real questions about how to comply with statutory reporting standards) (c) explain the process by which the plan manages its alphabet soup of pension risks and (d) help shareholders, taxpayers, plan participants and other interested parties assess whether a defined benefit plan is "excessively risky."

Is this too much to ask?

Pension Magic

I had the pleasure of speaking on October 23, 2008 in Stamford, CT about "New Directions for the Financial Services Industry." Part of the "Securities Forum 2008: Weathering the Economic Storm," sponsored by the State of Connecticut Department of Banking, panelists addressed the litany of current financial problems, proposed reforms and the likely future for investors and service providers alike.

I was asked to address FAS 157 and international equivalents. In doing so, I urged audience members to make a clear distinction between accounting representation and economic reality or accept the consequences. Unless one truly understands what reported numbers say (or just as importantly don't convey), poor decisions made on the basis of incomplete or even illusory information can lead to costly outcomes (GIGO = Garbage In, Garbage Out).

I've long maintained that disclosure about process is arguably more important than single numbers, derived at a particular point in time. For example, if I'm a pension fund decision-maker who has allocated monies to a manager that in turn invests in "hard-to-value" assets, which information is more helpful to me in understanding my risk exposure to that asset manager - (1) a FAS 157 disclosure that describes possible changes that could affect results or (2) identified likely risk drivers and the controls that have been established to mitigate risk accordingly?

Said another way, am I properly discharging my fiduciary duties by evaluating risk ex poste or instead assessing uncertainty ex ante? I think the answer is obvious, isn't it? After all, no one can respond to "what was" but can certainly act in anticipation of "what might be." By the way, I do believe there is merit in regularly conducting a post-audit of what went wrong and trying to learn lessons as a result.

According to FORTUNE Magazine senior editor Allan Sloan, critics of FAS 157 allege real harm is being done when illiquid securities are marked-to-model at "artificially low market prices." Call me clueless but finger-pointing seems to answer the wrong question. Instead of focusing on FAS 157 as the culprit because it supposedly forces reporting entities to document "bad" economic numbers, why not create a standard that instills confidence in financial statement users? Sloan writes "It's easier to blame accountants for your problems than to admit you made your institution vulnerable by overleveraging its balance sheet and buying securities you didn't understand." Click to read "Playing the blame game: Will 'mark to market' accounting take the fall for the Wall Street mess?" (October 27, 2008).

Just like the magic impossibility of growing a silver dollar into four years of college tuition, accounting representation should be more than smoke and mirrors.

Would Better Disclosure Have Helped WaMu Shareholders?

According to a September 25, 2008 press release from the U.S. Securities and Exchange Commission ("SEC Seeks More Transparent Disclosure for Investors"), pundits will gather in Washington, D.C. on October 8 to wax poetic about transparency. Two panels will convene to address "data, technology, and processes that companies and other filers use in satisfying their SEC disclosure obligations" as well as "how the SEC could better organize and operate its disclosure system so that companies enjoy efficiencies and investors have better access to high-quality information."

While I am in favor of "sufficient" disclosure to inform shareholders, plan participants and other interested parties, a critical question remains. What exact type of disclosure can really make a difference? I vote for information about process and accountability. Otherwise, financial statement users end up with snapshot assessments of mandated metrics. While these numbers could be potentially helpful, they are made less so without an understanding as to how they are derived, why they change and the extent to which an organization is exposed to economic danger. A few of the countless questions on the minds of inquiring individuals are shown below. (This is by no means an exhaustive list.)

  • Who has the authority to effect change for all things financial management?
  • Who oversees authorized persons and the latitude they enjoy to make decisions?
  • How are risk drivers identified, measured and managed on an ongoing basis?
  • What creates "stop loss" threshholds?
  • How are functional risk managers compensated?

As reported by CNN.com, JP Morgan Chase has just purchased $307 billion in assets from Washington Mutual (ticker symbol WM) in what is described as "the biggest bank failure in history." Serious stuff indeed but would more detailed financials have helped? We know that the large thrift ushered in a new chief risk officer ("WaMu replaces its chief risk officer," April 29, 2008) to "help steer the nation's largest savings and loan through the fallout of the mortgage and credit crises."

The 2007 Annual Report on Form 10-K/A for Washington Mutual, Inc. is rich with information about risk management, credit risk management, liquidity risk and capital management, market risk management, operational risk management and "Factors That May Affect Future Results." Page 5 of said document states that an evaluation of the Company's disclosure controls and procedures allows the "Company's Chief Executive Officer and Chief Financial Officer" to conclude that, "as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company..."

A company press release dated July 22, 2008 informs the public of actions taken by the Company to build up its reserves and mitigate risk. See "WaMu Reports Significant Build-Up of Reserves Contributing to Second Quarter Net Loss of $3.3 Billion." The bank's website provides a slide presentation about credit risk management also dated July 22, 2008. It details all sorts of information about the loan portfolio, including allowances for loan losses.

According to Wall Street Journal reporters Robin Sidel, David Enrich and Dan Fitzpatrick, a flood of deposit withdrawals forced the demise of this Seattle based financial house. (See "WaMu is Seized, Sold Off to J.P. Morgan In Largest Failure in U.S. Banking History," September 26, 2008).

Question of the Day: What disclosures could have helped shareholders (including pension plans) to know how bad it could get and in what time?

Risk Management Adventures

Thanks to financial planner David Boczar for sending along a thought-provoking quote from famed commodities trader Ed Seykota. Described as someone who turned $5,000 into $15 million over a dozen years, this uber trend follower Seykota cautions: "Surrender to the reality that volatility exists, or volatility will introduce you to the reality that surrender exists."

As I've written many times, risk management is not the same thing as risk minimization. Risk is neither inherently "good" or "bad" but rather a reality, with potentially crushing economic impact if ignored or given short shrift. As we've seen in recent days, some attempts to tame the risk lion have resulted in serious casualties.

It is no surprise then that pundits and reporters are asking about the whereabouts of risk managers, part of the frenzied blame game afoot. (Is there a "Where's Waldo" equivalent here?) New York Times blogger Saul Hansell pressed a lot of hot buttons with his September 18, 2008 post entitled "How Wall Street Lied to Its Competitors." My response, now one of more than 100 posted responses, is shown below.

<< I concur with much of this article. Effective risk management is much more than quantitative analysis. Many individuals are lulled into false security when given a bunch of computer printouts, accepting numbers as gospel truth. Like the fictional Detective Columbo, decision-makers must search for “hidden” information, not reflected in computer printouts. I recently testified before the ERISA Advisory Council about “hard to value” assets. Click here to read my comments. http://www.pensionriskmatters.com/2008/09/articles/valuation/testimony-of-dr-susan-mangiero-about-hard-to-value-assets/

P.S. Some of the quants sat on boards of financial institutions. It would be helpful to know more about their role as relates to oversight of risk management activities. >>

To my last point (above), it should be noted that litigation risk could be a deterrent for prospective directors with risk management experience. For example, Ms. Leslie Rahl (who is quoted in Hansell's blog post about the perils of underestimating risk of complex mortgage backed-securities) is, according to the Financial Post, named in a lawsuit filed against Canadian Imperial Bank of Commerce (CIBC), along with others such as the former Chief Risk Officer and the current Chief Risk Officer. Journalist Jim Middlemiss quotes the bank as denying allegations and expressing confidence that their conduct was appropriate. (See "CIBC hit by suit over subprime lending," July 24, 2008.) Additionally Rahl, a former Citibank derivatives division head, is listed on the Fannie Mae website as a "Fannie Mae director since February 2004."

For interested readers who want to follow the mounting litigation related to sub-prime activities, check out attorney Kevin LaCroix's blog entitled The D&O Diary. Be forewarned that Kevin posts volumes about Director and Officer (D&O) liability. Should we be disturbed that he has so much news about which to write?

What does this mean for institutional shareholders? Run, don't walk, to the closest risk management analysts who can help you decipher whether a company is doing a "good" job of identifying, measuring and managing a panoply of financial and operational pain points. Send us an email if you want some help.

On the topic of models, my article entitled "Asset Valuation: Not a Trivial Pursuit" (FSA Times, The Institute of Internal Auditors, 2004) still rings true. Check out the 10 prescriptives discussed therein. (This is by no means an exhaustive list.)

  1. Gain an intuitive understanding of the model.
  2. Ask questions of the model builders.
  3. Determine whether or not a model meets regulatory requirements.
  4. Inquire whether or not different models are being used for tax reporting versus financial statement presentation.
  5. Understand the data issues.
  6. Ask about model access.
  7. Evaluate the asset portfolio mix.
  8. Ascertain the extent to which a model incorporates embedded derivatives.
  9. Determine the simulation approach used to value path-dependent securities.
  10. Enlist senior management to assign someone from the finance team to work closely with the auditing team.

New Pension Investment Disclosure Rules a Reality

Unhappy auditors and plan sponsors may be roaring in response to the outcome of yesterday's FASB board meeting. In case you missed it, Norwalk-based accounting rulemakers opine in favor of enhanced asset risk disclosures. Despite industry arguments to the counter, FASB concludes that benefits outweigh costs, citing credit-related large losses as a factor in their decision to enhance plan transparency.

As stated in our July 15, 2008 post ("FASB Meets to Unlock Pension Investment Risk Information"), critics offer that FAS 132(R) compliance entails time-consuming data collection and analysis, across asset categories and fund managers and, in some cases, for multiple corporate entities. According to CFO.com reporter Marie Leone, FASB chairman Bob Herz (himself a former pension fiduciary) favors layers of information. A plan that allocates four out of every ten dollars to equities would be asked to disclose industry and sector concentrations as follows:

  • 40% in equities
  • 25% of that 40% in pharma
  • 50% of that 25% in high-growth pharma stocks.

Leone adds that FASB board members unanimously dismissed the need for a materiality guidance rule, also concluding that "drilling down to the underlying assets that make up mutual funds, trusts, and fund of funds was not necessary" as long as qualitative text is provided to financial statement users. Click to read "One Step Forward on Pension Disclosures" by Marie Leone (CFO.com, July 16, 2008).

Click to access the FASB audio file for "Disclosures about plan assets" (July 16, 2008 FASB board meeting). Noteworthy is the discussion about what constitutes an "optimal" level of granularity, while acknowledging that some fund managers are VERY reluctant to say too much about how they invest.

Call me circumspect but one wonders whether point in time qualitative information would be better replaced with a description (even if somewhat broad) of risk management and valuation policies and procedures for (a) the plan sponsor and (b) external money managers, respectively.

Process is extremely important. An investment may not return much over a given period(s). However, if financial statement users know that a plan sponsor (and/or asset managers, in the case of outsourcing the investment function) is regularly measuring and managing risk, there may be less angst on the part of nervous beneficiaries and shareholders.

What an interested party does not know (and can't control or influence as a result) is a sure way to lose sleep.

FASB Meets to Unlock Pension Investment Risk Information

The Financial Accounting Standards Board ("FASB") meets on July 16, 2008 to discuss how much investment-related information pension plans should disclose to the public. Following the "exposure" of Statement 132(R) on March 18, 2008, industry participants weigh in about the feasibility of compliance. In its 17-page summary of comment letters, FASB notes disagreement among respondents with respect to the need for asset categorization. Some suggest the use of Form 5500 as a guide to the proper delineation of asset investment risks. (As mentioned elsewhere in this blog, we take issue with the Form 5500 as a meaningful guide for economic risk assessment purposes.) 

Surprising to this blogger, only one other organization (Eli Lilly) besides Pension Governance, LLC comment on the need to better understand a reporting entity's process. In our May 2, 2008 letter, we suggest  that accounting rules "require plan sponsors to describe how it decided on a particular concentration, who monitors the concentrations, what triggers a breach, and what happens when a concentration is exceeded."

Regarding fair value, several companies aver that such disclosures would "provide little information to users because annual postretirement benefit cost is based on the expected return on plan assets rather than the actual return." In stark contrast, note that the U.S. Department of Labor is holding hearings today about "hard to value" assets held by ERISA plans.

More than a few respondents claim that the costs of gathering, and then analyzing, requisite information will outweigh the benefits, especially for those companies with geographically dispersed benefit plans. Others cite problems related to assets held by "multiple trustees in pooled asset accounts" whereby the "look through" process cannot be done by a "trustee with partial information, and the employer may not have the skills or proper information to do so."

A key question remains - If something like FAS 132(R) is not adopted, what do critics propose in its place? At a time when more and more plans allocate monies to complex securities and/or funds with less than full transparency, is it sufficient for fiduciaries to simply say "trust me" and assume that disclosure of investment risk is unwarranted? That may be a lot to ask of plan participants who are already nervous about their financial futures.

Editor's Notes: Click to read "Postretirement Benefit Plan Asset Disclosures - Comment Letter Summary" (FASB). Click to access comment letters submitted by various organizations (including Pension Governance, LLC) about "Employers' Disclosures about Postretirement Benefit Plan Assets."

New Accounting Rules for Public Pension Funds

According to "Government Rule Makers Looking at Pensions," New York Times reporter Mary Walsh (July 11, 2008) describes a new initiative, sure to create headaches for troubled state and city pension plan auditors. Announced at its July 10, 2008 public meeting, the Government Accounting Standards Board plans to "force state and local governments to issue better numbers and reveal the true cost of their pension promises." Walsh describes a GASB report that is frightening at best. (I am trying to get a copy of the report to upload to this blog.) Questionable practices include:

  • Award of retroactive employee benefits without recognizing the incremental costs
  • Use of "skim funds" which diverts some investment income dollars away from the pension plan for other uses
  • Amortization of expenses over 50 or 100 years (versus the customary 30 years)
  • Use of a 30-year amortization period with an annual reset back to Year 1.

Additionally, on June 30, 2008, GASB issued Statement No. 53, Accounting and Financial Reporting for Derivative Instruments in order to promote transparency about the use of derivatives by public entities. In its news release, GASB describes the need to determine "whether a derivative instrument results in an effective hedge." Unclear is whether GASB 53 applies to public pensions that employ derivative instruments for hedging, return enhancement or a variety of other applications. Also unclear is whether embedded derivatives must be accounted for. (I am researching these questions.)

Having been on the front lines of FAS 133 implementation (the corporate equivalent of GASB 53), challenges await auditors and pension finance managers alike. Click to read "FAS 133 Effectiveness Assessment Issues" by Dr. Susan Mangiero (GT News, June 15, 2001) or "Is correlation coefficient the standard for FAS 133 hedge effectiveness?" by Dr. Susan Mangiero and Dr. George Mangiero  (GARP Risk Review, May 2001).

Notably, a survey soon to be released by Pension Governance, LLC and the Society of Actuaries suggests that public and corporate pension plans worry about accounting representation. A large pool of U.S. and Canadian respondents rank compliance with new accounting rules as their number one concern. The survey, entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" is tentatively scheduled for release during the week of July 21, 2008.

Editor's Notes:

  • You may have to register in order to read articles online by New York Times reporters.
  • Check out "The $3 Trillion Challenge" by Katherine Barrett and Richard Greene (Governing, October 2007) and the related "Q&As With the Experts" - Gary Findlay, Susan Mangiero and Richard Koppes.

FASB Releases New Pension Accounting Rules for Comment

In an effort to unlock the mystery about pension investment risk-taking (something we've discussed at length in previous posts), the Financial Accounting Standards Board recently released FASB Staff Position FAS 132r-a (Employers' Disclosures about Postretirement Benefit Plan Assets) for public comment. This author is preparing a response on behalf of Pension Governance, LLC (having also been invited to informally speak with FASB last summer about risk metrics and disclosure pitfalls). If adopted, it will combine elements of FASB Statement No. 157, Fair Value Measurements, and FAS 133/161, the latter being focused on accounting for derivative instruments. 

Critics are already sharpening the proverbial knives, asserting that the proposed rule addresses the asset side only, leaving interested parties in the dark with respect to the economic impact of integrated asset-liability management strategies. Others suggest that a requirement for plan sponsors to separately disclose the fair value of each "significant" category of plan assets will be lots of work with limited benefit to financial statement users. Having worked with FAS 133 compliance (sometimes referred to as the "consultants' full employment act"), I believe that FAS 132r will encourage plan sponsors to hire outsiders to assist with fair valuation and valuation process checks. (We offer this service as do others.) For some plans, the cost of engaging an independent third party might be cost-prohibitive, putting fiduciaries in a difficult spot as to what to do instead, especially if staff members are ill-equipped to do the work on their own. On the positive side, a comprehensive review (if done properly) can aid plan sponsors by pointing out compliance and economic gaps.

Click to read the draft of the FASB proposed pension accounting rules. Public comments will be accepted until May 2, 2008.

The Plan That Didn't Bark

This blog's author is proud to have been asked by CFA Magazine to author a short piece about employee benefit plan disclosure rules and the likely impact on share price. As I've written many times before, what we know about risks being taken by plan sponsors could fill a thimble. In "The Plan That Didn't Bark" (March/April 2008 issue), I suggest that "to solve the mystery of benefit plans," analysts must play the role of investigator. This remains a truism despite recent attempts to enhance reporting guidelines about economic risks of benefit plans, including healthcare offerings.

Even clever analysts who know their disclosure standards cold must nevertheless look beyond reported numbers. "Financial analysts really have no choice but to become forensic detectives. They cannot rely solely on published numbers but instead must ask lots of pointed questions about how plan sponsors identify, measure, and manage myriad types of risk. Knowledge of accounting rules is only a beginning, and a humble one at that. Economic, fiduciary, and regulatory factors count too."

Click to "The Plan That Didn't Bark" by Dr. Susan Mangiero, AIFA, AVA, CFA, FRM (CFA Magazine, March/April 2008).

Warren Buffett on Pensions - Crazy Assumptions?

In case you missed it, the Oracle of Omaha, Mr. Warren Buffett opined on the less than sanguine state of pension reporting. In his 2007 Letter to the Shareholders, this famed CEO of Berkshire Hathaway Inc. made the following comments about corporate and public pension finance. His comments echo our concern (a repeated favorite topic of this blog) about the black box we currently call pension reporting is going to rear its ugly head in a horribly painful way. What we don't know is going to really hurt. Shareholders, beneficiaries and taxpayers, are on the hook at the same time that Medicare and Social Security (and international equivalents) are in deep trouble.

We concur Sir!

For more than a few plans, the sky is falling. Unfortunately, we don't have a way to gauge when and by how much. Is this anyway to run things?

Excerpted from "Warren Buffett's Letters To Berkshire Shareholders
Updated February 29, 2008" - 2007 Letter:

<< Fanciful Figures – How Public Companies Juice Earnings
Former Senator Alan Simpson famously said: “Those who travel the high road in Washington
need not fear heavy traffic.” If he had sought truly deserted streets, however, the Senator should have looked to Corporate America’s accounting.

An important referendum on which road businesses prefer occurred in 1994. America’s CEOs had just strong-armed the U.S. Senate into ordering the Financial Accounting Standards Board to shut up, by a vote that was 88-9. Before that rebuke the FASB had shown the audacity – by unanimous agreement, no less – to tell corporate chieftains that the stock options they were being awarded represented a form of compensation and that their value should be recorded as an expense.

After the senators voted, the FASB – now educated on accounting principles by the Senate’s 88 closet CPAs – decreed that companies could choose between two methods of reporting on options. The preferred treatment would be to expense their value, but it would also be allowable for companies to ignore the expense as long as their options were issued at market value.

A moment of truth had now arrived for America’s CEOs, and their reaction was not a pretty sight. During the next six years, exactly two of the 500 companies in the S&P chose the preferred route. CEOs of the rest opted for the low road, thereby ignoring a large and obvious expense in order to report higher “earnings.” I’m sure some of them also felt that if they opted for expensing, their directors might in future years think twice before approving the mega-grants the managers longed for.

It turned out that for many CEOs even the low road wasn’t good enough. Under the weakened rule, there remained earnings consequences if options were issued with a strike price below market value. No problem. To avoid that bothersome rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market. 

Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved. 

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss. This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the
20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?

Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and highpriced managers (“helpers”).

Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about doubledigit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

Some companies have pension plans in Europe as well as in the U.S. and, in their accounting,
almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.

What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them
report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire. After decades of pushing the envelope – or worse – in its attempt to report the highest number possible for current earnings, Corporate America should ease up. It should listen to my partner, Charlie: “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement – sometimes to those in their low 40s – and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep. >>

Bank Risk Managers - Missing in Action?

In a recent interview on the John Batchelor show, Globalprivatequity.com, Inc. CEO Doug Miles described the current credit crisis as a "black swan" event. This summer, Miles predicted the valuation fallout associated with complex derivative instruments. Adding that banks can't know the extent of their problems anytime soon, an uncertain interest rate environment, new valuation accounting rules such as FAS 157 and infrequent trading in instruments such as Collateralized Debt Obligations make life very uncomfortable. Click here to listen to the November 11, 2007 interview with John Batchelor and Doug Miles.

In his bestselling book, The Black Swan: The Impact of the Highly Improbable, essayist Nassim Nicholas Taleb assigns three attributes to a black swan event in business. "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable." Click here to read the first chapter, as reprinted by the New York Times on April 22, 2007. In his video interview entitled "Learning to Expect the Unexpected," Taleb describes the human brain as "designed to retain, for efficient storage, past information that fits into a compressed narrative." He adds that "this distortion, called the hindsight bias" makes it difficult to learn from past mistakes.

If true that the sub-prime situation is a black swan as Miles asserts, and taking a page from Taleb, we embrace the notion that we are blind to randomness, what then is the proper role of risk management? According to Financial Week reporter Matthew Quinn, inquiring minds are asking "Where were the risk managers?" He avers that some pundits debate whether technology can keep up with product innovation or adequately assess leverage. He suggests that, even if rocket scientists raise their hand, warnings may go unheeded, especially given banks' dependence on proprietary trading. See "Risk managers return (belatedly) to Street: Chastened banks, brokerages get religion on minimizing exposure to hidden bombs. Coulda, woulda, shoulda?" (Financial Week, November 19, 2007). 

In an article I wrote in mid 2003, I commented that the life of a risk manager is challenging to say the least. In addition to a plethora of data analysis skills, a Chief Risk Officer ("CRO") or someone with similar functional duties must be a diplomat, a motivator and a keen student of human behavior. Most people don't want to hear bad news since it usually means more work for them, not to mention the added stress and the potential damage to one's career of being tainted with a problem. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange, July/August 2003).

Unfortunately, for retirement plan decision-makers, risk management is going to be impossible to ignore. Pension funds that include allocations to bank stocks or equity in bank-like financial organizations are already feeling the pinch. Plan sponsors who hired bank asset managers or hedge funds/mutual funds that invested in banks are going to be asked tough questions about the due diligence they performed. Did they sufficiently kick the tires with respect to understanding how the banks managed risk? Fiduciaries of banks' 401(k) plans who recommended company stock are getting sued for allegedly having done too little to assess the attendant risks. Just last week, a complaint was filed against the Federal Home Loan Mortgage Corporation ("Freddie Mac"), citing poor controls that encouraged the acceptance of "risky" loans and inappropriate appraisals of those loans. Click here to read the class action complaint against Freddie Mac.

Black swan or not, the current credit crisis is going to get nastier. Expect many more litigation complaints in the ensuing months.

FAS 157 is Heeeeere!

As of November 15, 2007, those organizations who did not adopt FAS 157 early on will be obliged to disclose much more information about their "hard to value" assets and liabilities. Despite industry's attempts to forestall compliance for another year, the Financial Accounting Standards Board reiterated its intent to force implementation for financial assets and liabilities. Read "FASB Rejects Deferral of Statement 157 for Financial Assets and Liabilities" (November 14, 2007 FASB press release).

For those seeking a user friendly version of this new accounting rule, check out "A FAS 157 Primer" by Mark Gongloff (Wall Street Journal, November 15, 2007). Also check out "A Summary of Statement No. 157" on the FASB website. One important element of FAS 157 is the requirement that items be categorized as belonging to Level 1, 2 or 3 in order of ease of valuation with respect to observable prices (or lack thereof). Predictions abound that FAS 157 will force larger asset write-downs, creating jitters for pensions, endowments and foundations who invest in Level 2 and Level 3 sensitive funds. In a November 15, 2007 CNBC video, economist Nouriel Roubini warns of an impending global recession and a financial meltdown that could roil financial markets for months to come. He is not alone.

In "Why FAS 157 strikes dread into bankers - Just when we hoped the worst was over," William Rees-Mogg (The Times, November 12, 2007) cites research by financial analyst Martin Hutchinson. Financial giants such as Bear Stearns, Lehman  and J.P. Morgan Chase account for more than $100 bilion of FAS 157 Level 3 assets, requiring mark to model information not heretofore provided. The author adds "Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two, and they have an interest in placing as little in level three and as much in level two as they reasonably can." Noteworthy is Hutchinson's analysis that Goldman Sachs has disclosed $72 billion of Level 3 assets. That number is relatively big or small, depending on the point of comparison - a $900 billion asset base but capital of $36 billion.

Lest pension decision-makers think they are immune from valuation issues, nothing could be further from the truth. Decision-makers for both 401(k) and defined benefit plans are squarely on the hook for vetting external money managers. This absolutely includes asking copious questions about managers' valuation policies and procedures. A poor job, or ignoring the issue altogether, is going to keep the plaintiff's bar busy indeed.

Will Auditors Become the Next Dismal Scientists?


Since Thomas Malthus predicted the end of mankind as population growth surged, economists have been known as the dismal scientists. (Click here to check out U.S. and global person counts.)

According to "Auditors set for tough talks with clients" by Jennifer Hughes (Financial Times, November 5, 2007), valuation challenges may force accountants to wear the mantle of "life of the party NOT." Though a current focus is on how clients plan to report valuations at year-end, a la FAS 157, auditors must be concerned about ongoing general lack of good process by some reporting entities.

Clients' failure to thoroughly document, and implement, a (hopefully) robust valuation process puts auditors squarely in the litigation crosshairs if they are seen as doing less than a good job of oversight. Though a few years old, the AICPA published a summary of problem areas based on SEC investigations. Four out of five times, the auditor failed "to gather sufficient audit evidence," with countless cases involving "inadequate evidence in areas such as asset valuation, asset ownership and management representations." Click here to access "Top 10 Audit Deficiencies" by Mark S. Beasley, Joseph V. Carcello and Dana R. Hermanson (Journal of Accountancy, April 2001).

It was not too long ago that the U.S. SEC Division of Enforcement and the Office of the Chief Accountant alleged that a CPA "failed to adequately assess the substantial evidence produced by the audits" that there were material "overstatements of the value of convertible bonds and convertible preferred stock." Click here to read the overview.

In "Auditor liability and caps get a hearing in Washington," Financial Week reporter Nicholas Rummell (October 15, 2007) quotes the co-chair of a newly formed committee, Donald Nicolaisen, former chief accountant at the SEC, as saying that "now is the ideal time to look at auditor liability because there is no crisis." Yet the article states that "audit expenses for the largest accounting firms related to litigation and liability had risen to $1.3 billion in 2004, 14.2% of total revenue. In 1999, related expenses were about 7.7% of revenue." (By the way, life sure has changed in the last few weeks as market volatility seems the norm.)

This blog author's take on things is that there will be some "issues" going forward. The math is simple: Investor Losses = Investigation Into What Went Wrong = Blame. While auditors may not be the only ones asked tough questions about oversight, issues abound.

  • How much rigor should be applied by auditors in assessing the mark-to-market (model) process?
  • How do internal auditors treat a lack of independence for those reporting entities that create their own marks in lieu of hiring an outside third party?
  • How many auditors feel comfortable valuing complex derivative instruments?
  • Is statistical sampling of holdings in a large portfolio of "hard to value" instruments considered sufficient?

Stay tuned...

 

Pension Investors, Corporate Governance and Financial Reporting



According to the New York Stock Exchange Fact Book, pension ownership now accounts for nearly twenty-five cents of every equity dollar. No surprise then that the governance movement is alive and well and ensuring that forthcoming talks about proxy reform receive wide attention.

Part of the SEC's roundtable discussions about voting reform, various institutional investors, attorneys and governance experts will meet on May 7 to talk about topics such as shareholder rights under state law, whether investors should be able to exert more influence over corporate management and the role of the SEC in overseeing the proxy process. Click here to access the full agenda and list (and bios) of speakers. Subsequent meetings will take place later this month.

At a time when large shareholders crave more power over issues such as executive pay, corporate social responsibility and proper financial disclosure, a meaningful conversation is welcome.

On a related note, the PCAOB (Public Company Accounting Oversight Board) concluded its first International Auditor Regulatory Institute on May 4, 2007. With representatives from over forty countries assembling to discuss how the PCAOB handles Sarbanes-Oxley Act of 2002 compliance, chairman Mark Olson extols the notion of global oversight.

Also in the news, BDO Seidman's "Financial Reporting" letter (dated May 2007) is replete with question lists for shareholders. Organized by topic such as board composition, audit committees, preparation of financial statements, management's strategic plans and business ethics, the publication is easy to understand and serves as a useful guide.  The sub-list on risk management emphasizes company-wide issues, including, but not limited to, topics such as the role of the board in developing a risk management system and the choice of risk management techniques to evaluate "the adequacy and cost effectiveness of insured risks." Questions related to derivatives and financial risk are shown below (excerpted verbatim from the BDO document). Click here for the full text publication.

1. Does the company use enterprise risk management?
2. What is the company's attitude towards financial risk?
3. Were there any significant foreign currency exchange gains or losses in 2006 and in interim 2007 operations?
4. What is the company doing to minimize the impact of changes in foreign currency rates?
5. Does the company hedge its foreign currency exposures?
6. What types of financial instruments and derivatives does the company use?
7. What are the major risks from the company's use of financial instruments or derivatives (e.g. options, futures, forwards, caps, collars, interest rate swaps)?
8. Does the company have written guidelines and policies on the use of financial instruments and derivative instruments?
9. Who formulated those policies?
10. Did the board of directors approve those policies?
11. Do management and the board of directors monitor the company's financial instruments and derivatives exposures?
12. Is there a limit system in place (i.e. a system that sets the maximum amount of loss the company would tolerate before liquidating a position)?

PG Editor's Note: We are (and will continue to) address many of these issues online. Visit www.pensiongovernance.com. Also watch for our soon-to-be published newsletter about the use of derivatives, investment fiduciary risk, financial statement analysis and so much more. Pension Risk AlertSM will examine risk and valuation issues from a "how-to" perspective. Email us if you want to be notified about the availability of this informative newsletter.

Pension Accountants - Where Are You?


A crisis is upon us. According to Wall Street Journal reporter Ronald Alsop, U.S. business schools are scrambling to find qualified professors in accounting, finance and management, respectively. (See "Ph.D. Shortage: Business Schools Seek Professors, January 9, 2007) Alsop offers sobering statistics, courtesy of the Association to Advance Collegiate Schools of Business (AACSB International). A current estimated shortage of 1,000 Ph.D.s is expected to grow to 2,400 by 2012. Supply and demand dynamics are in full force with B-school salaries on the rise. Unfortunately, money alone will not help. Someone starting doctoral studies today will be lucky to finish by 2011 and that's if they attend on a full-time basis, ignoring the lure of Wall Street.

While one can reasonably dispute the merits of putting Ph.D.s in the classroom (versus industry practitioners), the reality is that business school accreditation mandates certain coverage ratios. When too few academically qualified professors are available to teach, courses are cut, class size is reduced and/or admissions are scaled back.

Under any of these scenarios, fewer students become business school graduates. The resulting dearth of trained technicians is problematic. At a time when new pension accounting rules are upon us, investing is global and financial engineering requires more than a passing knowledge of basic concepts, where will much-needed expertise come from?

Pension Accounting - Here It Comes



The long-awaited U.S. pension accounting overhaul is coming. According to their website, the Financial Accounting Standards Board ("FASB") will announce new rules tomorrow morning in the form of FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans.

Part of a multi-phase project to promote transparency as relates to post-retirement benefits accounting, companies will initially have to recognize the "overfunded or underfunded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation." Income statement adjustments are expected to follow thereafter.

Already, experts are predicting a dire impact for more than a few companies. According to the Center for Financial Research & Analysis, their survey of S&P 100 firms suggests a reduction to total equity of nearly eight percent. Their Portfolio Pension Monitor provides investors with details on a company by company basis.

What has most people worried is not only the direct impact of the new accounting rule but also the domino effect that is likely to occur. CFO.com earlier quoted John Ehrhardt, a principal with the actuarial consulting firm Milliman, as saying that new pension accounting requirements "could wipe out a company's entire net worth, forcing some to grapple with lenders on the terms of their loans or else fall into default. (See "FASB Pension Rule Could Spur Loan Woes" by David M. Katz, April 13, 2006.)

AltAsset.net just published summary results of a Grant Thornton survey that bears bad news for companies with defined benefit plans. They quote Mat Bhagrath, partner at Grant Thornton Corporate Finance as saying: "Following the introduction of new accounting rules, pension fund deficits have risen to the top of the corporate agenda. It is hardly surprising that private equity investors have become increasingly cautious about investing in companies with a defined pension shortfall." (See "Private equity investment in companies with a defined pension scheme deficit plummets", September 27, 2006)

Not one to underestimate the import of this brave new pension world, other accounting issues loom large. With little fanfare, FASB released its Statement of Financial Accounting Standards No. 157, Fair Value Measurements, a few weeks ago. Its potential impact is huge.

OPEB for public funds is right around the corner in the form of Statement No. 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions and the Government Accounting Standards Board has announced its intention to create what I call a "FAS 133 look alike" for states, cities and other municipal users of derivative instruments.

Add other regulatory mandates for reporting and the picture is clear. Pension professionals everywhere are going to be very busy.

Are you ready?

Managing Pension Yield Curve Risk



"A Different Strategy on Pensions" by New York Times reporter Mary Williams Walsh (September 9, 2006) showcases International Paper Company for its use of swaps as a way to hedge interest rate risk. She writes that "International Paper's $7 billion pension fund, which covers 175,000 people, is three years into a broad revamping, one that the company believes will protect it from the forces that wreaked havoc in the last few years."

Several points are worth mentioning.

First, the Pension Protection Act of 2006 makes a practice known as smoothing more difficult. The implication? It will be harder for companies to disguise funding problems going forward. Changes due out any day from the Financial Accounting Standards Board are likewise expected to put the kibosh on this type of illusory reporting mechanism. CFO.com reporter Helen Shaw writes that FASB Chairman Bob Herz opposes smoothing and favors a more accurate representation of funding status. (Click here to read her 2005 article.)

Second, defined benefit plans are affected by changes in interest rates (and related yield curve shifts). As rates drop, pension liabilities increase. (The extent to which they rise depends on a host of factors.) Moreover, a drop in rates (depending on the cause) could depress the return (assumed and realized) on some (not all) investments, thereby widening the pension gap and making things worse.

Third, the effectiveness of any interest rate hedging technique is influenced by current levels of interest rates, capital market conditions, the shape of the yield curve, the steepness of the yield curve, choice of instrument and so on. That's why Fed watching is such a popular activity.

Fourth, the pension situation is not hopeless. While some companies and municipalities are in dire straights (perhaps well on their way to financial distress or outright failure), other organizations can and should consider what works, what doesn't work and why.

Pension governance best practices are worth the time. Millions of people count on decision-makers to evaluate plausible solutions as a way to keep their word.

Pension Accounting Going Global



Global Pensions Magazine reports that the International Accounting Standards Board (IASB) has added pension accounting to its work plan. Smoothing and cash balance plans are two of the topics to make their way under the microscope. Executed in two stages, the goal is for IASB and Financial Accounting Standards Board (FASB) rules to converge by end of Phase Two.

According to its website, the International Accounting Standards Board is an "independent, privately-funded accounting standard-setter based in London, UK. The Board members come from nine countries and have a variety of functional backgrounds." Similarly, the FASB is self-described as "the designated organization in the private sector for establishing standards of financial accounting and reporting." (Click here to download Facts About FASB.)

Accounting harmonization is the wave of the future as more and more companies go global and investors seek ease of financial statement use. What will be interesting to know (and only time will tell) is whether:

1. The business community outside the U.S. is likely to push back

2. Disagreement will focus on the same issues (In the US, liability calculation methodology has taken center stage.)

3. Shareholders will demand the same level of transparency as in the U.S. (or more)

4. The extent to which common accounting standards will facilitate capital market development with respect to cost, availability and liquidity.

Asset Allocation Anyone?



Taking time for some weekend reading, I was struck by several headlines that focus on a topic I predict we'll hear more about (much more) in coming months, namely how to best allocate assets to meet liability objectives. Here are a few examples.

"Big pension fund too equity-heavy, says consultant"

"Pension Fund to Expand Stock Buying"

"DB plan sponsors hedging their bets on hedge funds: Pension plans expected to invest $300 billion"

While a discussion of optimal asset allocation and portfolio re-balancing is left for another time and venue, a few questions and comments come to mind.

1. As new accounting rules encourage a focus on liability-driven investing, how will plan fiduciaries decide on a portfolio split between matching liabilities and generating excess return?

2. How can and should derivatives be used to transform assets and liabilities?

3. What role should alternatives play?

4. What will cause a shift away from the traditional equity-fixed income mix for defined benefit plans?

5. How should the equity risk premium be evaluated with respect to managing goals, knowing that greater reliance on fixed income is likely to widen a plan's pension deficit if equities outperform?

6. How should fiduciaries be evaluated and compensated if they focus on risk control in lieu of exceeding return targets?

7. Are decision-makers sufficiently trained to deal with surplus volatility, fat tailed distributions, side pockets and other financial delights?

8. What is the likely impact on capital markets as long-term pension investors begin to favor a radically different asset allocation mix?

As accounting rules, regulatory mandates, changing demographics and economic reality join hands, it's clear that a paradigm shift in asset allocation strategies and tactics is on its way. Are we ready?

Pension Accounting: Catalyst for Change?

I have long wondered when people would really start to pay attention to what some describe as the "pension perfect storm". Could new accounting rules be the catalyst for change? Just recently, the Financial Accounting Standards Board unveiled the first of several changes in how companies will have to portray pension fund finances. Arguably long overdue, a company will need to recognize "the overfunded or underfunded status of defined benefit postretirement plans as an asset or a liability in the statement of financial position". A second phase of this multi-year project will impact reported earnings.

What lies ahead?

If past is prologue, a change in the way financial statements are assembled will have a material influence on corporate behavior. Consider FAS 133, the mammoth rule book for derivative instrument accounting. Not long after it took effect, more than a few companies cut back on the use of derivatives, citing FAS 133 compliance as overly complex and time-consuming. Reducing speculative positions is one thing. Abstaining from the use of derivatives to mitigate interest rate, commodity, currency or equity risk is another thing altogether. Following the promulgation of FRS 17 in the UK several years ago, the National Association of Pension Funds "found that more than three quarters of companies offering final salary pension schemes were less likely to do so because of the new accounting standard".

In both cases, the law of unintended consequences prevailed. Instead of promoting transparency, new accounting rules encouraged outcomes that were contrary to the original intent. Does this mean that additional companies will shed their defined benefit plans rather than report "bad" numbers? (Note that freezing or terminating a plan has both an accounting and economic impact so the choice is not as straightforward as it may seem.)

Am I saying that accounting reform is bad? Not all all. I think the marketplace is desperate for more and better information. Will that ensue with FASB initiatives? It's too soon to say. Final rules are months away. (Subsequent postings will dive deep into the issue of pension information and the lack thereof. Suffice it to say, there is so much about pension assets and liabilities that remains a mystery.)

Will the new accounting requirements improve pension economics? Will shareholders have a better understanding of the true cost of providing post-retirement benefits and the related impact on dividends, earnings and flexibility? Will employees and retirees feel more or less comfortable that defined benefit plan promises will be kept? Will taxpayers worry that a federal bailout looms large as post-implementation numbers surface? Will reported figures square with actuarial or statutory assessments?

Notwithstanding a plethora of unanswered questions, I'm betting on FASB to mix things up. After all, the pension issue impacts the lives of nearly every adult in the U.S. (and abroad), either as investor, employee and/or taxpayer. When accounting rules change, so too do people's actions.