Where Do You Draw The Bottom Line?

Minus pension-plan earnings, corporate profits dip

Last year was a bad one for corporate earnings. Largely because of deflationary pressures triggered by Asia's financial crisis, the companies in the Standard & Poor's 500-stock index expanded their operating profits by a mere 3.7%, on average. But the collective bottom line would have been even lower--by 3 percentage points, in fact--without the fat investment gains these companies earned on their pension-plan assets. "When a company promises employees a pension, you would expect the company to have to put money into the plan, not that the plan would give it money back," says Janet Pegg, one of a team of Bear Stearns accounting analysts that recently issued a report on the topic.

The issue is not merely academic. It points out the risks associated with taking official corporate-earnings statements at face value. Consider USX-U.S. Steel Group. Any investor assessing the strength of its core steel-manufacturing operations would want to know that pension income accounted for what Bear Stearns figures is 40% of operating earnings in 1998. USX declined to comment for this story. But pension items usually are invisible on income statements. Accounting rules permit them to be lumped into broad categories, such as selling, general, and administrative expenses and cost of goods sold. Since income derived in this way is "not the highest-quality earnings," Eric Lofgren, director of the benefits group at consulting firm Watson Wyatt Worldwide, recommends combing through the pension footnotes in annual reports. It is only fair, Bear Stearns adds, also to consider the cost of providing health benefits to retirees. They erase two-thirds of the S&P 500's 1998 pension windfall.

Still, even after retiree health benefits are deducted, some companies--mostly industrial ones with defined-benefit plans--have profited hugely from the returns on their pension plans. Such gains were responsible for 28% of Northrop Grumman's operating income in 1998, and 15% of Lucent Technologies', Bear Stearns says. While Northrop defends its pension gains as "a strategic asset," Lucent argues that pension-plan gains, net of retiree health costs, contributed less than 4% to its 1998 operating income. Operating income excludes items that don't repeat, such as restructuring charges.

WINDFALL. Bear Stearns found pension-plan income helped the bottom lines of 124 S&P 500 companies--75 of which benefited by 5 percentage points or more. The windfall was largely due to the bull market, which has cut pension costs by increasing the value of plan assets. For many, the rising market has also inflated plan gains to the point where accounting rules require them to be included in income. Since firms are permitted to amortize such gains over years, it might take a while for the trend to run its course even if the bull dies, Pegg says.

Some believe the status quo is fine. But Pat McConnell, who led the Bear Stearns team, argues that when assessing the profitability of a firm's core operations, investors should ignore all pension and retiree health-benefit items save for service costs, which are the estimated value of the benefits employees earn in the current year. To aid investors, McConnell believes companies should segregate pension-investing returns in financing-related areas of their income statements. Indeed, Representative Earl Pomeroy (D-N.D.) has asked the Labor Dept.'s ERISA Advisory Council to research whether disclosure rules "obscure the transparency of earnings."

Timothy Lucas, research director at the Financial Accounting Standards Board, says the rulemaking body may examine the issue as part of a broad review of how income statements should be broken down. But that is "not something we would do imminently." For now, check the footnotes to make sure your firm's earnings haven't been obscured by the bull market.

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