Many pension plans could end up in deep trouble with investors when the next phase of accounting rules kicks in
By Beth Karlin
When the Financial Accounting Standards Board (FASB) adopted in 2006 a new accounting standard, FAS 158, that mandated fair-value reporting and considerably more transparency on pension plan liabilities and assets, few companies seemed to take the threat immediately to heart. Even after passage of the Pension Protection Act (PPA) that same year, which imposed strict funding standards on plans, many companies didn’t do much to prepare.
Don’t include VWR International LLC, a $3.5 billion West Chester, Pa.-based distributor of laboratory equipment, in that group. VWR saw the 158 writing on the wall and forged ahead. In the third quarter of 2007, it sold most of its stocks and reallocated the proceeds into longer duration, fixed income investments. The previous mix of 71% equity, 21% fixed and 8% cash mix became a mix of 19% equities, 37% cash and 45% fixed-income, explains Scott Smith, VWR’s treasurer. The key for Smith and VWR was to find suitable hedges against volatility and interest rates. They believe they found that in liability driven investment funds (LDIs) offered by Barclays Global Investors (BGI).
In some ways, VWR was unusually lucky, but it was also a case of judicious planning. Smith says the company unloaded stocks at or near the market peak, and transferred the money into LDIs as the subprime crisis gathered momentum. “It’s happened exactly as we expected,” says Smith. But what if the market had continued to climb? “We would have been comfortable with that,” he says. “We made a conscious decision that mitigating our U.S. plan’s risk trumped potentially greater returns—and potentially lower future funding costs.”
It paid off. At the end of the year, the fair value of plan assets was about $147.9 million versus $150.6 million in liabilities—a reduction in their U.S. plan’s underfunded status of $15.4 million during 2007. “We went from being approximately 88% funded to more than 98%during the year, which was quite remarkable given overall market performance,” Smith proudly notes. “I can’t help but think there are a lot of companies [that] didn’t revisit pension investment strategies who are now experiencing significant pain.”
Get used to it. Thanks to the PPA and accounting rule changes, finance executives in charge of pension plans will now have to start thinking of themselves more as risk managers than investment strategists, as pension funding levels and costs move from the footnotes to balance sheets—and perhaps soon, to the income statement itself. “These events combined to shine a spotlight on pension funds as risky investments,” says Joe McDonald, head of Hewitt Associates global risk services.
And it is likely to get worse before it gets better, given pending FASB proposals and recent discussions with the International Accounting Standards Board (IASB) on reconciling the U.S. accounting system with the one used in most of the rest of the world. The ticking timebomb, of course, is Phase II of FAS 158, which would record fund gains and losses as part of net income. This has the potential of creating swings of hundreds of millions in dollars in earnings. Phase II could come as early as 2010, says Peter Proestakes, manager of FASB’s post-retirement project. “We are actively considering the portion of Phase II that deals with the aggregation of the cost components,” says Proestakes. “Ongoing meetings with the board should begin in the next couple of months.”
When, and if, Phase II is implemented, companies, consultants and investment advisers unilaterally expect to see dramatic disparities between operating income and net income, a development that industry watchers consider nothing less than revolutionary. “When that penny drops, it will change the pension world,” says Andy Hunt, senior strategist in BGI’s strategic solutions group. William McHugh, chief pension strategist at JP Morgan Asset Management, amplifies the alarm: “We are looking at the most dramatic changes in pension accounting since ERISA (the Employee Retirement Income Security Act of 1974),” says McHugh.
If that sounds like hyperbole, there is data to back it up. Average operating earnings would have been 51% lower in 2002 and 10% higher in 2006 if pension assets and liabilities were included, according to Charles Mulford, an accounting professor at Georgia Institute of Technology. Mulford says the data argues against a unilateral earnings change in the second stage of 158. While shareholders and analysts should be able to clearly see pension gains and losses, he suggests that gains and losses resulting from fair value pension accounting are not equivalent to gains and losses incurred in selling products and services.
Indeed, in some instances, portfolio movement could affect earnings more than business operations. “It could result in an inverted yield curve,” explains Hewitt’s McDonald, as it has in the U.K., where regulators are about three years ahead of FASB in implementing disclosure rules.