Footnote 18 to a company's financial statements is an odd place to find a bombshell. But that's where you'll find the one
dropped in its recent 10-K filed with the
Securities and Exchange Commission
This year or next, this type of bomb could blow a hole in the earnings of
and dozens of other big U.S. companies.
What's the nature of this high explosive? Warren Buffett's company cut its projected rate of return for its corporate pension plans to 6.5% for 2001, from 8.3% in 2000, that's what. And unless the stock market starts turning in regular double-digit quarterly gains in the next few months, it looks like other U.S. companies will have to follow Berkshire's lead. Because of the arcane rules of pension accounting, that move could easily result in a huge hit to earnings at companies with big pension plans.
For example, at General Electric, which just lowered its expected rate of return to 8.5% from 9.5%, the change will slice $800 million to $1.2 billion -- or between 5 cents and 7 cents a share -- out of earnings. IBM, which cut its own estimated rate of return to 9.5% from 10%, will take a hit of about 10 cents a share as a result. And General Motors will show a drop of $1 billion or more in its earnings because of its pension plans.
Truly Bizarre Accounting
By now, in this season of
and other accounting scandals, most investors know that the rules of corporate accounting can produce some pretty illogical results. But frankly, you haven't experienced the truly bizarre until you take a look at how the accounting rules let companies generate earnings from their pension plans -- even if the plans are actually losing money.
Here's how it works: On the debit side of the balance sheet, companies are required to record the cost of pension benefits that they pay out annually, plus any money spent on servicing those pensions. On the other side of the ledger, companies record any income earned by the funds that they've invested in stocks, bonds and other instruments.
Seems straightforward, right?
Wrong. There's a twist in the rules that skews all the numbers. The rules let companies book as income not the actual dollars earned by their pension investments in any year, but the returns those assets would have earned if they had performed as the company expected.
So for example, in 2001, IBM recorded $1.45 billion in net pension income (that's after pension payouts and service costs), up from the $1.27 recorded in 2000, simply because it had assumed that the $61 billion in its pension funds would earn 10%. That actuarial assumption, rather than the real rate of return, is what counts under current accounting rules. Those rules were put in place to smooth out the annual swings in pension income that would result from using real returns.
Days of Reckoning
According to Milliman USA, an actuarial and consulting firm, the 50 largest U.S. corporate pension funds lost $36 billion in value last year, thanks to a dismal stock market. The companies had projected gains of $55 billion. And because projected gains are what count, the companies were able to put $9 billion in net pension income on their books after deducting the costs of their pension plans. Some smoothing, huh?
But the real numbers do count eventually. The Internal Revenue Service reviews corporate pension funds annually to see if they might be underfunded. If they are underfunded, a company has to pony up the cash to bring the plan's assets back into line with future liabilities. And any company with a pension fund that fails the test faces higher insurance premiums from the federal program that backs corporate pension liabilities.
That's why General Motors has said it expects to add $2 billion to its pension fund. In 2001 General Motors made no contributions to its plan, and in 2000 it added $5 billion in shares of
. Given the 40% decline in the market value of Hughes stock alone, it's not hard to see how the value of assets at the company's U.S. pension plans fell to $67 billion at the end of 2001, from $78 billion at the end of 2000.
Though eventually there is a day of reckoning, it can take some time. In its most recent 10-K, for instance, General Motors was still projecting returns of 10% for its pension plans. And even IBM's recent move to cut its projected return to 9.5% from 10% leaves the estimate rather rich for a pension portfolio with a considerable exposure to bonds and other instruments with relatively low current yields.
Two Key Chores for Investors
Investors have two jobs ahead of them: estimating the potential pension-related hit to earnings a company might face, and figuring out the potential timing of that hit.
Getting a handle on the size of the problem at a company isn't hard -- it just requires reading footnotes to financial statements. Some companies will show almost no exposure to pension accounting issues; companies that use 401(k) plans instead of the older defined benefit plans are likely to have almost no pension income or costs. At
, pension earnings aren't a big deal, because only employees at some foreign subsidiaries are covered by defined-benefit plans. The total cost in fiscal 2001, according to the ninth footnote of its most recent 10-K, was just $12 million.
But it is a big issue for older companies -- big enough that I don't think investors can safely ignore it. According to Goldman Sachs, 35 companies in the
got more than 10% of their earnings from their pension funds in 2001.
Three Numbers to Look For
If you own shares in companies with defined benefit plans -- and remember that this also applies to older technology companies such as IBM and
-- look for three numbers:
1. The projected rate of return for the company's pension fund.
Berkshire Hathaway's 6.5% projection is a solid, conservative benchmark to use for comparison. The further a company's projections are away from that number, the larger the potential shift in pension earnings that the company faces as it brings its numbers in line with reality.
2. Net profit or cost from pension expenses.
This will give you an idea of how much pension income has contributed to a company's bottom line in the last year. It's a good idea to convert this number into cents per share (by dividing the total pension income by the number of shares outstanding) and then compare it with a company's total earnings per share for the year. That will tell you how big a role pension income plays in a company's overall earnings.
3. Funded status.
This number compares the market value of a company's pension assets with the size of its pension liabilities. For example, General Motors shows a $10 billion deficit on its 2001 annual report, because assets have declined to $67 billion and obligations have remained relatively flat at $77 billion. That deficit explains why General Motors is planning to put $2 billion into its pension funds.
Deciding how long it will take before any company will change its pension assumptions is tougher -- and requires some judgments from you. Some companies will have to start reducing pension earnings this year; others seem likely to be able to put it off until 2003.
First, make sure you have the company's most recent thinking on the matter. This isn't exactly the kind of data that are trumpeted in a corporate press release, so you'll probably have to put in a call to investor relations.
Second, look at how out of line the projections are with reality, and see if the company has cut its projections recently. Companies that are still at the top of the scale -- near 10% -- and that haven't reduced estimates face the most pressure to act sooner rather than later.
And third, check the funded status numbers you looked at above. Companies with deficits, or with rapidly falling surpluses, will be under pressure to increase contributions to their pension funds.
Thanks to a falling stock market, IBM's assets now exceed obligations by less than $1 billion. At the end of 2000 the surplus came to $11 billion. Companies can show a deficit here -- just as General Motors does -- but a quickly declining surplus makes it more likely that a company will show a big swing in net pension income relatively soon.
It's been an irony, and not a particularly pleasant one, of the recent bear market that companies have continued to book profits from their pension plans even as investors with IRA or 401(k) retirement money took a beating. Over the next year or so, I think the market will begin to exact its pound of flesh from corporate pension fund earnings, too. Investors who don't want to get bitten twice need to read the footnotes.
But even reading that fine print won't give you all the details on another connection between the current stock market and corporate pensions. In this bear market, many companies have moved to give top managers sweet pension deals, even as the average employee worried about layoffs and damage to a 401(k). The deals have ranged from guarantees of above-market returns to multimillion-dollar special pensions for CEOs to higher payouts at an early age for certain executives.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Applied Materials, E*Trade and Wind River Systems. He does not own short positions in any stock mentioned in this column.