Underfunded Pension Plans: A Looming Crisis for Corporate America
The continued fall in the equity markets throughout 2002, combined with the close scrutiny corporations have faced as a result of the number of corporate scandals, have increased the focus on employees' retirement funding, particularly the obligations resulting from underfunded defined benefit pension plans.
Stock Market Declines: The Ripple Effect
Recently, articles in the Wall Street Journal, Financial Times and other business publications have made mention that a number of Standard & Poors 500 companies reported huge shortfalls in their employee pension funds. A cited study by Credit Suisse First Boston estimates that of the 360 companies in the S&P 500 index that have defined benefit pension plans, 325 will have shortfalls by year's end, and only 33 will be over-funded. The study's author, David Zion, believes the companies in the broad-based index will face a total pension shortfall of $240 billion as of the end of 2002.3
Huge corporations, particularly those within the airline and automobile industries, may be required to shell out billions of dollars to boost the value of their pension plan assets, resulting in lower earnings and a reduction in cash flow that otherwise could have been used to enhance a company's business operations. In some cases, these huge pension fund obligations could lead to a rapid decline in a company's financial situation as well as an inability to pay other debt obligations and meet shareholder expectations. A situation of this magnitude could create significant problems—in the worst-case, leading a company to chapter 11 protection.
The status of American pension funds was not a point of focus before the fall in the equity markets over the last two years. However, with the stock market down and its related effect on the value of pension fund assets, funding issues that once seemed non-existent are becoming a significant concern among lenders and investors. In turn, there is considerable attention on the Financial Accounting Standards Board (FASB) and the current accounting rules governing how employers account for pension obligations.
Under the current U.S. generally accepted accounting principles as embodied in Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions (SFAS 87), companies are allowed to include assumed returns on pension fund investments and the interest expense on the deferred benefits as elements of pension expense/income. Investment experts believe that FASB rules distort the true cost to corporations of providing pension benefits because only investment assumptions, not actual returns, are reported in the financial statements. In response to investor concern, the FASB might consider revising the way companies report the impact of pension funds on their bottom lines.
However, is it realistic to assume that pension accounting will be to the detriment of hundreds of huge corporations, or could it be that pension funding is just one issue confronting corporations in today's tough market? And what does it all mean? Who will be affected, and how significant will the losses be? Changes in accounting rules are generally not effected with alacrity. Are lenders and investors facing a period during which there is no practical way to track these issues and stay ahead of adverse developments?
Fundamental Aspects of Pension Accounting
Three long-held practices in accrual accounting for pensions are maintained in SFAS 87: delaying recognition of certain events, reporting net cost and offsetting liabilities and assets.
Delayed recognition refers to the systematic and gradual recognition of changes in a pension obligation and changes in the value of assets set aside to meet that obligation over periods subsequent to the change. All changes are recognized except to the extent they may be offset by further subsequent changes. At any point, changes that have been identified and quantified await accounting recognition as net cost components and as liabilities or assets. In the current environment, this means that the decline in the value of pension assets isn't immediately recognized. Current declines are added to the net "pot" of prior unrecognized gains and losses and recorded in the employer's results of operations over future periods.
The net-cost approach means that the recognized consequences of events and transactions affecting a pension plan are reported as a single net amount on the employer's statement of operations. The compensation cost of benefits promised, interest cost resulting from deferred payment of those benefits, and the results of investing what are often significant amounts of assets would generally be reported separately for any other part of an employer's operations. Under SFAS 87, these costs and earnings are reported net.
Offsetting means that recognized values of assets contributed to a plan and liabilities for pensions recognized as net pension cost of past periods are shown net (either a pension asset or a pension liability) in the employer's statement of financial position, even though the liability has not been settled, the assets may be largely controlled, and substantial risks and rewards associated with both of those amounts are clearly borne by the employer.
Two terms—accumulated benefit obligation and projected benefit obligation—were introduced with the adoption of SFAS 87 in 1985. These two terms represent the amount of an employer's obligation under a plan's pension benefit formula under two different scenarios.
Accumulated benefit obligation (ABO): The actuarial present value of benefits (whether vested or nonvested) attributed by the pension benefit formula to employee service rendered before a specified date and based on employee service and compensation (if applicable) prior to that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels. For plans with flat-benefit or non-pay-related pension benefit formulas, the accumulated benefit obligation and the projected benefit obligation are the same.4
Projected benefit obligation (PBO): The actuarial present value as of a date of all benefits attributed by the pension benefit formula to employee service rendered prior to that date. The projected benefit obligation is measured using assumptions as to future compensation levels if the pension benefit formula is based on those future compensation levels (pay-related, final-pay, final-average-pay, or career-average-pay plans).5
Moving beyond the question of whether pension accounting as it currently stands distorts the presentation of a company's performance, knowing the amounts of the ABO and the PBO provides lenders and investors with critical information—an answer to the question, "What does the company owe today (or as of the measurement date) on its pension promises?"
In answering the question, the ABO represents the present value of all of the benefits earned to date at the employees' current compensation level. In effect, if the plan were to stop accumulating new benefits to the employees at the measurement date, the ABO would only change going forward for the accumulation of interest cost and the payment of benefits to the employees (assuming all employees are fully vested).
The PBO represents the present value of the amount of the obligation earned including consideration of the employees' estimated compensation level at retirement.
Considering the current value of the assets set aside in the pension plan (another required disclosure), lenders and investors have a clear picture of the funding status of a company's pension promises available in the financial statement footnotes.
As amended by Statement of Financial Accounting Standards No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits, the accounting literature requires the disclosure of a number of other critical pieces of information, including:
- reconciliation of annual changes in the PBO and fair value of the pension plan assets
- funded status of the pension plan, amounts recognized and amounts not recognized on the balance sheet
- assumptions used in the accounting for the plan: assumed discount rate, rate of compensation increase and expected long-term rate of return on plan assets
- separate disclosure for employers with multiple pension plans of the aggregate amounts of PBO and ABO, and fair value of plan assets related to plans where the PBO and/or the ABO exceeds the fair value of the plan assets.
These disclosures, viewed annually and over time, provide lenders and investors with significant evaluative and decision-making information.
Where Do Plans Stand Today?
In a report issued by UBS Warburg, it was noted that in 2001, the aggregate pension surplus for S&P 500 companies dropped to $1.2 billion, which was 0.1 percent of the aggregate pension benefit obligation. In addition, the median pension plan had a deficit (plan obligations exceeded plan assets) of 9 percent as of the end of 2001, the lowest median funding level since 1992. This year's poor market performance has only made the problems associated with pension funding worse.6
Let's take a look at some of the corporations that have received attention over the past few months as a result of significantly underfunded pension plans. A few victims of the pension panic include General Motors Corp., Ford Motor Co., Delta Air Lines Inc., Goodyear Tire & Rubber Co., The Boeing Co. and Verizon, among others.
General Motors Corporation (GM)
GM, with a number of defined benefit pension plans covering substantially all employees, was reported as having one of the Top 10 Underfunded S&P 500 Company Pension Funds, with a deficit of $12.7 billion at the end of 2001.
GM's deficit across its U.S. and non-U.S. plans increased from less than $1 billion at the end of 2000 to $12.7 billion as a result of losses on the asset portfolio and nominal contributions being significantly offset by the accrual of benefits (with interest) to plan participants. While GM's plans accumulated benefits and interest costs in excess of $7 billion in both 2000 and 2001, contributions fell from approximately $5.2 billion in 2000 ($5.0 billion of which consisted of GM Class H common stock) to less than $200 million in 2001. Surprisingly, upon analysis GM's plans are almost as much the victim of a decline in current funding as of the current stock market environment.
GM has kept their expected rate of return on plan assets for U.S. pension plan benefits consistent over the past five years as highlighted in the chart below. In fact, the 10 percent assumption has remained steady since GM lowered it from 11 percent in 1992 and 10.1 percent in 1993.
The Boeing Co. (Boeing)
As reported, Boeing has various non-contributory plans covering substantially all employees. All of Boeing's major pension plans are funded. At the end of 2001, Boeing had not joined the ranks of the companies in a net underfunded position. On a combined basis, plan assets exceeded benefit obligations by $1.1 billion, down from $13.7 billion at the end of 2000. All but two plans have plan assets that exceed accumulated benefit obligations.
Like GM, Boeing made only nominal contributions to its plans in 2001. Portfolio losses ($7.1 billion), actuarial losses ($2.5 billion), and benefits earned and interest cost ($2.8 billion) account for the significant change in the funded status of Boeing's plans.
For 1998, 1999 and 2000, Boeing increased the expected rate of return on plan assets for pension benefits as highlighted in the chart below.
Delta Air Lines (Delta)
Company contributions are a small component of the change in funded status of Delta's pension plans as well. While benefits accrued (with interest cost) at approximately $1.0 billion, company contributions were $50 million. Add on an investment loss of more than 14 percent on the beginning fund balances, and a full accounting for the reasons for Delta's change in funded status is just about complete.
Similar to GM, Delta kept their expected rate of return on plan assets for U.S. pension plan benefits consistent over the past five years as highlighted in the chart below.
While various experts rail against current accounting standards for pensions as distorting company performance and hiding this "ticking bomb" from the public, the cure may not be new and more complex requirements. Perhaps analysts should work with the information that is presented in the footnotes in addition to hanging on to every rise and dip in a company's EBITDA. Lenders who have concerns about changes in a company's pension plan funding status have sufficient information available to craft protective covenants for allowing intervention before the problems grow too large.
Could companies disclose additional useful information? Certainly. One possible area of expanded disclosure could be providing information regarding age of work force, number of retirees at a given point in time, etc. A table of the expected payment schedule for the PBO similar to the disclosures of debt maturities would certainly assist users of financial reports to better assess the current and future impacts of pension obligations and make corporations more aware of the financial impact that pension obligations may pose for them ahead of time.
In each of the examples analyzed above, it appears that a large call on the companies' cash flow is building. In an environment where stock market uncertainties are so front-and-center, it is difficult to focus on the long-term nature of both pension promises and market performance. While the median funding level for the S&P 500 companies' pension plans is at its lowest since 1992, the immediacy of a crisis is questionable. Like so many things in the environment of corporate distress and rescue, everything is timing.
1 James M. Lukenda is a managing director in Huron Consulting Group's Corporate Advisory Services practice. The current president of the Association of Insolvency and Restructuring Advisors, he has a wide variety of experience in accounting, financial and operating matters related to corporate reorganizations. Return to article