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March 2003

Mar. 13, 2003

FASB To Look at Pensions
The Ticking Time Bomb Sees Set to Explode in 2004
posted by Rick Gagliano

News concerning the potential fallout from faulty, though legal, accounting for gains or losses in pension plan funds is finally making its way into the mainstream media,but most individual investors are still unaware of the distortions in earnings caused by the current accounting rules.

Now that the scandalous behavior of these companies is beginning to see the light of day, the Financial Accounting Standards Board (FASB) finally decided to add a project to its agenda that would seek to improve disclosures on pension plans. The Board expects to publish a draft on pension accounting in the latter half of 2003 with the goal of issuing an accounting standard in 2004, which seems to be - as usual with this toothless board - too little, too late.

Under current rules, publicly-traded companies are allowed to estimate returns on investment in these plans. During the go-go 90s, companies ratcheted up their estimates in line with the roaring stock market gains. But, in the first three years of the current decade, in which many stocks have fallen by 40-50% or more, most companies did not adjust their estimated downward.

The most probable outcome of this faulty accounting is a decline in the share price of companies' stock once the disparity is discovered. Firms which estimated gains but actually took losses have a dual-edged sword with which to deal. First, profits and earnings created by these estimated gains have to be reversed; second, the plans have to be refunded from current earnings. This double-whammy is going to slam some companies to the deck, reducing their true earnings over the past three years by 25% or more while putting a strain on current and projected earnings over the next few years.

For instance, suppose a company estimated gains of 7, 8 and 9% in 2000, 2001 and 2002 (not uncommon), when in fact the plan was losing 10, 10 and 12% (being kind here). That means their earnings would be taking a hit in each of those years, depending on how much the estimated earnings contributed to the bottom line. The percentages, turned into dollars, usually add up to billions for larger, well-established firms, so the downside could be severe. With plenty of companies struggling just to keep earning positive, the pension gains served as a buffer and booster over the past three years.

According to Credit Suisse First Boston Corp., had the S&P 500 companies included their actual pension plan losses in their 2001 earnings - instead of their fictional gains - their combined earnings would have been about 69% lower than what was actually reported, lowering the total to $68.7 billion in 2001, from the reported $219 billion.

What this means is that many of the S&P 500 companies' earnings are already grossly inflated, so when buying a stock which has a Price/Earnings Ratio of 23 (still pretty high), subtracting out the fictional gains from the pension plans and then subtracting some more because those plans suffered losses, pushes that p/e up into the stratosphere. Going forward, the plan has to be refunded, and that bites into future earnings. Truth is, some companies haven't grown for three years and aren't going to see earnings gains for maybe two or three more years.

This whole grab-bag of issues surrounding pension plans is going to blow up Wall Street in ways which people barely understand at this point in time. When the truth comes out, it's going to make the Enron and Worldcom scandals look like the antics of 4th graders hopped up on Hershey bars.

Companies guilty of the practice of estimating pension plan gains runs the gamut from financials to manufacturers to services. Looking for the worst offenders, start with the 30 companies which comprise the Dow Jones Industrials. Alcoa, IBM, GE, JP Morgan, 3M, Johnson and Johnson, Eastman Kodak, Du Pont, et. al., all have enormous pension plans and most of them - probably all of them - overestimated returns from 2000-2002. One can likely assume that these companies will also only revise their estimates slightly for 2003, awaiting the new rules from the FASB.

What this is going to do to the market is potentially devastating. Take, for instance, the Dow Jones Industrial Average, whose component companies carry an average price/earnings ratio of about 21, at current prices. Investors considering a possible investment in any of these companies might be well advised to simply double the p/e, based on the potential that these companies may have to restate earnings two or three years back and will be pressured to make estimates going forward.

The problem doesn't stop there, however, it has a cyclical effect and feeds upon itself. As more and more companies 'fess up, stocks will trade lower and lower, and the pension funds, heavily invested in stocks, will further deteriorate. Some companies will default on their plans, some will lower their payouts to retirees, others will simply go belly up completely due to the enormous amount of underfunding and the pressure to pay into the plans becomes simply unbearable.

When this begins to happen, the stock markets will go into a tailspin of unprecedented proportions as huge, supposedly stable companies variously restate earnings, cut benefits and declare bankruptcy.

By now, you're probably thinking that this is a doom and gloom scenario and that I'm being alarmist, but I assure you that this problem is real, it is looming and it will be devastating. Forewarned, as they say, is forearmed.

Avoid companies which have pension plans, especially those which are not crystal clear in their reporting (most of the largest companies). If you must invest in stocks, small caps at least offer some degree of safety by being out of the pension plan boondoggle.

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