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Feathering the Nest Egg

Pension surpluses are a boon to corporate bottom lines. But are efforts to expand them going too far?

1Oct

These sure seem like good times for pension plan assets. Thanks mainly to the long bull market, many corporate plans are brimming with surpluses. Sherwin- Williams Co., for example, has pension plan assets almost three times greater than its pension obligations. General Electric Co.'s pension assets of $50 billion are nearly double its liabilities. And the pension plans of Bank of New York, Westvaco, and Cincinnati Financial Corp. are also overfunded by nearly 100 percent, according to Bear, Stearns & Co.'s 1998 estimates.


And thanks to the prevailing accounting methodology, a significant portion of those surpluses are boosting corporate bottom lines. According to Bear, Stearns, 25 percent of the companies in the S&P 500 reported income from their defined benefit plans in 1998. And for 15 of those companies, including USX­US Steel, Unocal, Northrop Grumman, Westvaco, and Peoples Energy, pension income represented 10 percent or more of total 1998 operating income. In fact, says Jack Ciesielski, publisher of The Analyst's Accounting Observer, for many companies, "pension plans--in their ability to contribute to earnings--are becoming almost as significant as operating assets."


It's no surprise, then, that more and more corporations are devising new ways to preserve and expand their pension surpluses. Such efforts have included everything from lobbying for legislative changes to reducing pension benefits to, most recently, Bank of America's novel idea of channeling 401(k) monies into defined benefit plans.


But some analysts contend that using pension surpluses to boost earnings distorts financial reality. For one, the growth rates are not sustainable. "You can do these things, but only for so long," says Ashwinpaul "Tony" Sondhi, president of A.C. Sondhi & Associates, a financial advisory firm in Maplewood, New Jersey, and chairman of the Financial Accounting Policy Committee of the Association of Investment Management and Research. For another, the earnings aren't real. Because of Employee Retirement Income Security Act (ERISA) requirements, a company can't access the assets in its pension plans for purposes other than providing benefits to plan participants. "It cannot use this money to finance capital projects, to buy back stock, or to pay dividends," says Ciesielski. "It does nothing to increase or decrease cash flow."


Moreover, the mushrooming surpluses--which have to be fully disclosed only in the footnotes of a company's annual report--have raised the ire of the Securities and Exchange Commission, which is taking a hard look at broadening pension disclosure requirements. In addition, labor unions and retirees, concerned about the lengths to which companies will go to increase the surpluses, are reviving debate over the proper use of pension plan assets. Little wonder, then, that some analysts are wondering if the surpluses might be too much of a good thing.



Multiple Options

That hasn't stopped efforts to expand the surpluses, however. On Capitol Hill, the Senate is considering a bill that would repeal the limits on deductible employer contributions to pension plans. A similar version passed in the House of Representatives in July. But whether a final version will pass muster with the Clinton Administration remains to be seen.


Even without legislative change, employers are finding many ways to boost their plans' assets. That's mostly because "the accounting methodology [for pensions] is chock-full of assumptions that can be tweaked to achieve a desired result," says Ciesielski.


That methodology--Statement of Financial Accounting Standards No. 87, or FAS 87--requires companies to record surplus pension assets as a credit to pension expenses. Simultaneously, it gives companies some flexibility in making actuarial assumptions. Consequently, each year pension plan officers revise the discount rate used to value their plans' liabilities. The higher the assumed interest rate, the lower the present value of a plan's liabilities, the higher its surplus, and the higher the company's earnings. Similarly, pension plan officers revise the assumed rate of return used to estimate plan assets. "Even minute adjustments to these estimates can cause a big swing in a large pension plan's surplus," says James Turpin, vice president for pensions at the American Academy of Actuaries.


How much tweaking is actually going on, however, is subject to debate. Because of the bull market, says Ciesielski, "firms haven't had to resort to the skulduggery of tinkering with expected rate-of- return assumptions to improve earnings. The positive earnings effects are even more likely to be the result of the accounting model itself rather than its outright manipulation."


Companies have, however, become creative in keeping their plans as funded as possible. Bank of America blazed a new trail in July when it offered participants in its $4.7 billion 401(k) plan a one-time option to roll their accounts into the company's $8 billion defined benefit plan. The advantage to employees who make the switch is that they will be able to allocate the money among "virtual" mutual funds, hypothetical portfolios that track returns on the bank's in-house funds. But for Bank of America, the windfall is potentially much larger: its investment returns could be greater than the amount the company will be obligated to pay out to employees. Other companies are surely waiting to see if Bank of America runs into regulatory problems. If it doesn't, it's likely that there will be a flood of asset transfers from 401(k) programs into pension plans.


But not all companies are waiting patiently for the go-ahead to increase assets. Many are also attacking the issue from the liability side of the balance sheet and simply reducing benefits. Many major corporations--including IBM, Ameritech, Duke Energy, Kmart, and Lucent, to name just a few--have implemented pension cuts in recent years. In some cases, the changes have been in the form of subtle modifications to the compensation and benefits formulas, such as a reduction in the rate at which benefits are accrued. Increasingly, however, employers' efforts to boost pension plan surpluses-- and corporate earnings--have been far less subtle, consisting of the outright elimination of specific benefits, such as early retirement subsidies.


Historically, companies cut benefits when business is bad. But these are prosperous times, and most pension plans are fully funded, if not overfunded. "[FAS 87] has given companies the ability to realize the economic value of pension plan assets without actually going through a reversion," says Richard P. Hinz, director of the Office of Policy and Research at the Pension and Welfare Benefits Administration. As a result, he says, pension plans are now effectively a profit center.



Could it Backfire?

All of this maneuvering has provided considerable short-term benefits to companies. But many experts fear that corporations' increasing reliance on growth in pension plan surpluses will backfire over the long term.


Sooner or later, the stock market will stop performing as spectacularly as it has in recent years. At that time, says Sondhi, "not only are companies going to have to make pension contributions, [but] they will no longer be able to recognize the credit." In this scenario, pension plans easily could become a cost center again. "[They are], after all, a cost of doing business," says Sondhi. "Right now, [they're] not showing up as a cost of doing business because [they're] shielded by a confluence of events--the market's performance and changes in assumptions."


A change in the current environment, say analysts, may also reveal subpar growth in income from certain companies' primary businesses. "Pension plan returns are far in excess of the return on assets of their sponsors," says Ciesielski, noting that according to his estimates, 32 of the 87 S&P 100 firms with defined benefit pension plans had pension plan returns in excess of their operating returns in 1999.


Still, Gaston Kent, vice president of investor relations at Northrop Grumman, maintains that as long as firms adequately disclose their pension income, pension fund accounting should not be an issue. "Every shareholder that I talk to is fully aware of it," he says. "And there are also some fairly significant noncash expenses."


While many analysts believe that companies should be required to treat pension income the same way they treat earnings on investment--as nonoperating income--no one expects any changes in the accounting rules anytime soon. While the Financial Accounting Standards Board acknowledges the validity of some of the recent criticisms about pension accounting, it currently has no agenda item scheduled to address the issue. "There is obviously a lot going on in a pension plan," says Jim Kroeker, a FASB fellow. "But it seems that all of the necessary information is available in the footnotes to the financial statements."


The SEC, however, is trying to get pension surplus information out of the footnotes and into the spotlight. Although the commission does not plan to organize a task force or propose new rules on the issue, it is "sensitive to the disclosure of pension fund details," says a senior official. Most recently, in December chief accountant Lynn Turner sent an audit risk alert letter to the American Institute of Certified Public Accountants, letting accountants know that any gains or losses on pension fund investments that are "reasonably likely to have a material impact on financial condition, liquidity, or results of operations of the company" should be included in the management discussion portion of a company's filings. Changes in types of plans must also be discussed, the letter said.



The Other Shoe

The continuing desire of corporations to maintain pension surpluses, say some observers, is the force behind the recent spate of cash- balance plan conversions. An estimated 500 defined benefit pension plans in the United States have been converted to such plans in recent years.


By definition, a cash- balance plan conversion does not have to mean lower benefits for employees and retirees. "There are valid reasons for switching to a cash- balance plan," notes Turpin of the American Academy of Actuaries. In theory, it can be structured to provide employees and retirees with long-term retirement benefits equivalent to those in the old defined benefit plan, while also meeting the portability needs of today's workforce.


In practice, however, the conversion generally produces significant reductions in the employers' total pension liabilities by reducing benefits for many employees. Last year, for example, when IBM converted to such a plan, one of the company's engineers calculated that he would lose $212,000 when he retired in 10 years after 30 years of service. "The purpose of IBM's cash-balance plan conversion was to slash obligations to employees, increase the pension plan surplus, increase the company's operating income, and drive up its stock prices," says James Marc Leas, an advisory engineer and patent lawyer at IBM's Burlington, Vermont, semiconductor fabrication plant.


As has been widely reported, IBM employees didn't take the conversion lying down. After months of protests, Leas and 329 other shareholders submitted a shareholder resolution calling on IBM to give all employees, regardless of age, the same pension choice and retirement medical plan as older employees were given. And although the resolution did not pass, it captured 28.4 percent of the shareholder vote--far more than the 3 percent needed for employees to win the right to bring the issue up again at next year's annual shareholder meeting. And, largely in response to the protests of employees at IBM and other companies, a Senate panel, the Internal Revenue Service, the Equal Employment Opportunity Commission, the Department of Labor, and the Pension Benefit Guaranty Corp. are all in the process of reviewing cash- balance plan conversions to determine if, among other things, they violate U.S. age-discrimination laws.


Meanwhile, General Electric's huge surplus, and the $4 billion it has contributed to earnings in the past five years, have also stirred up dissent. At demonstrations throughout the country, GE retirees and union representatives have been pressing for permanent cost-of- living increases. And at GE's last two annual meetings, union workers and retirees proposed resolutions seeking shareholder approval of top executives' benefits. Although the resolutions didn't pass, they appear to be gaining institutional investor support. GE retiree groups are also uniting with retiree groups from IBM and four other corporations to seek protection from benefit reductions in the event of a merger.


Such protests from retirees and labor could be the main price companies pay for increasing their pension assets. "There's no question that this has made employees more cognizant of pension trusts and where they sit in the overall spectrum of the employer's assets," says Bob Patrician, a research economist at Communications Workers of America. Retirees are also more likely to push for cost-of-living increases and, in the process, revive the decades-old debate over the proper use of surplus pension plan assets.


"The only thing that will stop this is political intervention," says Norman Stein, a professor at the University of Alabama School of Law. "The idea is now too well entrenched that this money belongs to the shareholders, not the employees, and [companies] are going to give as little of it as possible to the employees--even though it was supposedly put aside for their retirement." 



The Deductible Debate



Congress addresses limits to pension contributions.


For years, companies have pushed for legislative changes that would allow sponsors to pump more assets into their pension plans. Most recently, major employers have advocated for a repeal of the limits on deductible employer contributions to pension plans.


On July 19, the House of Representatives overwhelmingly passed the Comprehensive Retirement Security and Pension Reform Act of 1999 (H.R. 1102), introduced by Reps. Rob Portman (R­Ohio) and Ben Cardin (D­ Md.). A key provision of the proposed legislation is the repeal of the funding limit. Employers currently cannot deduct contributions to a defined benefit plan once the plan's assets exceed 150 percent of its liability. As a result, many corporations haven't made contributions to their pension plans in years (General Electric Co., for example, hasn't contributed to its pension plan since 1987). Under the current law, the funding limit will be raised to 170 percent by 2005.


The Portman-Cardin bill, in contrast, phases out the ceiling on deductible contributions more quickly and eliminates it entirely after December 31, 2003. If passed by the Senate (a vote was expected at the end of September), the bill would also raise the existing percentage of salary limitations on employee contributions to qualified savings plans (defined contribution plans, 401(k) plans, and individual retirement accounts), relax existing antidiscrimination and "top- heavy" protections, and provide some anticutback relief to employers under specific circumstances.


The bill's opponents, which include the Clinton Administration, say it primarily benefits higher-paid employees while relaxing the nondiscrimination rules designed to protect lower-wage workers. Some also fear that it includes language that could have the unintended consequence of giving employers greater leeway to cut benefits, such as early retirement subsidies. In addition, the bill is likely to cost the U.S. Treasury tens of billions of dollars in revenue losses. "There's a significant amount of support for the bill in the Senate," says David Certner, senior coordinator at the AARP. "The question is whether or not the problems with the Clinton Administration can be worked out."



WHO'S OVERFUNDED



The 10 most overfunded defined benefit pension plans

CompanyPlan assets as a % of the PBO**

% increase/(decrease) from operating income to adjusted operating income*

Sherwin-Williams291%(6%)
Bank of New York238%(3%)
Westvaco216%(28%)
GTE204%(13%)
Cincinnati Financial199%(1%)
FPL Group199%(10%)
Mellon Bank196%(0%)
Coastal 196%(11%)
Northern States Power194%(7%)
Consolidated Natural Gas184%(10%)

**Projected benefits obligation 
*The % increase (decrease) is calculated using adjusted
operating income that reflects pension adjustments only.

Sources: Company reports; FactSet Research Systems Inc.; Bear, Stearns & Co. estimates

WHERE PROFITS ARE COMING FROM

Pension income representing 10% or more of operating income in 1998.

CompanyPension income as a % of operating income ('97)

Pension income as a % of operating income ('98)

USX­ US Steel Group24% 40%
Unocal4% 38%
Northrop Grumman15% 28%
Westvaco14% 19%
Peoples Energy14% 18%
Allegheny Teledyne12% 17%
Lucent Technologies13% 15%
Armstrong World Industries11% 13%
Crown Cork & Sea10% 12%
Consolidated Natural Gas8% 11%

Sources: Company reports; FactSet Research Systems Inc.; Bear, Stearns & Co. estimates.

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