That’s no shadow – it’s sunlight on pension problems

Implications: The silver lining in the so-called Subprime Crisis is that it is yet another event that illustrates the need for greater quantities of more useful information in financial statements and financial reports.  As long as management chooses to comply only with the most minimum of standards, they are surrounding their stock with uncertainty, which, in turn, creates risk and drives the stock value down, not up. With regard to pension funds, they are nothing more than proprietary mutual funds in which the employer’s stockholders are obliged to hold an interest, whether they want to or not.  Their fortunes are linked to the management’s ability to manage this pension/mutual fund, and it only makes sense for them to be fully informed as to its portfolio and their risk exposure. In other words, that’s no shadow being cast on pensions – it’s the bright disinfecting sunlight that’s been needed for a long time.

Analysis: Ever since SFAS 87 was issued in 1985, accounting for defined benefit pension plans has been in need of significant reform.  In that standard, FASB members said that they had a great deal more they wanted to accomplish but that they had gone just about as far as they could against the irrational opposition from managers who were worried that telling the truth about their plans would be fatal.  It took 20 years, but SFAS 158 accomplished a modest reform by forcing a net liability on the balance sheet for underfunded pension and other post-retirement benefit plans (or a net asset if they’re overfunded).  This was nothing more than a baby step compared to what’s needed and what’s surely coming.

With regard to the so-called Subprime Crisis, it is yet another event that illustrates the need for greater quantities of more useful information in financial statements and financial reports.  As long as management chooses to comply only with the most minimum of standards, they are surrounding their stock with uncertainty, which, in turn, creates risk and drives the stock value down, not up.

With regard to pension funds, they are nothing more than proprietary mutual funds in which the employer’s stockholders are obliged to hold an interest, whether they want to or not.  Their fortunes are linked to the management’s ability to manage this pension/mutual fund, and it only makes sense for them to be fully informed as to its portfolio and their risk exposure.

What I think has happened is that managements have been advised by their money managers to put together extra-risky portfolios in order to earn a higher return and eventually close the funding gap while driving the net annual pension cost lower.  But, the absence of any but the most modest requirements for describing the portfolio has permitted them to take these risks without revealing what they’ve done.  The Subprime Crisis is calling attention to the risk associated with junky bonds, and that is surely going to impact a great many pension fund portfolios and returns.

The most useful information about pension funds is their contents and their risks and returns.  And the best way to do that is open and above board reporting, primarily by flowing the investment results right into the income statement where they can be seen by all.  Managers objected in the 1980s, and will do it again in the 21st century, that this flowthrough reporting will cause their earnings to be volatile.  This view is, of course, nothing but nonsense.  The income statement cannot cause income to be volatile, but it can reveal whether it is volatile or not.  If it’s volatile, then greater risk is associated with future cash flows; if it’s not, then less risk is associated with those flows.  

All that happens under existing GAAP is that the volatility is CONCEALED from scrutiny because it defers unexpected investment gains and losses in hopes that they’ll be offset in the future.  This hiding does nothing but encourage unwise managers to take even greater risks because they’re sheltered from accountability for their actual results.

If managers want to show nonvolatile results, they need to implement investment strategies that produce nonvolatile returns, not rig the scorecard to make the returns look nonvolatile.

To get to that point, the best path for FASB to take is to get more truth into the markets by requiring managers to describe their portfolios in more detail and their returns with more candor and without artificial smoothing of real volatility.

While they’re at it, as Mr. Katz suggests in his column, FASB is going to reconsider the most flawed part of defined benefit pension (and OPEB) accounting.  Under SFAS 87, the annual cost gets run through a giant blender, sort of like the famous “Bass-O-Matic” from Saturday Night Live where a whole fish is placed in a blender and ground up into a uniform revolting liquid.

What happens in SFAS 87 is that the annual pension cost consists of these disparate components:  (a) a labor cost (ongoing service cost), (b) a financing cost for borrowing (interest on the liability), (c) an investment return (on the plan assets), (c) amortization of a goofy off-balance sheet intangible asset (prior service costs arising from increasing benefits) or an even goofier off-balance sheet liability (prior service savings from cutting benefits), and (d) corridor amortization of excessive accumulated deferred gains and losses from unexpected asset returns and actuarial adjustments to the estimated value of the pension liability.  Just as no one would really drink the output of the Bass-O-Matic, no one should believe that the annual pension cost under SFAS 87 actually means anything worth knowing.  It simply conveys no useful information whatsoever.

What FASB should do, and what I think it will do, is decompose that aggregate cost into its components, each of which will end up in its own useful segment of the income statement.  (a) Service cost will be expensed as incurred as an operating cost or added to inventory cost and eventually cost of goods sold.  (b) The interest cost on the liability will be included with other financing charges.  (c) The investment return, unsmoothed, will flow through to the other income section of the income statement.  (d) If the liability gets bigger through a grant of higher benefits, a loss should appear on the income statement as the consequence of the agreement.  If the liability gets smaller through a concession from the labor union, there should be a gain on the income statement for the savings.  And, (e) if actual conditions change concerning the pension liability, such as new market discount rates, different longevity, and different life spans for the beneficiaries, this gain or loss should also appear on the income statement when it happens.

Look at it this way – a defined benefit pension plan (or a medical plan) creates an irrational liability to pay (a) an unknown amount (b) to an unknown set of persons (c) for an unknown period of time.  In some respects, it is the consequence of an irrational transaction.  As such, the only rational way to report about it is to tell the truth, the whole truth, and nothing but the truth.  

If management doesn’t like the results, then it needs to reshape its policies for granting benefits and for managing its portfolio.

NO ONE will benefit in the long run if FASB simply leaves pension and OPEB accounting unchanged.  

The Subprime Crisis did not create this mess, but it has served to shine some sunlight on a huge problem that has stayed below the surface.  The only good answer is more information of a different character.  And I think the board will do it and do it well.  And, wise managers would be extra wise if they started now without waiting for FASB.  The consequence of the additional information will be less risk, a lower cost of capital, and higher stock prices.  It’s as simple as that.