WASHINGTON -- Just in time for annual report season, the SEC is reminding companies that it expects them to discuss upfront the extent to which pension fund earnings boost their bottom lines.
The Securities and Exchange Commission's directive comes as scores of large companies have retooled their traditional pension plans into cash balance plans, frequently cutting pension liabilities in the process. At the same time, the exuberant stock market has boosted pension fund assets, resulting in huge surpluses for hundreds of companies. Consequently, many companies are reporting higher earnings not because of higher profits from their operations, but because they are able to include pension surpluses in their income.
Current accounting rules permit this practice and don't require a discussion beyond a footnote in their financial reports. The SEC is putting companies on notice that it expects those with sizable pension income to discuss it in the text of annual financial reports, in the management's discussion and analysis of financial conditions and results of operations section.
In a Dec. 22 letter to the professional association the American Institute of Certified Public Accountants, SEC Chief Accountant Lynn E. Turner wrote: "If a company has made a change in its pension plan, or activity in the plan itself, such as gains or losses on investments, are reasonably likely to have a material impact on financial condition, liquidity, or results of operations of the company, then that information should be disclosed in the MD&A."
That section of the annual report, Mr. Turner's letter explained, focuses on "material events" that would cause the reported financial results to not necessarily predict the company's future operating results or financial condition.
Thus, the SEC wants companies to discuss if they have converted their plain vanilla pension plans to cash balance plans or altered their pension plans in any way that would result in lower pension liabilities or reduced contributions. Also, the SEC wants companies to discuss pension liabilities that have shrunk because of the booming stock market.
Although the SEC did not spell it out in its letter, companies should be prepared to discuss changes in pension assumptions that could result in higher pension earnings, said Jack Ciesielski, president of R.G. Associates Inc., a Baltimore-based investment research firm.
"This is not a paint-by-numbers exercise. They are not going to tell you everything, but logically that is something that ought to be mentioned," said Mr. Ciesielski, who also publishes the Analyst's Accounting Observer newsletter.
Keith Ambachtsheer, president of K.P.A. Advisory Services Ltd., a Toronto-based investment research and consulting firm, agrees.
By fiddling with their assumptions about how much they can expect to earn on their pension assets, or the interest rate they use to discount their liabilities, companies have a lot of room for using "good-looking numbers that are not going to create sustainable earnings and that should be pointed out to investors," he said.
Moreover, companies should be prepared to disclose if their pension income or expenses -- and therefore the bottom line -- were affected by a one-time event such as shutting down a pension plan, explained Peter Knutson, associate professor emeritus of accounting at the University of Pennsylvania's Wharton School, Philadelphia.
Meanwhile, the Association of Private Pension and Welfare Plans, a Washington trade group representing many of the nation's largest corporations, is preparing a paper on pension accounting issues, especially those dealing with the conversion of traditional pension plans to cash balance plans, said James M. Delaplane Jr., vice president of retirement policy.
The SEC's directive was not completely unexpected. Alarmed at the number of companies that have benefited hugely from their pension income in recent years, SEC officials had been looking at this issue for some time (Pensions & Investments, Oct. 4).
"Companies would be well advised to get a copy of the SEC letter in preparation for those reports," suggested Brian J. Lane, partner in the Washington law firm of Gibson, Dunn & Crutcher LLP, and, until recently, director of the SEC's division of corporation finance, which reviews corporate financial statements before companies can release them.
Upfront and coming
One company that has been forthright about its considerable pension income propping up its bottom line is the U.S. Steel Group of USX Corp., Pittsburgh.
The company, whose work force has dwindled to around 20,000, has a sizable pension fund supporting its nearly 100,000 retirees and, in essence, makes more from its pension fund than from selling steel.
The company logged a $373 million pension credit in 1998, up from $287 million in 1994, which enabled it to record a $201 million credit -- instead of reporting any selling, general and administrative expenses -- in fiscal 1998.
"It's the only company I know of that records a gain in its SGA (selling, general and administrative expenses) and not a cost," said James N. Kelleher, a securities analyst at Argus Research, New York.
Moreover, the company is frank in telling shareholders that its earnings could drop if its pension income falls.
"To the extent net pension credits decline in the future, income from operations would be adversely affected," the company stated in its discussion of financial results.
Michael R. Dixon, a company spokesman, said U.S. Steel, which is expected to report its 1999 earnings any day, intends to continue discussing its pension fund in its annual financial reports.
Lucent Technologies Inc., Murray Hill, N.J., also discussed its pension income at length in its 1999 annual report, issued in October.
Although the company's accounting practices have come under fire recently, it told shareholders in its annual report that its pension liabilities fell as a result of a change in the way it accounts for its pension and retiree health care costs. Moreover, the company said its pension income "is expected to continue in the near term."
Lucent's pension fund contributed 15% of its operating income in 1998, according to a September 1999 analysis by Pat McConnell of Bear Stearns Inc., New York.
Northrop Grumman Corp., which has reported steadily growing pension income in recent years -- $266 million in 1998, up from $39 million in 1996 -- and told investors that its pension income was due to the booming stock market, also plans to discuss the impact of its pension fund on its bottom line this year, according to Bob Bishop, a spokesman.
"Of course we plan to comply with a directive from the SEC," Mr. Bishop said.
The company merged its three pension plans last July and expected that would result in an improved after-tax cash flow in the second half of the year. The company expects to publish its annual financial statements at the end of March.
