Executives at publicly owned companies with defined benefit pension plans would have no trouble identifying with an often-told joke among accountants and other initiates. A business executive wanted to determine a certain liability. He asked a couple of his advisers what the amount would be and received different but earnest estimates. But when he asked his accountant, the response was wonderfully accommodating: "What would you like it to be?"
Pension executives know retirement plan liabilities and expenses are in the eye of the beholders - the shareholders, the Financial Accounting Standards Board, the Pension Benefit Guaranty Corp., the Internal Revenue Service, as well as the executives themselves. As a result, the costs and liabilities reported in financial statements can vary widely from year to year and often bear little relation to a corporation's pension funding practices. The rules governing the amounts a corporation can charge as "pension expense" under Financial Accounting Statement 87 do not necessarily reflect the actual contributions a corporation makes to its defined benefit plan.
This separation makes it difficult at best and sometimes impossible for analysts and investors to get a true picture of these companies' financial positions. As for the PBGC, it is not particularly interested in the amounts a corporation shows as pension expense in its financial statements. It wants corporations to maximize pension contributions so risks to the PBGC's plan termination insurance are minimized. In sharp contrast, the IRS wants to maximize its tax revenue and is quite amenable to a corporation's funding practices as long as they do not maximize contributions.
How did this maze of contradictory postures come into being? In 1987, the accounting standards board adopted FAS 87, a rule intended to bring some consistency to the reporting of pension expenses by corporations. The idea was to create a level playing field for readers of financial statements, whether they be financial analysts or individual investors.
FAS 87 prescribes a formula for determining pension expense. It places no limitations on maximum amounts that can be contributed to pension plans. And it prescribes no formula for minimum contributions to fund a plan. As a result, the amount reported in a corporate financial statement as pension expense may - and often does - bear no relationship to the amount actually contributed to the plan.
Here's a hypothetical but typical example of how this works: Company X wants to make a contribution of $10 million to its pension plan this year to keep the plan fully funded. The actuary says OK, that's no problem. Then, when it's time to prepare year-end financial statements, the auditors ask how much the company wants to report as pension expense for the year. The company would like to show as much profit as possible, so it tells the actuary to calculate its pension expense by using a 10% rate of return in his calculations.
So the actuary makes his computations and tells the company, "Using a 10% rate of return, your pension expense will be $1 million."
This enables the company to show as pre-tax profit the difference between the $10 million actually contributed to the plan and the $1 million shown as pension expense. This discrepancy is accounted for by showing the $9 million difference as a pre-paid asset of the company. But this is all a hoax, of course. The $9 million in additional apparent profit was actually deposited in a trust fund and is an asset of the pension plan, not of the corporation.
Now let's go on to the next year. Well before year end it's obvious this will be a very good year, and for one reason or another management doesn't want profits to look too big. So the company says to its actuary, "We want to contribute $10 million to the pension plan again this year, but use 8% instead of 10% and see what that does to profits."
The lowered assumed rate of return means the company will have to charge against corporate earnings a greater pension expense than it did when the assumed rate for statement purposes was 10%. So the actuary comes back and says pension expense under an 8% rate will be $10 million.
By using the $10 million pension expense figure, the company instantly lowers its reported pre-tax earnings by that amount. But, in fact, the company has contributed just as much in the latest year as it did in the prior year.
See what we mean about misleading people who examine the company's financial statements?
Now let's rewrite the Company X scenario to show another typical situation. The actuary has been using a 7.5% rate of return on plan assets to calculate what the company must contribute to the plan. Many actuaries would consider 7.5% to be a realistic rate for a typical pension portfolio.
But Company X's situation looks much different to the PBGC. The PBGC's aim is to make sure pension plans become fully funded as soon as possible, so that a corporation's pension liabilities can't be dumped on the federal insurance agency if the corporation becomes bankrupt.
So the PBGC is ultraconservative in evaluating how well-funded a pension plan is. One of many factors the PBGC uses to determine the "sufficiency" of a plan's funding is the mortality table it requires a plan's actuary to use in figuring vested benefit liabilities for plan termination purposes.
Let's say Company X's actuary is using a 1971 group annuity mortality table to calculate plan liabilities. He's confident the plan is healthy and that his assumptions for the plan are all reasonable.
The PBGC looks at Company X and says, "You should be using the 1983 group annuity mortality table," which assumes lower death rates and, in effect, that retirees will live longer and receive more in benefits. The PBGC also says that, to measure "sufficiency," the actuary must use an assumed annual rate of return of (currently) 5%. In such a case, the PBGC requires companies to pay a risk premium of $9 per $1,000 of unfunded vested benefit liability. (The plan's actuary who uses the 1971 group annuity mortality table and 7.5% interest may have determined that all vested benefits are fully funded, whereas the PBGC's mandated assumptions may produce a multimillion-dollar unfunded vested benefit liability and thus a sizable risk premium.)
How would these requirements affect this company? To illustrate, we'll assume the company has been showing assets of $120 million and a vested benefit liability of $100 million. Under PBGC rules, it could suddenly find itself looking at a vested benefit liability of $175 million and an unfunded vested benefit liability of $55 million.
Using PBGC rules, the risk premium in this example would be $495,000 - enough to push some companies from the black into the red, and badly distort their true profitability and financial health. Company X also would suffer if it wanted to borrow money or sell debt, because it would have to disclose a $55 million unfunded liability.
Finally, let's turn to the IRS. Because its job is to collect the maximum it can from taxpayers, it looks at assumed interest rates from a point of view directly opposite that of the PBGC. It objects when a company uses a low assumed rate of return on its pension plan assets.
Let an actuary use an unrealistically high interest rate to minimize a company's pension contributions, and the IRS couldn't care less. But use 5% or thereabouts, and the IRS applies a tough rule that tests the reasonableness of interest rates. This rule was adopted because professional corporations often have used very low interest rates to calculate their pension contributions and tax deductions. Many of these plans were set up essentially for the benefit of the owners of these professional corporations, not for rank-and-file workers.
The IRS has brought legal actions against many of these professional corporations but, at last count, has been almost uniformly unsuccessful in disallowing the tax-deductibility of their pension contributions. Still, if the IRS breaks its past pattern and gets on a winning streak, corporations, both large and small, had better look out. Many undoubtedly will be presented with some huge tax bills.
Pension liabilities and expenses shouldn't differ to satisfy every reviewer or evaluator. The plan's liabilities reported in financial statements should be consistent with the liabilities determined by the plan's enrolled actuary for IRS purposes. The current system is unfair to those who have to make sense of corporate balance sheets, and public confidence will be undermined if nothing is done about these abuses and inconsistencies.
"What would you like it to be?" should be a question asked by bartenders when you're offered a drink on the house - not by those who would manipulate and meddle with pension plans.