Why Earnings Are Too Rosy
If you think corporate earnings are bad this year, you're wrong--they're even worse than reported.
Companies are inflating earnings with income from pension-plan assets, making their results look better than what's really happening with their businesses. More surprisingly, the income boost is coming when plan assets are earning less because of the stock market slump. How can that be? Easy. The feat is possible--and consistent with accounting standards--because outsized gains early in the bull market pumped up pension coffers to more than cover obligations to pay benefits. The phenomenon will likely continue at least another year. But if stocks stay in the doldrums, the plans will lose that earnings kick and become drags on their companies.
The current impact on earnings varies widely, from adding a tiny 0.7% to pretax income in 2000 at Emerson Electric (EMR ) to 13% at DuPont (DD ), and a bountiful 253% at Qwest Communications International (Q ), according to Credit Suisse First Boston. For the market overall, as measured by companies in Standard & Poor's 500-stock index, pension plans are hyping earnings by about 5%, estimates Trevor S. Harris, accounting analyst at Morgan Stanley Dean Witter & Co.
Some 171 companies in the S&P 500 have pension plans that are contributing to earnings. The plans are called defined-benefit plans through which companies invest to pay for the benefits they've promised employees. The plans are different from increasingly popular defined-contribution plans, which include 401(k)s, where employees direct the investments and bear the risks and rewards. Companies with defined-benefit plans tend to be in older industries, such as autos, metals, aerospace, forest products, and old Baby Bell telephone systems.
MAGIC. The logic behind reporting income from well-funded plans is sim-ple: Company accounts ought to reflect the advantage of not having to pay into the funds. For these companies, what started as pension expense has become pension income.
The plans are lifting earnings in spite of damage from the bear market. In a tally of plans at the 20 biggest corporations reporting annual results through December, actual returns on assets in 2000 fell $19.2 billion short of the estimated cost of benefits for the year, according to actuarial and consulting firm Milliman USA. While it looks as if the companies suffered a $19.2 billion expense for the plans, together they reported $7 billion pretax pension income.
Here's how the magic works: The key is expected return-on-pension assets. Under current accounting standards, companies start each year estimating the cost of pension benefits and the return that plan assets will earn. If the return exceeds the cost, the difference is booked as income. If the return is less than the cost, the difference is booked as pension expense. The 20 companies surveyed projected an average rate of return of 9.5% for 2000 on their boom-enhanced assets. At that rate, the plans would have returned $32.7 billion, or $7 billion more than the cost of benefits.
As 2000 unfolded, the strength of the bond market offset losses in stocks, and the plans eked out a collective gain, but it was only 1.3%. That left the actual return $26 billion short of estimates. But accounting rules don't require companies to adjust for such shortfalls immediately. So the companies went ahead and reported the $7 billion worth of pension income they had originally estimated. And they projected a 9.5% return again this year.
Big shortfalls get tossed into accounts to be amortized later, typically over 15 years. Those accounts at many companies are chock-full of unrecognized gains left from the bull-market years when returns were much more than expected. Thus, companies can raise their expected returns, and pension income, with little risk, says Jane Adams, accounting analyst at Credit Suisse First Boston. If the companies are wrong in their estimates, the pain will be virtually unnoticeable and dissipated far into the future.
Some 63 companies in the S&P 500 raised their expected rates for this year, while 31 adjusted downward, says Adams. The hikes averaged 0.44 percentage points. Of the companies that raised their rates, 34 did so even though their investment returns in 2000 were lower than they had expected and lower than their actual results the year before.
These higher expected returns foretell yet more reported pension income in 2001. Ford Motor Co. (F ) raised its rate from 9% to 9.5%. After the first six months, pension plans for its worldwide automotive business contributed $161 million to income, up from $13 million of expense at this time last year. Why would Ford expect a higher rate after last year's low actual results of 2.5% brought in $2 billion less than expected? Ford says 9.5% is consistent with past investment performance and changes in how the assets are managed.
LESS IMPACT. Companies can not only play around with the expected rate of return on assets but also with the value of the assets themselves. Accounting standards allow them to use a mechanism known as "smoothing." Smoothing blends the market values of plan assets from recent years. The aim is to dilute the impact of market volatility on pension income and expense. Most companies smooth over five years, so the asset values underlying their expected returns in 2001 are based on stock market levels from 1996 through 2000. For now, pension income is still enjoying bull- market growth, says Adams, even though asset values have fallen from their peaks.
Ford, like most companies, doesn't disclose how it smooths assets. But its financial reports strongly suggest that the company is calculating returns from an asset level that is still rising. Its 2000 pension income was apparently based on a blended value of $36.5 billion. This year, that value could rise to $37.1 billion as smoothing replaces a lower asset value from the mid-1990s with a higher one from the start of 2001. The rise in blended value could contribute an additional $60 million to Ford's pretax income even though the market is way down this year.
While pension earnings aren't as valuable as earnings from normal business, losing them to a long market decline would be bad. Companies with pension income do not generally pay cash toward this employee compensation. "Pension plans give you financial flexibility" to work through problems with operating businesses, says Harris. Sometimes, companies can tap plans indirectly. Last year, Qwest's plan paid $27 million toward employee severance. Companies can hike plan benefits to lure employees and sometimes use assets for retiree health benefits.
If the stock market doesn't get back to its historical 11% annual returns before long, companies will likely hear complaints that they are exaggerating pension income. "Auditors will start to put pressure on plan sponsors to use lower projected returns," says Alan H. Perry, a Milliman consultant. The impact could be severe. If the typical big plan were to lower expected returns even 2 percentage points, to 7.5%, pension income would fall by 50% next year and keep going down, says Perry.
If returns continue to decline, corporations will find that their pension plans have turned from blessings to burdens.
By David Henry in New York