could potentially be added to a company’s income. Suddenly, the $1 trillion that companies owed three generations of employees and retirees for pensions and retiree health benefits became potential earnings enhancements. Cuts generate gains, which lift earnings, which help the stock price, which boosts the compensation of the executives whose pay is based on performance. What CFO could resist that?
Not too many, and not for long. By the late 1990s, roughly four hundred large companies, most of which had well-funded or overfunded pension plans, had cut pension benefits, primarily by changing to a less generous cash- balance plan, which for many older workers was no different from freezing their pensions.
Pension managers faced a fresh conflict of interest: Should they manage the plans for the benefit of shareholders (and themselves) or for the benefit of retirees? Pension law requires that the plan be managed for the “exclusive benefit” of its participants. But on this point, pension law is like a toothless dog: It might sound scary, but it has no bite. Short of outright theft of pension assets, employers have been fairly free to make a lot of self- interested decisions when it comes to managing pensions.
Accounting professors at Cornell and the University of Colorado examined hundreds of companies that had converted their pensions to a cash-balance formula and found that the average incentive compensation for the chief executive officers jumped to about four times salary in the year of the pension cut, from about three times salary the year before. When companies didn’t change their pensions, CEO pay also didn’t change much. “You could have real economic wealth transfers away from employees,” concluded Julia D’Souza, a Cornell associate professor of accounting and lead author of the study.
Gains from benefits cuts were only one way the pension plans were lifting earnings. The investment returns in the plan were another. Under the old system, employers got only one benefit from the investment returns in the pension plan: If the investments did well, the company would have to contribute less to the plan to keep it well funded.
Under the new rules, employers got a second benefit: If investment returns on pension assets exceed the pension plans’ current costs, a company can report the excess as a credit on its income statement. Voila: higher earnings. The bigger the pool of assets, the greater the potential gains.
This gave employers an incentive to cut benefits, even when the plan had a surplus. By the end of the decade, ten of the twelve companies with the most pension income had cash-balance or similar benefits-reducing pension plans. In 1998, Bell Atlantic Corp.’s pension plan produced a $627 million pretax credit for the company, and GTE Corp. reaped a $473 million pretax credit. US West, Boeing, IBM, and Ameritech had pension income ranging from $100 million to $454 million.
The desire for pension income also encouraged employers to increase stock holdings in the pension plans, in an effort to generate more income. The percentage of pension assets invested in stocks rose from 47 percent of assets in 1990 to more than 60 percent since the mid-1990s. A peculiar result of the accounting rules was that, instead of earnings driving the stock price, the stock market was driving earnings. In 1998, more than $1 billion of GE’s pretax profit of $13.8 billion came from the pension plans. Caterpillar Inc. scored a $183 million credit. At Northrop Grumman Corp., 40 percent of first-quarter pretax profit was attributable to the surplus. USX–U.S. Steel Group would have reported a first-quarter loss except for its overfunded pensions.
In the euphoria of the bull market, few analysts noticed that a big chunk of company profits was coming from the pension plans. Patricia McConnell, a senior managing director at Bear Stearns, was one of the few who noticed the trend. Concerned that investors didn’t understand that pension income was the result of smoke and mirrors, not improved sales or some other tangible achievement, she conducted an eight-month study and found that pension income accounted for 3 percent of the operating income of the S&P 500 companies in 1999. At some, it made a big difference. Without pension income, the income at People’s Energy, Westvaco, U.S. Steel, and Boeing would have been 20 percent to 30 percent lower. Northrop Grumman’s income would have been 43 percent lower.
Pensions not only generated profits; they also became tools to manage earnings, thanks to the enormous control employers had over the size and timing of pension profits. Need to lift the stock price before a merger? About to miss earnings targets by a few cents per share? No worries: The pension plan could get you there. The new accounting rules gave a whole new meaning to the words “pension fund management.”
The mechanics aren’t that complicated. Pension managers make a number of assumptions when they estimate the size of their pension liability, such as how long employees will work, what their annual pay increases are likely to be, whether they’re married, and how long they’ll live. One of the most powerful assumptions used to determine the size of the pension obligation is the “discount rate.” A lower discount rate produces a higher liability, because if a company assumes that the assets in the pension plan will grow at a rate of 5 percent a year, it will need more money in the fund today than if it’s assumed to grow by 7 percent.
Pension managers can’t just pull any number out of a hat; they generally use a rate based on long-term, high-grade corporate bonds to calculate their benefits obligations. But companies have some wriggle room, and even seemingly small differences can have a big impact. In 2009, for instance, Lockheed decreased its discount rate from 6.4 to 6.1 percent, which boosted its pension obligation by $1.7 billion.
Another key assumption is the “expected rate of return” on pension assets. This isn’t the assumption used to measure the size of the liability; it’s the assumption used to measure the pension plan’s impact on quarterly income. Odd as it may sound to people who hear about it for the first time, accounting rules permit pension managers to use hypothetical or “expected” returns on their pension assets—instead of the actual returns. This is intended to smooth out the impact of the investment returns, so that a year of large increases or decreases doesn’t affect earnings dramatically. This “smoothing mechanism,” which employers insisted on having when the rules were developed, gives companies a great deal of control over the amount of pension income or expense.
Researchers at Harvard University and MIT analyzed filings from more than 2,000 companies and found that companies near critical earnings thresholds had boosted their estimated returns the prior year. One of the companies was IBM. As its operating performance was deteriorating in 2000 and 2001, in the wake of the tech bubble bust, the company raised its expected return from 9.25 percent to 10 percent. The increase in the assumed return accounted for nearly 5 percent of IBM’s pretax income in 2000 and 2001.
The researchers also found that firms used higher expected returns on pension assets prior to acquiring other firms. “Managers may want to raise reported earnings… both to boost the price of stock that might be used as currency in such transactions and to generate greater bargaining power in the bidding process,” they concluded. In addition, they found that firms raise their assumed returns when they issue equity and when their managers exercise stock options.
Using expected returns to boost income isn’t the only way companies can use pensions to manage earnings, but these other ways have received little or no scrutiny. For example, underestimating the return on the pension assets can also render a benefit. For much of the nineties, the average expected rate of return companies used was 9 percent, even though returns were usually in the double digits, and exceeded 30 percent in some years. When the assumed (i.e., “expected”) return is lower than what the pension assets actually return, the excess gains—the amount that exceeds the expected returns—are set aside. Over time, companies add some of these excess gains into future years’ earnings calculations, a process called amortizing. By 2000, there were billions of dollars in “actuarial gains” sitting in reserves. When pensions had huge losses in the early 2000s, companies used these gains to cushion and delay the impact on earnings. (The reverse is also true: If losses are greater than the expected returns, the excess losses are parked on the sidelines and get added to the income calculations in subsequent years.)
