Tuesday, November 30, 2010

Pension Accounting Change to Hit Profits?

Bob Tita of the Dow Jones Newswire reports in the WSJ, Pension Accounting Change Could Make Company Profits Less Predictable:

Efforts to make pension accounting more transparent could cause corporate profits to become more volatile if gains and losses from pension assets are mingled with results from companies' business operations.

The agency for international accounting standards is expected to take up a proposal next year that would require companies with defined-benefit pensions to report annual changes in the value of their pension assets as part in their income statements. Under current procedures, returns on pension investments and gains and losses in pension-plan assets are accounted for in small increments over several years to keep them from skewing companies' earnings.

The change would provide a more immediate snapshot of companies' pension-plan performance. But U.S. companies, aside from Honeywell International Inc. (HON), have so far been reluctant to voluntarily change their pension accounting. Observers warn that investors could be subjected to bouncier stock prices if earnings become significantly less reliable with the addition of unpredictable gains and losses from pensions.

"If we've learned nothing else over the last three years, it's that the market isn't always rational," said Alan Glickstein, senior consultant for Towers Watson, an employee benefits consultancy. "It's not necessarily a good thing if [the accounting change] just increases earnings volatility."

If the International Accounting Standards Board--the nongovernmental agency for accounting rules used by companies outside the U.S.--adopts the change for pension accounting, observers predict the Financial Accounting Standards Board will follow suit for the sake of consistency and amend the Generally Accepted Accounting Principles used by U.S. companies.

"To the degree that a company wants to make sure that their financials are reflective of their operations, it would make sense to go through a change like this. It would add transparency to the numbers," said Daniel Holland, an analyst for research firm Morningstar Inc.

More than 340 companies in the Standard & Poor's 500 Index have defined-benefit pensions that guarantee employees pension incomes when they retire. To meet these obligations, the companies have set aside a combined $1.22 trillion that is invested in stocks, bonds and other types of investments.

Smoothing out annual gains and losses from defined-benefit pensions has come under increasing scrutiny as regulators dismantle other accounting practices used for decades to wall off pension costs and liabilities from companies' balance sheets and their profit statements.

"The pension volatility has always been there. It's just not measured today. The accounting doesn't require that it be highlighted," said David Larsen, managing director for corporate finance consulting at Duff & Phelps Corp., a financial services and investment banking advisory firm.

Honeywell is the largest U.S. company to begin using market-to-market accounting for its pension. The move is intended to put the brakes on escalating costs for Honeywell's pension. Falling interest rates on bonds used to determine companies' future pension obligations have driven up annual pension costs for all companies with defined-benefit plans. But Honeywell's expenses have been exacerbated by a decision it made in the late 1990s to use a six-year schedule for amortizing pension gains and losses on pension assets and a three-year schedule for smoothing out returns from pension investments. Most companies amortize gains and losses over 10 years or 12 years and account for investment returns over five years.

Honeywell's shorter time frame helped the company lower its pension expenses when asset values soared. But when pension-fund performance tanked in 2008, Honeywell's pension headwinds were magnified in its earnings.

Without the option of switching back to a longer amortization schedule, Honeywell will stop deferring gains and losses. The aerospace and building-systems manufacturer will recognize $5.5 billion in prior asset losses in its 2010 income statement. Going forward, Honeywell will report gains and losses in their entirety during the year they occur.

The change will increase the company's pension costs for this year to $1.61 billion, compared with $791 million under the six-year schedule. But its pension expenses are expected to plunge to $200 million in 2011.

"It takes all that old stuff and puts it behind them," said Howard Silverblatt, an analyst with Standard & Poor's investment services unit.

Once the slate is wiped clean, Honeywell aims to limit its pension expenses to about $200 million a year. Moreover, the company will attempt hold down pension-related volatility in its earnings by making pension asset values and returns more predictable than in the past.

"I can see investors having this fear that every fourth quarter there's going to be this wild swing," Chairman and Chief Executive David Cote said during a Nov. 16 conference call with analysts. "More likely than not, that is not going to happen."

In the coming years, Honeywell plans to shift more of its pension funds from equities to fixed-income investments. That will lower annual returns to 6.5% from 9%, but will lessen Honeywell's exposure to sudden swings in stock values and returns that would contribute to earnings volatility.

If mark-to-market pension accounting becomes the standard, other companies will likely change their investment mix as well, creating a profound shift in the allocation of pension funds the next decade.

"I would expect it to take a while, but pension assets would shift to less volatile securities," Morningstar's Holland said.

Is there a "profound" shift in asset allocation going on? I'm not convinced. If corporate plans adopt mark-to-market pension accounting rules, they will reduce pension costs and likely shift assets into less volatile securities, winding up their existing defined-benefit plans while scrapping them for new employees (moving them into defined-contribution plans).

But I've already discussed that while private pension plans are reducing risk, most public plans are increasing risk, continuing to invest the bulk of their assets in equities and alternatives. Public plans are much larger and shifts in their asset mix carry a lot more weight. In other words, we can speculate all we want, but it remains to be seen whether a "profound" shift in asset mix will take place over the next decade, even among corporate plans.

Of course, if Charles Nenner is right (see Yahoo Tech Ticker interview below), and a Japan-style slump hits the US economy, then corporate plans adopting Honeywell's approach might come out ahead. I don't agree with Mr. Nenner (correlation does not imply causation!!!), but if he's right, bonds will continue to outperform over the next decade.

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