Worries about pension deficits just won't go away.

Despite a big rally in the stock market, most companies in the

S&P 500

have seen their pension deficits expand even further this year, meaning even bigger cash contributions could be necessary and earnings could take another hit as a result.

What's more, companies continue to assume very high rates of return on their pension assets, suggesting that the quality of corporate earnings will remain poor in 2003. David Bianco, head of the valuation and accounting group at UBS Investment Research, believes that S&P profits will be overstated by about $2 this year because long-term asset assumptions are too aggressive. Thomson First Call is currently looking for the S&P 500 to post earnings of $52.10 this year.

Here's what's going on. Companies treat pension contributions from workers as if it were income that they can invest in the financial markets. When times are good, pension assets typically expand, but when financial conditions turn south, companies can lose money on their investments. Pension accounting rules require that firms contribute money to their pension plans if they are deemed to be sufficiently underfunded, and big contributions to these plans can act as a drag on earnings.

But wait, hasn't the stock market moved higher this year? Yes, but at the same time interest rates have moved to multidecade lows, and interest rates help to determine the present value of future pension liabilities. For example, let's say company XYZ has to pay an employee $20,000 per year in 20 years. If interest rates are very low, at say 2%, the firm would need $13,459 today to cover the expense. But if rates were higher, at say 8%, the firm would need just $4,290 to cover.

The upshot of this is that while pension assets have increased this year, low interest rates have raised liabilities even more. The aggregate pension deficit for S&P 500 firms stood at a record $239 billion as of the end of May, according to Bianco, who estimates that this will increase to $278 billion by the end of fiscal 2003.

Firms with the largest deficits relative to their market cap at the end of 2002 included

Delta Airlines

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Goodyear Tire & Rubber

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McDermott International

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General Motors

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. GM said Friday that it plans to sell $10 billion in debt and convertible securities to finance part of its pension plans, which were underfunded by about $19 billion at the end of 2002.

Bianco believes aggregate pension costs will surge to $14.7 billion this year compared to just $2.4 billion at the end of 2002. That would shave about 87 cents from aggregate S&P earnings this year and would have an even bigger impact on 2004 earnings, which could be reduced by as much as $1.90, he said.

Meanwhile, the estimated rate of return on pension assets is too high for many firms. An accounting quirk lets companies book gains on the basis of assumed rates of return, not the actual rate.

While the projected return on total pension assets did fall to 9% in 2002

for larger plans from 9.5% in the prior year, Bianco said these estimates are overly optimistic.

"The quality-of-earnings problem is more widespread than major deficits, often worst at companies with surpluses," he said.

Unlike the pension deficit problem, which mainly affects industrial, material and certain consumer cyclical companies, aggressive pension estimates are more widespread, he said. "It is crucial that investors consider the influence pension accounting may have on the quality of a company's reported earnings in addition to its pension's current funding status."

According to data from Morgan Stanley, 147 companies in the S&P 500 are expecting a return on their pension assets of between 9% and 9.99%, while 101 firms expect returns of between 8% and 8.99%. Another 13 companies are looking for their assets to grow by 10% to 10.99%.


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, at 10.9%, has the most aggressive assumption rate of any firm in the index, followed by


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at 10.5% and

General Mills

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Darden Restaurants

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at 10.4%.

Although these companies could argue that their assumptions are reasonable because their portfolios have heavy exposure to stocks, distressed debt or other assets that carry higher returns, it's worth noting that these assets come with higher risk and the returns might never be seen. In the meantime, however, these firms are recording gains based on these assumptions.

"Now let's get this straight," said Steven Galbraith, equity strategist at Morgan Stanley. "Arguably the best investor of the modern era

Warren Buffet sees equity returns in the 7% range, yet more than half of U.S. corporations still see blended returns on bonds, stocks and alternative assets north of 9%. We have two words of advice on this point -- get real!"