Stuffing money into a pension plan is another way companies manage the timing and size of an income boost. When Lockheed Martin contributed $2 billion to its pension in 2010, the 8 percent expected return on assets guaranteed the aerospace-and-defense giant a $160 million boost to the bottom line in 2011, regardless of whether the company made any money selling jets. And because pension contributions are deductible, Lockheed was able to shave $64 million from its taxes.
The accounting and tax breaks explain why companies with well-funded pension plans happily shovel money into them. Why let a billion dollars in cash sit around unproductively when parking it in the pension can be so rewarding? Being able to park money in pension plans has so many rewards that employer groups have perennially lobbied to be allowed to put as much as they’d like into the plans. (Current law doesn’t let companies deduct contributions to pension plans once the level of assets reaches 150 percent of the plans’ liabilities.)
Companies also have a variety of reasons to adjust their assumptions to make their pension appear less well funded, or even terminally ill. This might be helpful prior to union negotiations or layoffs.
Mergers and acquisitions can offer companies an opportunity to monkey with the numbers. Prior to putting itself up for sale, a company may want to cut benefits or take other actions to make itself look more profitable.
Or perhaps it might want to sell some of the surplus. This was a common enough scenario that it was the topic of a panel at an annual actuaries conference in Colorado Springs in the summer of 1996. The panelists put on a skit involving a company that has asked its actuary to help increase the liability for the pensions of the transferred employees and retirees, so the company can justify transferring more assets than necessary and get cash in return, built into the sales price. The actuary does this, but is later called before a standards board and asked to justify the assumptions he used.
The “prosecutor,” played by the chief actuary at the American Academy of Actuaries, asks the actuary to defend his decision to use a 1951 mortality table to calculate the liability.
PROSECUTOR: Didn’t you choose these assumptions… so you could transfer as much money as possible to the buyer?
BAD ACTUARY: No, these are miners, so their life expectancy is not nearly as great as that of the general population.
PROSECUTOR: How much did you get for them in the purchase price? Is it 80 percent or 90 percent?
BAD ACTUARY: Well, it turned out that way in this transaction.
But he defends his actions saying he was just doing what his client wanted.
The skit concludes with the “prosecutor” telling the “bad actuary” that he’s done a good job. “Someday the PBGC is going to… make an example of somebody. So when you get involved in these areas, make sure you’re ready to answer all those questions. Have your answers ready.”
None of this was illegal, but it shows how routine these sales transactions were.
ACCRUAL WORLD
The pension income charade began to change after the market tanked in 2001. When the market was rising in the nineties, few analysts noticed that falling pension obligations and 30 percent investment returns were fluffing up profits, and companies didn’t go out of their way to call attention to it, preferring instead to let investors give company executives all the credit.
But when pension plans began losing money from 2000 through 2002, in part because managers had loaded them up with stock to boost pension income, companies quickly blamed the pension plans for their financial woes. Securities analysts who had been oblivious when pensions were pumping up income began cranking out reports dissecting the many ways pension plans were hurting earnings. These newly minted pension critics didn’t notice that companies could manage earnings by adjusting discount rates, dumping money into the plans, or cutting benefits. But they did notice that companies were using expected returns of between 8 percent and 10 percent. In 2002, for example, GM assumed a 10 percent return, even though assets actually lost 5.2 percent. Companies had been using the same 8 to 10 percent assumptions for years, including those when assets were earning 30 percent, but analysts acted as if they’d discovered the next Enron, and they cranked out even more reports. Even Warren Buffett, chairman of Berkshire Hathaway, weighed in, scolding companies for “legal but improper accounting methods used by chief executives to inflate reported earnings. The most flagrant deceptions have occurred in stockoption accounting and in assumptions about pension-fund returns. The aggregate misrepresentation in these two areas dwarfs the lies of Enron and WorldCom.”
The market plunge had smoked out accounting innovations at Enron, Lucent, Nortel, Tyco, Waste Management, and WorldCom, most of which involved management efforts to bump up the share price by manipulating earnings. Many of these practices involved “accrual accounting,” i.e., the way companies report such things as debts and reserves. Retiree benefits are a form of accrual accounting, too, subject to the same manipulation but not to the same scrutiny.[9]
Chapter 4
HEALTH SCARE
COMPANIES HAVE BEEN PLAYING even more elaborate games with their retiree health plans. These health plans are essentially medical pensions that employers have promised to decades of workers. If someone worked long enough to earn retiree health benefits, then, when he retired at fifty-five or later, his employer’s medical plan would continue to cover him until he qualified for Medicare at age sixty-five. Some plans, particularly for unions, provided a Medicare supplement, covering things like prescription drugs.
And then, in 1992, companies began sending letters to hundreds of thousands of retirees, all of which contained eerily similar messages: “Health care costs continue to skyrocket,” wrote McDonnell Douglas. Health care costs were “skyrocketing,” wrote R.R. Donnelley. In these letters, Sears, Caterpillar, Unisys, and scores of other employers, citing “spiraling” health care costs, all informed retirees that, regretfully, they had no choice but to cut benefits.
The companies blamed a new accounting rule—FAS 106—for the changes. The rule was similar to the one employers had adopted with pensions a few years earlier in that it required companies to estimate their obligations for the health coverage they would provide to retirees—current and future—and report the obligation to shareholders. When the companies did this, they claimed to be shocked to find that the costs were so high. This, they said, called for hard choices, and regretfully, they would have to cut benefits. It was a matter of survival.
Though corporate America acted as though it had just discovered it was sitting on a neutron bomb, CFOs knew well ahead of time what the charges would be. Major companies, including IBM and GE, had worked with the Financial Accounting Standards Board (FASB) to create the rules, as they had with the pension rules, and had persuaded the accounting board to build in as much flexibility as possible. As with pensions, companies had substantial leeway to raise or lower their obligations by changing the assumptions they used, including interest rates, expected returns on assets, employee turnover, marriage rates, retirement age, and mortality rates. But companies had another powerful lever for manipulating the numbers: the health care inflation assumption (also known as a “health care trend rate”). Despite its name, this isn’t an actual measure of inflation in the cost of hospital stays, premiums, or prescription drugs. Rather, it’s simply a company’s estimate of the increase in what it might pay, based on undisclosed factors. In other words, they can pretty much make it up.
