Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

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.

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In case you missed it a few weeks ago, the Financial Accounting Standards Board voted 4-3 in favor of implementing FAS 157 on time. Ignoring early adopters, FAS 157 takes effect as of November 15, 2007. A company reporting at year-end (or any time after mid November) will be obliged to consider FAS 157. Its companion, FAS 159, allows organizations to "choose to measure many financial instruments and certain other items at fair value."

While "employers’ and plans’ obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits)" are excluded from the list of eligible items that can be measured at fair value, plan sponsors are nevertheless impacted by both FAS 157 and FAS 159. 

• If an employer issues stocks or bonds or transacts in other eligible assets and liabilities, FAS 157 and 159 will apply and could, at the enterprise level, indirectly impact pension plan economics.
• If a plan invests in a wide variety of stocks and bonds issued by other reporting entities, fiduciaries will need to fully understand the gap between economic risk and the accounting representation.
• In selecting external money managers, defined benefit and defined contribution plan fiduciaries alike will need to add FAS 157 and FAS 159 questions to their RFPs. Focus on  valuation model selection and testing, choice of inputs and appropriate "level" of three possible categories are a few of the many items to vet.

How FAS 157 relates to existing standards is not known with certainty at this time though FAS 133 accounting for derivative instruments is one affected area. While FAS 133 does not directly apply to a pension plan that trades derivative instruments, as investor, that plan must be savvy enough to access how issuer risk is impacted by new rules.  Consider a hypothetical scenario.

A defined benefit pension plan (Pension Plan Y) hires Bank X as a value-oriented equity portfolio manager. Bank X is a significant user of derivatives and has existing derivative instrument contracts with five different counterparties such a Bank Z, Corporation A and so on. Under FAS 157, Bank X must reflect counterparty risk in assessing fair value. Conceivably, this could result in a FAS 157 fair value for any or all of the five positions held by Bank X that is different enough from the fair value of the "hedged item." The result would be a nullification of favorable hedge accounting treatment for Bank X and reported post FAS 157 earnings that are more volatile. How does Pension Plan Y respond? Do they stop doing work with Bank X because their financial statements make them a higher risk? 

Reporting entities and investors alike are going to have to roll up their shirt sleeves and get to work. It doesn't take a rocket scientist to see the obvious. An incomplete understanding of FAS 157 and 159 lends itself to bad decision-making on the part of plan sponsors. 

Here we go...

Editor's Note: There are many ways to determine FAS 133 hedge effectiveness. If you want copies of selected articles on the topic, click here to send an email. Please include your name and company.) Click here to visit the FASB website to learn more about FAS 157 and 159.

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As plan sponsors ready themselves for new valuation rules, it's critical to understand that "FASB Speak" is not always the same language as that used by traditional business appraisers. Consider the term "fair value."

According to FAS 157, "The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)." Click here to read a summary of Statement 157.

In contrast, the Model Business Corporation Act 3rd edition (copyrighted 2003 by the American Bar Foundation), defines "fair value" to mean "the value of the corporation’s shares determined:
(i) immediately before the effectuation of the corporate action to which the shareholder objects;
(ii) using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and (iii) without discounting for lack of marketability or minority." Dr. Shannon Pratt (in his book entitled The Lawyer's Business Valuation Handbook) describes "fair value" as a statutory standard of value applied in dissenting shareholder cases but influenced by the actual state venue. He goes on to say that "fair value" is seldom mistaken for "fair market value" in appraisal land.

According to the International Glossary of Business Valuation Terms  (2001),  fair market value is "the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts." Click here to access the full glossary.

What's the moral of the story? When people banty about valuation terms, ask exactly what they mean.

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