Simplicity is great, but everything has its price. And in the case of the new Financial Accounting Standards Board (Fasb) regulations for reporting pensions, the one paying the highest price – at least in terms of time and effort – may be the investor relations officer.
Under SFAS (Statement of Financial Accounting Standards) 158, released last September, companies reporting in US Gaap must now account for the true cost of their pension plans on their balance sheets for any financial statements released after December 15, 2006. It doesn’t necessarily affect the underlying financial strength of companies, but it definitely affects the perception.
Fasb’s goal is clarity. Investors can finally see the impact that a pension plan has on a company’s financial situation without having to dig through enough footnotes to rival a 19th-century Russian novel. One problem is that many companies will see a significant change in their shareholder equity – and usually in a downward direction. To avoid an onslaught of distressed investors, potential pressure on stock prices and extensive amounts of time spent dealing with problems, it’s best to get ready now.
Shortfall becomes liability
What’s changed is basically that companies must now put the funded status of their pension plans on the balance sheet. This may sound straightforward, but the amifications can be enormous.
For companies with defined contribution plans, where the business and employees both put money into something like a 401K account, there is no funded status; as the money is held in the names of the employees and the company, payments are treated as expenses as they happen.
But the world is different for companies with defined benefit plans, in which the employer essentially invests money and pays benefits to retired employees out of the proceeds.
According to Brian Matt, vice president of institutional targeting at CapitalBridge, which has been eyeing SFAS 158’s effect on client companies, around 350 of the S&P 500 have defined benefit plans. ‘I’d guess that a majority – two thirds to three quarters – are probably underfunded,’ he estimates. For these companies, the shortfall becomes a liability on the balance sheet that must be matched by an equivalent drop in shareholder equity.
Look at the pension poster child – or basket case – that General Motors (GM) has become. In its 2005 10K statement, the company showed $6 bn in its pension fund. ‘But because of the quirks of the accounting rules, that figure showed up on GM’s balance sheet not as a $6 bn asset, but as a $36 bn asset,’ says John Hepp, senior manager in Grant Thornton’s national professional standards group. Because about $30 bn of that actually consisted of deferred losses, and losses will now be brought up onto the balance sheet, GM will show an immediate hit to shareholder equity.
In the past, getting a complete picture required poring through the numerous relevant footnotes in financial statements. Now that the information is obvious, it’s likely to have a greater impact on investors who didn’t grasp the full picture, including some institutional investors.
Adding to the confusion is the fact that the income statement is yet to be covered by the new regulations, so much of the pension information remains buried in the footnotes.
There is also the question of how the income statement will track changes in the cash value of a pension plan.
Fielding questions
In short, the complete picture could be confusing. Corporate IR personnel will be the ones fielding the questions, and they need to prepare the right answers. The first step is to understand exactly what your pension situation is. According to Anthony Eppert, a counsel with Sheppard, Mullin, Richter & Hampton, five factors go into determining your pension status: service cost, interest in the projected benefit obligation (PBO), expected return on plan assets, amortization of prior service cost, and actual gains and losses in investments. ‘Once you put all that together, the net amount is the pension expense,’ he says.
There is an additional complication: Hepp says the balance sheet will show the pension expense net of taxes. ‘If I’m looking at the notes from GM’s 2005 10K and I see $30 bn, and if the tax rate is, for example, 40 percent, then I am going to recognize $18 bn in loss of equity and not the full $30 bn.’ Yet if a company is financially distressed or for some other reason cannot realize that future reduction by taxes, the balance sheet may bear the full amount.
Now for the big pothole in the IR road: the Pension Protection Act of 2006 (PPA). SFAS 158 defines the funded status of a plan using a PBO. This requires a company to take into account each employee’s service history as well as a projection of future pay increases. Because benefits are based on final average pay, the amount of pension obligation for an employee will increase as salary rises. To be considered fully funded, a pension plan needs enough assets that the projected return would completely fulfill these obligations.
Yet when Congress set out to ensure that corporations would properly fund their pension obligations, it used a fundamentally different definition of sufficient funding. Instead of a PBO, the PPA mandates calculation of pension obligations on an accrued-to-date basis. As long as a company has enough assets to cover all present obligations should the pension plan suddenly end, it is considered to be fully funded.
The two approaches come from two different philosophies. From the PBO viewpoint, a plan needs enough assets to cover what the obligations will likely become – an approach tailored to an investor’s priorities. Accrued-to-date basically says that as conditions change, a company can add the additional necessary funds; it is therefore primarily an operationally oriented model.
‘There will be times when pension plans are considered overfunded on a legislative basis and underfunded on an accounting basis,’ says Jon Waite, chief actuary in the global institutional group at SEI, a provider of outsourced asset management. Someone will have to reconcile the two views for investors and show that what may be underfunded in one view is actually financially sound in another.
Soft dollars
In addition to queries about the balance sheet and income statement, IROs might get questions on Form 5500, the annual report filed by pension plans, as there are changes here as well. ‘There will be an extra piece for you to disclose: the soft dollars,’ says Rania Sedhom, senior manager in the employee benefits group at BDO Seidman. Fees for everything from administration to advertising get explicit disclosure on the form and become potential fodder for investor inquiries, she explains.
‘I wouldn’t view irate investors as the problem,’ Eppert remarks. ‘At least they’re talking to you. It’s the silent investors you should be more worried about – the ones who don’t know and don’t ask and just sell their stock.’
To be informed, IR departments must confer with their CFOs, attorneys and auditors to understand what changes might appear in the financials due to the new accounting rules. They should then determine strategies for dealing with the new reporting requirements. Companies with defined contribution plans might be able to better position the value of their stock compared to competitors with defined benefit plans that suddenly show a book reduction in shareholder equity. Meanwhile, companies with defined benefit plans need to see whether they have a reported reduction or increase in shareholder equity and then devise ways of communicating to investors of all sizes how the underlying financials are no different from what they were in the past. After all, those first financial statements with updated balance sheets will ship soon – if they haven’t already.
