Pros and Cons of Marking to Market

In response, some plan sponsors are considering switching from standard GAAP smoothing methods to mark-to-market (MTM) accounting in calculating pension cost. In general, mark-to-market accounting involves applying actual plan gains and losses to the calculation of pension plan expense. This approach means eliminating some or all of the smoothing techniques that a company may currently employ.

The major benefit of implementing mark-to-market accounting for a pension plan is that the company can restate historical financial statements to reflect actual losses experienced within the plan. The company can also remove "escrowed" losses—losses that were incurred in the past but are still awaiting future amortization—from its income statement. The risk in a transition to MTM accounting arises from the fact that the company's pension expense is likely to be more volatile going forward. Shifting to mark-to-market accounting also carries the potential threat of a negative earnings impact, as happened when the 2012 decline in interest rates overwhelmed the rise in pension asset values and eroded funding levels in most plans.

To better understand the impact that transitioning to mark-to-market accounting might have on a company's key financial metrics, SEI conducted an analysis of 23 public companies that have made the switch within the past two years. (See Figure 1, on page 2.) In doing so, SEI identified four key areas that might be impacted by an organization's transition to mark-to-market accounting for its pension fund:

Investors.  The first question we considered was: Do investors view the shift to mark-to-market negatively, and do companies pay a price in terms of share value for making the move? In each of the 23 companies in our analysis, SEI conducted an event study to evaluate movements in share price over a five-day period surrounding the announcement of the accounting change. In addition, the analysis included each company's Q4/2012 earnings release in order to provide insight into the mark-to-market impact for the full calendar year. The research then constructed a capital asset pricing model line for each company, based on actual performance relative to that of the appropriate subset of the S&P 1500, and used regression analysis to predict an expected change in company return given a change in benchmark return.

This analysis indicated that the companies in the study experienced no statistically significant changes in share price that would reflect a direct, obvious shareholder response to the implementation of mark-to-market accounting. In addition, the analysis showed no change in share price as a result of the "noise" inherent in utilizing actual asset and liability returns on financial statements rather than including those results in the footnotes. Although a few early adopters, such as Verizon, experienced abnormally large, but transitory, changes in share price following the initial announcement, those changes did not translate into sustained effects on share value, either positive or negative. This research confirms what SEI expected: With no cash implications, changes in accounting measures have no direct impact on share prices.

Analyst community.  Next, we looked at whether analysts appreciate the change in accounting for pension expenses and whether they recognize the impact on earnings volatility for comparison purposes. For some time, analysts have frequently employed mark-to-market analysis in evaluating "core" earnings and the cash impact of the pension plan. For large companies in which the pension is large relative to market capitalization, analysts unwind GAAP treatment of losses and focus on the projected cash impact of the plan going forward. Likewise, in comparing a mark-to-market company's EPS with non-mark-to-market comparables, analysts generally unwind the MTM adjustment, using the companies' smoothed GAAP earnings across time periods to compare performance.

A careful review of the Q4/2012 earnings calls of the 23 companies in our study revealed little to no discussion of the impact of mark-to-market versus GAAP accounting for the organizations' pensions, nor did company representatives spend time discussing the resulting volatility in their earnings. Analysts appeared to be unsurprised by the earnings drag that mark-to-market companies felt in 2012 due to the decline in interest rates. Across all 23 calls, there were very few questions and no direct criticisms of the new accounting implementation. It is worth noting that in many analyst reports pension liabilities were still calculated using GAAP accounting, meaning the mark-to-market impact was adjusted out of the analysts' annual earnings forecasts for those companies.

Ratings agencies.  We also looked at whether a plan sponsor's credit rating tends to be affected by a move to mark-to-market accounting. Reviews of the rating practices of Standard & Poor's, Moody's, and Fitch, as well as discussions with Moody's Investor Services, indicate that a shift to mark-to-market by a plan sponsor does not cause a significant disruption to the financial analysis practices of the major ratings agencies. Among several other non-GAAP adjustments that the ratings agencies make to corporate financial statements, applying full mark-to-market treatment for pensions appears to be standard practice.

At the same time, pensions and pension volatility have a discrete but limited effect on overall ratings. Compared with a company's revenue and leverage level, pension-related factors generally have a modest impact on its credit rating. Significant changes to a plan's funded status may limit credit rating upgrades, but such changes are unlikely to lead directly to a downgrade if they're not accompanied by other changes in the company's creditworthiness; since the major ratings agencies already are, in effect, using MTM in their analyses, a shift to MTM accounting should have a negligible impact on a particular plan sponsor's credit rating.

Internal management.  Finally, we evaluated how management incentives are affected by the change in earnings per share that results from the increased volatility in pension gains and losses. It is not unusual for some portion of a management team's incentive compensation to be tied to annual GAAP earnings performance. Since pension expenses average approximately 10 percent of a company's EPS, the additional volatility associated with a mark-to-market implementation has the potential to have a material impact on earnings. In response, based on available proxy statements, all companies adopting mark-to-market accounting have appeared to revise their compensation plans to exclude the MTM adjustment, effectively shielding management bonuses from the volatility of actual pension performance.

Interestingly, many of the companies that SEI surveyed did not de-risk their pension plans to reduce volatility prior to implementing mark-to-market accounting; instead, they chose to maintain more aggressive investment portfolios. The net effect of combining the higher expected return in accounting for pension expense, eliminating the amortization associated with historical losses, and adjusting out the mark-to-market impact is that management ultimately gets the benefits of a more favorable EPS without the penalty of past poor performance. In many respects, this is an ideal outcome for management.

The Right Move—for Certain Companies

While there is much discussion in the industry regarding the pros and cons associated with full mark-to-market accounting for pensions, SEI's research suggests that the reaction of stakeholders and the subsequent impact on corporate financial metrics is generally negligible. Investors appear to see through the GAAP-accounting conventions to appreciate the underlying economics of a pension's actual performance. Financial analysts and ratings agencies are already in the practice of "unwinding" the smoothed assets for comparison purposes. And management teams that move to mark-to-market receive the benefit of removing a drag on earnings, while often retaining the GAAP smoothing techniques to shield their incentives from the possible impact of poor pension plan performance on their balance sheet.

Our research indicates that a change to mark-to-market accounting is likely to result in little substantive change on the part of investors, analysts, or managers. But does this mean it's the right move for your company's plan?

During our review, it became apparent that the 23 companies we considered share two characteristics which likely drove their decisions to transition to mark-to-market. First, the companies' pension plans were typically two times larger than those of the median plan sponsor, relative to the company's market capitalization and balance sheet. As Figure 1 illustrates, the median ratio of pension assets to corporate market capitalization is 20 percent for the MTM companies in our study, versus a median of 10.9 percent for U.S. public companies overall. Along the same lines, the median ratio of pension assets to adjusted corporate assets is 16 percent for MTM companies, compared with 9.5 percent for all U.S. public companies.

Second, as Figure 1 also demonstrates, the 23 companies that moved to mark-to-market accounting were experiencing pension-related loss amortization expenses, as a percentage of net income, that were more than three times higher than those of the median U.S. pension plan in the year prior to switching to mark-to-market accounting. Clearly, mark-to-market accounting is most attractive to plan sponsors in which the size and impact of the pension plan is disproportionately large relative to the plans of their competitors.

————————————–

Tom Harvey is director of advice for SEI's Institutional Group. In this capacity, he oversees the corporate finance practice, analyzing the risk profiles of corporate defined benefit clients and the corresponding impact on asset allocation and funding strategies. An expert in corporate finance and a frequent speaker at industry events, Tom has over 15 years of experience in the investment industry.

 Joe Busillo is a senior strategist for SEI's Institutional Group, where he works closely with defined-benefit clients in providing strategic advice. He is responsible for the development and application of SEI's global liability-driven investing strategy. Joe has over 14 years of experience in the investment industry.