WASHINGTON -- Three new studies suggest pension funds might have morphed into profit centers from cost centers at many of the nation's largest companies.
Early results of a study by two Federal Reserve Board economists indicate that savvy stock market investments by big corporate pension funds helped fuel the S&P 500 during the last half of the 1990s. Their data show that investment gains above what pension funds had expected contributed to a sizable five percentage points in the 29% pretax profit growth of the Standard & Poor's 500 stock index between 1995 and 1998.
Without the surplus pension investment gains, pretax profits for the S&P 500 would have grown 24% during that period, said Julia Coronado, a Fed economist who, along with Steven A. Sharpe, is conducting the study.
The surplus pension earnings helped lift pretax profits for the 500 companies in the benchmark by approximately $20 billion in 1998, to $499 billion, from $387 billion in 1995, Ms. Coronado noted.
Ms. Coronado and Mr. Sharpe are studying pension income of the S&P 500 companies for the five-year period ended Dec. 31, 1999. (The preliminary results reflect the period ended 1998; statistics from 1999 are still being analyzed.)
Income exceeds expense
At the same time, a new study by Towers Perrin, the Valhalla, N.Y.-based employee benefits consulting firm, shows that companies in the Dow Jones industrial average reported an aggregate of $1.4 billion in pension income in 1999, a far cry from the $1 billion in pension expense they had reported a year earlier and the $2.6 billion in pension expense they had reported in 1997.
Of the 25 companies in the DJIA that sponsor defined benefit pension plans, 11 recorded pension income last year. Their total pension income exceeded the pension expense of the 14 other companies in the index that reported pension expense.
In 1998, only nine of the nation's bluest chip companies reported pension income, even though 28 of the 30 companies in the index at the time sponsored defined benefit plans.
Moreover, a recent study by Watson Wyatt Worldwide, the Bethesda, Md.-based consulting firm, noted that nearly one-third of 500 companies studied reported pension income in 1998, up from about one-fourth in 1992.
The Watson Wyatt study suggests as many as 40% of the companies studied might report pension income today.
At some companies, pension income exceeds 10% of total corporate income, that study notes, adding that pension income could be a fixture in many financial statements for years to come.
Accounting rules permit companies to include pension income as part of their overall profits, even though they cannot easily siphon surplus pension assets to pay for other business expenses.
And because those rules also permit companies to spread out their pension income -- or liabilities -- over many years in order to minimize earnings volatility, corporations could maintain profits through their pension funds even if the stock market stumbles.
An odd label
A "profit center" might be an odd label for a pension fund, but that is what it has become, agreed Adam J. Reese, a consulting actuary in the Arlington, Va., office of Towers Perrin, who analyzed pension expenses at the DJIA companies.
"It is no longer a business expense. It is contributing to the earnings of the corporation."
So, what's happening here?
Very simply, corporate pension funds have hit the jackpot in the stock market. As a result, pension assets far exceed what companies need to pay for promised benefits.
Companies also benefited last year from the bump up in interest rates, which had the effect of lowering pension liabilities.
The combined pension surplus (or the amount by which pension assets exceed pension liabilities) surged to more than $100 billion for the DJIA companies last year, up from $24 billion a year earlier.
The increase in companies now reporting pension income has set off a chain reaction, boosting corporate profits and in turn driving up stock prices.
"There is the potential for self-feeding effects from the stock market to profits back to the stock market," said Mr. Sharpe, a senior economist at the Fed.
The Fed study found that while companies generally had assumed investment returns of between 8% and 10% on their pension fund assets in the late 1990s, they earned as much as twice that, Ms. Coronado said.
Indeed, the Towers Perrin study shows the DJIA companies combined produced a whopping $75 billion return on their pension assets in 1999, with a median return of 18.6%, or twice what was expected.
The three main components of a company's pension cost are the service cost, or the cost of benefits earned by workers during the current year; the interest expense on the deferred benefits; and the return on pension fund investments.
At the DJIA companies, the expected return on pension fund investments of $34 billion last year alone was more than enough to offset the interest cost of $23.7 billion and service cost of $8.2 billion.
$83 billion unrecognized gain
The fact that many pension funds earned well above what they had hoped to earn is money in the bank for their corporate sponsors. At the DJIA companies, the excess earnings, along with what companies had accumulated in earlier years, amounted to a total of $83 billion in unrecognized gains at the end of 1999.
Consequently, pension funds might continue to contribute to the bottom lines of their corporate parents for years to come.
"Many of these companies have surplus assets in such a strong position that even if the market performed just close to or below the expected return on assets assumption, they are still likely to have pension income," Mr. Reese said.
At the end of 1999, the DJIA companies had combined pension assets of $459.7 billion, up 11.5% from the $412 billion they had a year earlier. This means that total pension plan assets of the DJIA companies alone current ly equal nearly three-quarters of Canada's gross domestic product, and the average value of the pension plan assets held by the 25 companies has reached $18 bilion, the Towers Perrin study noted.
The implications of pension funds' becoming profit centers instead of cost centers are huge.
For one thing, it allows many companies to deploy elsewhere the assets that would have been contributed to the pension fund. Many companies, for example, have boosted other retirement benefits for their employees through higher matching contributions to 401(k) plans and through stock option programs.
Other companies might choose simply to give workers bigger pensions. Last year, the DJIA companies as a group amended their pension plans to dish out an extra $8 billion in future benefits.
Meanwhile, the economists conducting the Fed study worry the stock market might be ignoring the fact that some of the earnings companies have been reporting in the last several years have come from their pension funds and are unsustainable, unlike earnings from their operations.
Some securities analysts have questioned whether companies should be allowed to include pension income in their bottom lines. Last December, the Securities and Exchange Commission asked companies to prominently report their pension income to investors in the text of their annual financial statements, and not just in footnotes.
"We are aware that pension plans have been a source of growth of (corporate) earnings in the last few years, and there is an intent to see if the market is naively applying the same kind of multiple to this component of earnings that it applies to the rest of the firm," Mr. Sharpe said.
The concern is that if the stock market tanks, pension income would plummet too -- which could put pressure on corporate earnings if a large share is from pension income.
The Federal Reserve's study is looking at how much of companies' pension income is attributable to returns above and beyond what they had expected to earn. The Fed also is looking at the extent to which companies attempt to manage their earnings by using favorable assumptions in valuing their pension fund liabilities.
What's more, the Fed is examining the extent to which companies have been able to cut their pension liabilities and boost their pension income by retooling their traditional pension plans into cash balance or other hybrid plans. The Fed economists are looking at a swath of 10% or more of the S&P 500 companies that converted to cash balance plans, Ms. Coronado said.
Finally, the Fed is hoping to figure out how many companies have used assets from overfunded pension plans to pay for the costs of downsizing and restructuring their companies.