New GAO Study Addresses Performance Audit Reports

Courtesy of the U.S. Government Accountability Office, a new study looks at performance audits for different types of pension plans. The report is entitled "Oversight of the National Railroad Retirement Investment Trust" (May 2014) and responds to requests from members of the U.S. Congress for information about this $25 billion retirement plan. Based on countless interviews with regulators, private fiduciary experts (and yes, I did answer some questions about benchmarking) and pension fund executives, the authors put forth the idea that performance audits could be mandated to occur more often. Interestingly, GAO researchers point out that "the frequency with which the Trust has commissioned performance audits is comparable to or exceeds most state efforts," adding that "...nine state plans are audited at least once every 2 or 3 years" with interviewees from 19 states pointing out that retirement plans "were subject to audits at longer set intervals that varied from state to state or were not reviewed according to any established time frame."

Pension fund accounting and performance benchmarking is certainly getting its share of attention. U.S. Securities and Exchange Commissioner Daniel Gallagher recently decried what he believes is an under-reporting of "trillions of dollars in liabilities. In his May 29, 2014 speech before attendees of the Municipal Securities Rulemaking Board's 1st Annual Municipal Securities Regulator Summit, Commissioner Gallagher talks about pension and OPEB liabilities as a serious threat and warned that " is imperative that bondholders know with precision the size of the potential pension liabilities of the entities in which they are investing. And yet, they do not." He adds that the "threat has been hidden from investors." As Lisa Lambert and Lisa Shumaker describe, government officials say that these sharp remarks sting and will scare people into thinking that a systemic problem exists. Read "Pension groups strike back at SEC commissioner's criticism" (Reuters, June 16, 2014). In its Q1-2014 update, the National Association of State Retirement Administrators ("NASRA") show that public pension fund assets have grown to $3.66 trillion, up slightly from the year-end 2013 level of $3.65 trillion.

On the rule-making front, the Governmental Accounting Standards Board ("GASB") just published an update to its pension accounting standards and posted a pair of brand new proposals to "improve financial reporting by state and local governments of other post-employment benefits, such as retiree health insurance." See "GASB Publishes Proposed Accounting Standards for Government Post-Employment Benefits" by the editor of, Michael Cohn. You can download the three documents by visiting the GASB website. Click to access GASB's microsite about Other Postemployment Benefits ("OPEB").

The good news, as I have said all along, is that initiatives for heightened transparency are underway. For more difficult situations, don't be surprised if litigation about disclosures continues to occur. In case you missed the February 24, 2014 Practising Law Institute ("PLI") CLE webinar, you can purchase the slides and audio recording of "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends." I co-presented with Orrick, Herrington & Sutcliffe LLP partner, Elaine Greenberg. My focus was on risk management, valuation, performance and investment decision-making.

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.

Bad Disclosures - Recipe For Disaster?

According to "State workers face privatization" by Jason Stein (Milwaukee Journal Sentinel, January 6, 2011), over 300 Wisconsin State Department of Commerce employees may soon be classified differently. The stated goal is to better deploy its $183 million budget to try to create jobs. (Whether you believe that governments are the engine of jobs creation is a post for another day.)

Questions remain about the benefits for identified employees and whether they will be covered by the state's retirement system. A related question is whether the general public will have a true assessment of Wisconsin's retirement plan IOUs if these privatized workers are counted as "public" for some purposes but not for others. In reading the many comments posted for the aforementioned article, emotions are running high about the real costs associated with this decision. Clearly, more information would go a long way to quelling any concerns.

The topic of financial disclosures may soon create real problems for public plans and, by extension, ERISA plans that are sponsored by companies that issue stocks and/or bonds. In today's New York Times, Mary Williams Walsh reports that the U.S. Securities and Exchange Commission ("SEC") may be investigating the large California pension plan known as CalPERS. It's premature and inappropriate to speculate but the inference is that bond buyers may have been in the dark about the "true" risks associated with this $200+ billion defined benefit plan. If true, California could pick up an even bigger than expected tab and municipal security investors could be in a position of having paid too much to own state debt. See "U.S. Inquiry Said to Focus on California Pension Fund."

As recently as 2009, then Special Advisor to California Governor Arnold Schwarzenegger, David Crane, referred to public pension plan reporting as "Alice-in-Wonderland" accounting. He added that "state and local governments are understating pension liabilities by $2.5 trillion, according to the Center for Retirement Research at Boston College." Since these are legal contracts that bind the state, city or municipal sponsor, they are on the hook for bad results, with large cash infusions likely.

It's not rocket science to conclude that other states and municipalities could face the same type of securities regulation inquiry. Indeed, even ERISA plans are vulnerable to allegations of fraud or sloppy reporting if their risk disclosures are incomplete, inaccurate, misleading or all of the above. See "Testimony for Securities and Exchange Commission Field Hearing re: Disclosure of Pension Liability" (September 21, 2010). Investors want to know whether they have a striped horse or a zebra in their stable. They need and deserve a solid understanding of investment risks to which they are exposing themselves. That can only occur if accurate and complete information is provided. To its credit, CalPERS seems to be emphasizing risk-adjusted performance as paramount. A December 13, 2010 press release describes the adoption of a "landmark" asset allocation that emphasizes "key drivers of risk and return."

Email Dr. Susan Mangiero, CFA and certified Financial Risk Manager if you would like information about what a risk disclosure assessment entails for your organization or on behalf of a client(s). You may likewise be interested in one of our workshops for directors, trustees and/or members of the investment committee about performance reporting within a fiduciary and financial risk management framework.

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.

Eeny, Meeny, Miny, Mo - What Accounting Rules Do You Want?

Throughout my career, I've been fortunate to work on multi-disciplinary projects, many of which combined accounting with finance. It is my personal view that the two areas are integral to good business decision-making. Whether I've taught eager MBAs or corporate executives or managed analysts, I've cautioned people to look beyond the numbers, try to ascertain what information is missing and identify whether there are gaps between the accounting representation and potential economic profitability. Citing Columbo and the need to "be a good financial detective," I've suggested that (dare we say it?) accounting numbers can be illusory and therefore require a proper vetting. (By the way, my mention of the venerable television sleuth drew blank stares from the students so I had to switch to CSI characters instead.)

What does this mean for institutional investors?

Anyone committing funds to fixed income, equity or hybrids must have a solid understanding of what financial statements convey, and by extension, what they do not reflect. Assessing the quality of earnings (balance sheet) is often difficult. Rules are complex. Companies can have tremendous latitude in their reporting choices. This puts the onus on the investor to do a good job of comparing reported numbers against industry/company factors as they relate to predicting future expected cash flow or some other measure of economic profitability.

Always challenging, it may become more so now that the SEC has opened the door to foreign companies (and perhaps U.S. firms by extension) being able to choose which standards make sense for them. In his April 25 article, ("SEC to Mull Letting U.S. Companies Use International Accounting Rules"), Wall Street Journal reporter David Reilly writes: "The commission said it will begin soliciting comments this summer on a possible change allowing foreign companies registered with it to file financial results using international financial reporting standards, or IFRS. Currently, foreign companies that file with the SEC must reconcile their results to U.S. GAAP, a costly and time-consuming process that many companies, especially in Europe, want to do away with."

Whatever the choice, financial statement users have a tough job. First of all, analyzing industry peers could require even more attention being paid to HOW numbers are put together. Company X uses U.S. GAAP (Generally Accepted Accounting Principles) and Company Y uses an altogether different approach. You have two sets of numbers. Which one is right in terms of assessing economic potential?

Still a classic (but pay attention to new rules) is Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 2nd edition by Dr. Howard Shilit.  Also check out Michelle Leder's blog, Author of Financial Fine Print: Uncovering a Company's True Value," Leder drills down deep into the footnotes that many ignore.

On the pension accounting front, European firms are still reeling from rigorous rules. The adoption of new financial strategies and plan redesign (or perhaps termination) are not uncommon in some countries such as the UK. Stateside, FAS 158 is getting lots of attention with much more to come.

If people ignored accounting numbers and chose instead to focus on economic forecasts alone (i.e. take a fundamental approach to investing that emphasizes competitive structure, operating environment, etc), that would be one thing. However,  there is extensive research that suggests that companies DO behave a certain way in response to accounting rules.

Therefore, as companies get to choose accounting rules by which they will abide, investors must:

1. Understand what the different standards mean in terms of an accounting - economics "gap"

2. Identify whether a reporting entity is perversely changing its behavior to game a particular rule and buoy its numbers

3. Roll up those shirt sleeves and sleuth away. What you see may not be what you get!

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: 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.