A New Abacus For Pensions

The FASB rules on post-retirement accounting are changing. Benefits could suffer

The nation's accounting rulemaker, the Financial Accounting Standards Board, recently announced that it will revamp how companies account for pensions and "other post-retirement employee benefits" (OPEBs) -- mainly retiree health insurance. In a recent report to clients, analysts at Bear Stearns (BSC ) wrote that they expect this to be "the most controversial project the FASB has ever undertaken."

BusinessWeek Associate Editor Anne Tergesen spoke to Bear Stearns accounting analyst Janet Pegg about what investors and pensioners can expect from the proposed changes, which are scheduled to take effect in two stages -- at the end of 2006 and around 2009.

Why will pension reform be more controversial than expensing stock options?

Stock option changes have had the biggest impact on tech companies. And while many companies are reducing options awards, this has the biggest impact on senior executives. In contrast, a broader segment of employees benefits from pension and retiree health plans. Companies are already scaling back these benefits, but accounting changes could accelerate this trend.

Why the changes?

The current accounting has a lot of problems. One is that the rules allow companies to keep some of their pension and benefit liabilities off their balance sheets. As a result, many companies report healthy pension plans even though the plans are actually underfunded.

Another problem is that when calculating the amount of pension income that goes to the bottom line, companies use an assumed rate of return -- frequently 8% or more -- on plan assets. And rather than using the current value of the plan assets, companies average them over up to five years.

When the difference between a pension plan's assumed and actual returns gets large enough, a company must recognize the discrepancy -- but this occurs over years. These practices artificially dampen the volatility of the returns that flow from the pension plan to the bottom line. As a result, even though most companies lost money on their pension plans between 2000 and 2002, some were able to report pension income.

How is the FASB likely to fix these problems?

It's expected to require companies to put real [pension and health benefit] numbers on their balance sheets by the end of 2006. We estimate that this will cause S&P 500 company liabilities to increase by a couple hundred billion dollars. The second phase of the accounting project is expected to take until at least 2009. It's hard to predict what will happen, but the FASB will probably require companies to report gains and losses on their pension and retiree health plans that more closely resemble reality. Since returns on these plans affect the bottom line, this is going to make corporate earnings more volatile.

Will the new rules improve the quality of earnings?

Yes. Since the current rules sometimes produce numbers that don't come close to reflecting the economics of these plans, we're very supportive of the FASB's decision to take on this project.

How might companies respond?

Anything that causes earnings to become more volatile and balance-sheet liabilities to rise is going to be of great concern to firms. I wouldn't be surprised to see companies make further cuts to their benefit plans. I also think companies might change the way they invest the money in these plans to aim for less volatile returns. For example, they might put a greater portion of their assets in fixed-income instruments. That will mean lower returns and may reduce benefits further.

Which companies are likely to report the biggest increase in liabilities for pensions and OPEB plans?

Companies in the car, steel, telecommunications, aerospace, defense, and airlines industries will be most affected.

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