Sunday, January 4, 2009

Flawed Accounting Hiding Pension Losses?


Before delving into today's topic, I wanted to mention that I updated the last section of my Outlook 2009. Please note that my stock recommendations are to be used as a guide. Do your own due diligence and ask yourself what risk your are comfortable with.

Importantly, I like to swing trade and I can sit on cash for a long time enter the market, make a gain or take a loss, holding a position for a couple of days or a couple of months. In other words, I am more nimble, but in the recommendations I made, I included companies that you can buy and hold in safer sectors like pharmaceuticals or consumer staples.

My buddy told me that I am nuts to recommend stocks because I am sticking my neck out. I replied that the whole point is to stick your neck out and if you are wrong, at least you had the guts to recommend something you thought was going to make money.

But remember what I told you, if debt deflation develops, you are better off forgetting about the stock market altogether and just buying good old government bonds.

There is no easy way to make money - if there was, we'd all be trading for a living. I am bullish on stocks for January right up to Obama's inauguration, but then again, who knows what will happen from now until then.

Today I am going to talk to you about flawed accounting methods which are hiding the true scale of pension fund losses:

Many of Britain's biggest companies are preparing year-end accounts that show their pension schemes moved into surplus last year despite the collapse in world markets, which wiped hundreds of billions from their assets.

The latest figures from the pensions advisers Aon Consulting show that a steep decline in the FTSE 100 over last year and a sharp drop in commercial property values has sent most final-salary schemes into crisis and pushed fund deficits to new lows. According to government figures, company pension fund deficits rose in the 12 months to November from £58bn to £155bn.

Aon Consulting warned that the figures underestimated the problem and pension funds had suffered a £226bn loss on their investments in the year to October.

However, accounting rules - which critics argue distort company pension scheme fund values - will show a rise in assets. For the top 200 companies in Britain, that will mean a £13bn surplus at the end of 2008. Aon says the top 100 firms have seen a £5bn improvement over the last year, based on current accounting rules.

Auditors must calculate deficits using the IAS19 accounting method, which assumes pension funds are invested entirely in corporate bonds and ties the value of the fund to current bond yields. Calculations under IAS19 put pension deficits at £2bn in December 2007. Figures from Aon show that a subsequent rise in bond yields turned that small deficit into a surplus of £3bn.

Marcus Hurd, of Aon, said when bond yields were low IAS19 exaggerated deficits, but now it was hiding them. In 2007, yields were 5.75% whereas last November they stood at 6.8%. He said that while a handful of schemes were heavily invested in corporate bonds, most had a mix of assets and tended to rely heavily on stockmarket investments. "They will be invested in stocks and shares, commercial property and bonds, which have all gone down in value, but the accounting rule says it is only the bond yield that counts."

In the battle over the future of company pension schemes, it is expected unions will use IAS19 to argue that employers must honour existing commitments because the accounting figures show schemes remain in a healthy state.

Union leaders have already fought several high-profile disputes over cuts in pension benefits and in most cases forced employers to backtrack. In May, workers at the Grangemouth oil refinery went on strike to keep its final-salary pension scheme open to existing members and new entrants.

Final-salary schemes typically promise to pay a retirement income worth two-thirds of a worker's last wage slip after 40 years of employment. About 80% of schemes in the UK are closed to new entrants. Unions fear employers are planning to close the remainder and may halt accruals for existing staff.

Hurd said employers and scheme trustees were well aware that the underlying assets in their funds had collapsed in value. In a report last month Aon said companies could be forced to pay up to £45bn a year for the next five years into their final-salary pension schemes to make up for the £226bn loss this year on their investments.

As you can see, pensions accounting is under fire and at the heart of a heated dispute between employers and unions in Britain.

But what about another accounting flaw that gets little or no mention in the press? I am, of course, talking about how pension funds value their illiquid investments.

Quick, how much is your house worth? Your neighbor sold his for a cool million dollars so you think yours is worth $1 million easy. Right?

Wrong! Your house is worth whatever someone is willing to buy it from you and in this market, it can be significantly less than what your neighbor sold his house for.

Now pension funds do value their illiquid holdings using a fair value methodology, but if you ask me, it tends to grossly exaggerate the true value of these illiquid holdings during a downturn.

That by the way, is another reason why pension funds were loading up on real estate, private equity, infrastructure - so they can "smooth" overall returns.

This is the running gag of the Public Markets guys who deal with mark-to-market rules for their investments, including illiquid stuff like ABCP, CDOs and CDS (albeit some are more conservative than others in marking down this toxic debt).

They only wish they can cook the books as easily as their Private Market counterparts using stale pricing methodologies that do not reflect the true value of their holdings.

Listen very carefully to how much money was made in private markets and ask yourself if these investments are being properly valued.

Sure, they will tell you that they were audited by some big and reputable accounting firm, but the methodology they are using grossly overestimates the economic value of these illiquid holdings.

Then again, private markets were a critical source of "bogus alpha" for most of these pension funds. If you take that away from them, what will they do? Will they find another source of bogus alpha to justify their bogus bonuses?

I don't think so. The end of the great pension con job is near. It's time that pension fund managers get back to work and earn their bonus the old fashion way.

***Update***

I received a message from a pension fund expert who wrote me the following:

Have been reading your Pension Pulse blog and enjoy it. I would note on your recent one on pension fund funding that while your main point is accurate I would caution you on the real estate valuation issue a bit (when compared to market).


Appraisals tend to lag on both the way up AND the way down and tend to smooth results – which isn’t altogether a bad thing for truly long term assets. Just because all you can get –right now- this second – this single moment in time – doesn’t define either value or appropriate pricing.


Here is a little example. While at XXXXX we bought ZZZZZZZ (a RE company). We only wanted half of the assets so decided to create a REIT with the rest (which trades on the market today). Essentially all the properties were the same and originally we decided to keep half of each and REIT the rest but our accountants couldn’t live with a live price and an appraised price for the same assets so ultimately we arbitrarily split the properties up.


Initially the properties in the REIT (or more precisely the price of the REIT) far exceeded the appraised price and it has now come down substantially- to approximately the appraised price of the other properties held outside the REIT and in fact may be a little lower right now.


Bottom line however is that none of the properties have ever been resold and both groups are providing the income expected. So who is really wrong? And more importantly which pricing model provides a better societal impact (which ultimately is the most important issue).


I would note - and you do speak of this – that the key is transparency. How are you pricing it? Why? Are incentives appropriately aligned? Are people aware of the potential perverse effects? How much out of line are they? These are often more pertinent questions.


I agree that appraisals tend to lag on the way up and down, but I suspect the lags on the way down are more pronounced. Also, keep in mind we have not experienced a meltdown in commercial real estate prices in a very long time. I am curious to see how pension funds will value their real estate holdings over the next few years and how they will benchmark this investment activity in a downturn.

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