I have always been amazed by the complexity in our accounting system. Most of the time, GAAP provides complicated accounting solutions to simple problems. Pension accounting is certainly one area where makes it almost impossible for a non-professional investor to understand. The complexity in pension accounting and the lengthy nature of the pension disclosure , when combined, results in the almost universal and complete neglection of this enormously important topic. My goal in this part of the article series is not to fully explain everything about pension accounting because that will take an ungodly amount of them, but to provide a few key ideas in pension accounting so that the readers can at least get through the pension footnote of a public company.
While there are many jargons that will make every investors sweat quite a bit when reading the pension and postretirement benefit footnote, the good news is, you only need to understand the key concepts in order to get through the footnote with a pretty good idea of the pension obligations and funded status of the company. Let’s review them one by one.
Projected benefit obligation - This is an estimate of the future stream of pension obligations discounted to the present value. In other words, this is essentially what the company owns to its current and future retirees.
Plan asset - This is the investment portfolio the company has put aside in order to fund the future obligations. Ideally, this amount is the answer to the question how much money is needed now so that it will grow to the amount needed on the retirement date.
Funded status - This shows if the company’s pension plan is under-funded or over-funded. It is calculated by subtracting plan asset from projected benefit obligations. You should pay a lot of attention to this number.
Service cost (current period) - This is essentially the amount of the retirement check the company would have written you annually had you retired today, for your current year’s service at the company. This is an annual calculation.
Prior service cost - Similar to current period service cost, this is essentially the amount of the retirement check the company would have written you annually had you retired today, for your years’ of service at the company prior to the inception of the plan.
Interest cost - Although named interest cost, this is really just the elapsed time value of money of future obligations. Say you have an obligation of $100 in two years. This $100 has a PV of $82.6 today if we discount it back using 10%. A year later, the PV of the same 100$ would increase to $90.9 simply because now we only need to discount it for 1 year instead of 2 years. This increase of $8.3 a year would be the so-called interest cost.
Actuarial gains and losses - This is basically the changes in pension costs due to changes in assumptions and amortization of past service cost. Think of this mostly as change in economists’ estimate of current economic data, which is often wrong but claimed to be right by the economists. In other words, you shouldn’t pay much attention to this number unless the actuarial gains are unusually large in a year, in which case you should be watch for earnings management.
Pension expense - The component of pension expenses are:
Current period service cost
+ Interest cost
+ Amortization of past service cost
+ Amortization of actuarial gains and losses
- expected return on plan assets in $ values
Theoretically, this is the additional pension obligation incurred in current year. However, in reality, this number is most likely a phony bologna number made up by management and actuaries because all components of pension expenses are subject to considerable human judgment.
Discount rate - The rate at which future obligations are being discounted, chosen by management. The higher the rate, the lower the obligation.
Expected return on plan assets - The “this is what the management says” projected investment return to be produced by plan assets. The higher the rate, the lower the obligation.
Rate of salary increases - Rate of wage increases in a world where everybody wears actuaries’ glasses. The lower the rate, the lower the obligation. This number is disclosed because most annual retirement check calculations use the final salary, which is calculated by taking the current salary and compound it at the rate of salary increases for the number of years between now and retirement.
The big picture timeline looks something like this (please excuse my poor drawing)
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That’s all the concepts you need to know. All you need to do is familiarize yourself with the above concepts, which shouldn’t take more than 30 minutes.
Here comes the fun part - the most important things
1. Locate the funded status, which is the fair value of plan assets minus projected benefit obligations. Is the plan under-funded and if so, how much?
2. Look for signs of aggressive accounting in the following assumptions -
Discount rate - The higher the more aggressive.
Expected return on plan assets- The higher the more aggressive.
Rate of salary increases - The lower the more aggressive.
It is helpful to compare the rates to a few key competitors.
3. Go to the plan assets allocation table and find out how much is allocated to bond, how much is allocated to equity, and how much is allocated to other asset classes.
4. Go back 5 to 10 years and calculate the actual annual return on plan assets and compare that to the previously disclosed expected return on plan assets.
Once you’ve completed the above 4 steps, you should know enough about the company’s pension plan. You should also spot any red flags related to either the funded status of the plan or potential earnings management.
I know this is all theory. In my next article, I will walk through a real life example. In the meantime, if you have any questions or any other concept you want me to clarify, please comment on the article.
Appendix - Warren Buffett (Trades, Portfolio) on pension fund investment return assumptions from the 2007 annual letter to shareholders.
Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.
The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.
This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.
How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.
Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.
It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?
Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high- priced managers (“helpers”).
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double- digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.
Some companies have pension plans in Europe as well as in the U.S. and, in their accounting, almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.
What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire.
After decades of pushing the envelope – or worse – in its attempt to report the highest number possible for current earnings, Corporate America should ease up. It should listen to my partner, Charlie: “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”
Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement – sometimes to those in their low 40s – and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.
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