There’s been plenty of fear and loathing of corporate pension plans in the last few years, and with good reason: most of them have gone from overfunded to underfunded in the space of two years. That meant more cash hovered out of the corporate till, away from shareholders or projects that benefit shareholders, and increased possibilities that plans might actually fail.
Why did the plans go underfunded so quickly? Obvious reasons: a large portion of pension plan assets are invested in equities, which tanked from 2000 to 2002, and at the same time, interest rates declined, inflating the present value of pension plan obligations. The financial community blathered endlessly about that “perfect storm”, wrung its hands, wept and prayed. When the markets turned up again in 2003 and 2004, the Etch-A-Sketch was turned over, and the memory of the perfect storm’s punishment was erased.
The not-so-obvious – and more permanent – reason for underfunding: the ERISA and Internal Revenue Code rules requiring contributions to defined benefit plans have all the snarl and bite of Paris Hilton’s Chihuahua. That’s finding of the Government Accountability Office in its study entitled “Private Pensions: Recent Experiences of Large Defined Benefit Plans Illustrate Weaknesses in Funding Rules” (GAO-05-294).” It’s a study of the 100 largest plans in the United States, and I highly recommend that you read it if you want to understand why the system is pretty much rigged for funding failure when it comes to requiring adequate contributions to pension plans.
Most investors and analysts are familiar – or should be familiar – with the crazy exceptions built into the GAAP reporting of pension cost. For example, losses on assets and plan obligations can be deferred and amortized into cost after the accumulated amount of the losses reaches a 10% threshold, based on the greater of assets or projected benefit obligation. Additionally, gains and losses on plan assets can be figured on a “market-related” basis: a derived figure that defers gains and losses over as much as five years. The point: all of these smoothing devices are just so much book-keeping lard in the pension cost that have nothing to do with the events that occurred in a given year. They’re just smoothing devices that make pension cost less intrusive into earnings.
No further private investment trust -thrash today; suffice to say it’s just not clear reporting. You’d expect that the funding requirements would be more stringent: after all, ERISA was enacted by Congress to clean up pension scandals in the 1970’s, and it was supposed to ensure that employees who kept their side of the labour bargain over say, the first 30 years of their working adulthood were going to be rewarded with the corporate side of the promise afterwards.
Yet the requirements for funding the promise are incredibly flaccid: they seem to borrow from the GAAP concept of spreading volatile results over a number of years so that they don’t have much effect. A plan has a funding standard account that tracks its contributions and changes in plan status in each year; the problem is that the good that occurs in one year can be carried over to later years when it’s underfunded. The funding mechanism relies heavily on contribution “credits” that can be applied to to required contributions; worse, those credits grow due to an interest factor – and they mean nothing to cash put into the plan. A simple example: suppose a firm contributes in excess of its minimum contribution for a given year and accrues a $1 million credit. The excess is invested in assets that go to zero value in the following year. Even though the assets no longer exist, the sponsor could use the credit of $1 million – and the accrued interest on the credit balance – to reduce its current year required contribution to the plan.
That disconnect between the funding accounting and the true state of the plans is illustrated by two major plan failures: those of Bethlehem Steel and LTV Steel Company. Both were terminated in 2002, with assets about 50% of benefit obligations – pretty sad shape. But neither of them had been required to make cash contributions between 2000 and 2002. Their “credits” bailed them out.
Another angst-fest for investors in the GAAP accounting has been in the area of discount rate selection for figuring the present value of the projected benefit obligations. I think it’s actually more water-tight conceptually in GAAP than it is in the realm of setting funding minimums. In GAAP, there’s one rate to be used; in the funding arena, not only do firms have a range of rates to be used on a particular bond instrument, they also get to use an average rate for up to four years. What might that have to do with the present value of an obligation at a certain point in time? Nothing. But it can be gamed to minimize necessary contributions.
I could go on, but I won’t. I recommend you spend a little quality time with the GAO’s report. But let me give you some of their key findings to perhaps persuade you that it’s worth reading:
– “Reported plan funding levels were generally stable and strong over the late 1990s, with no more than 9 of the 100 largest plans less than 90 percent funded in any year from 1996 to 2000. However, by 2002 over half of the 100 largest plans were less than 100 percent funded, and
approximately one-fourth of plans were less than 90 percent funded. Further, because of leeway in the actuarial methodology and assumptions that sponsors may use to measure plan assets and liabilities, underfunding may actually have been more severe and widespread than reported.” [Emphasis added.]
“…each year on average 62.5 percent of sponsors of the 100 largest plans made no annual cash contributions to their plans. One key reason for limited or no contributions is that the funding rules allow a sponsor to satisfy minimum funding requirements without necessarily making a cash contribution each year, even though the plan may be underfunded.” [Emphasis added.]
“From 1995 to 2002, very few sponsors of the 100 largest plans were required to pay an additional funding charge (AFC), a funding mechanism designed to reduce severe plan underfunding. Most of the affected plans were less than 80 percent funded by the time they were assessed an AFC, and those that owed an AFC were likely to remain significantly underfunded and owe the AFC again in the future.”
“Because funding rules allow sponsors owing an AFC to use credits other than cash contributions to satisfy funding requirements, sponsors’ contributions on average were less than the AFC assessed. Just over 30 percent of the time a plan was assessed an AFC, the sponsor of that plan did not make a cash contribution in the year that the AFC was assessed.”
– “Underfunded plans sponsored by financially weak firms pose a greater risk to PBGC than do other plans. From 1995 to 2002, on average, 9 percent of the largest 100 plans each year had a sponsor with a speculative grade credit rating, suggesting these firms’ financial weakness and poor creditworthiness. Firms with a speculative grade credit rating were more likely to sponsor underfunded plans, implying that these plans presented a significant risk to PBGC and other premium payers… Of PBGC’s 41 largest claims in which the rating of the sponsor was known,
39 have involved plan sponsors that were rated as speculative grade just prior to termination. Among these claims, over 80 percent of plan sponsors were rated as speculative grade 10 years prior to termination.”
– “Plans sponsored by companies with speculative grade credit ratings and classified by PBGC as “reasonably possible” for termination represent an estimated $96 billion in potential claims.”
The root of all the folly – GAAP or funding rules – is the attempt to camouflage volatility – which in itself is to deny facts. The question should be: how do you like your volatility? Served up in small annual chunks that might disturb markets and force managers to act upon the circumstances causing the reported volatility? Or do you like your volatility dished up in mega-size portions that require taxpayer bailouts of government agencies like the PBGC? Increasingly, it looks like we’ll be facing the super-sized volatility because nobody wanted the annual ration in contribution calculations.