Some pension experts are beginning to urge plan sponsors to lower their pension funds' return assumptions.
They suggest dropping the assumptions to as low as 6%, down more than three percentage points from the 9.17% large companies assumed, on average, last year, according to Watson Wyatt Worldwide.
Several big corporations used return assumptions of 10% or higher: PPG Industries Inc., 10.9%; Atlantic Richfield Co., now part of BP Amoco, 10.5%; and American General Corp., 10.35%.
Many large companies have been counting on pension assets to prop up their bottom lines, but if the returns don't materialize, those bottom lines could sag, and their stock prices could sink if disappointed investors bail out.
Plus, the companies themselves might need to rework their calculations of surplus pension assets, and be forced to make unanticipated contributions to their pension funds.
The culprit is the stock market.
"I'm finding that more of the sophisticated pension funds understand that equity returns going forward are not going to be as high as historical" returns, said Michael Peskin, an actuary and the head of asset-liability analysis at Morgan Stanley Dean Witter & Co., New York.
"No matter how you push and pull the numbers, you can't get a real return as high as the returns assumed by actuaries," warned Robert D. Arnott, president and chief executive officer of First Quadrant LP, a Pasadena, Calif.-based money manager.
Typically, the return assumptions are at least one or two percentage points too high, Mr. Arnott said.
Keith Ambachtsheer, president of K.P.A. Advisory Services Ltd., a Toronto-based pension research and consulting firm, said a diversified equity portfolio can be expected to return only 5% a year these days.
Mr. Ambachtsheer assumes a 1.5% dividend yield, 3% inflation-adjusted growth in earnings and a 0.5% contribution from stock buybacks. Assuming inflation to be around 3%, companies can realistically expect to earn no more than 8% on their pension assets over the long haul, he said.
Accounting rules require companies to start with the interest rate on long-term government bonds when they set pension assumptions, and then overlay the returns they expect from equities, in proportion to their allocation.
Assuming a 6% interest rate on Treasury securities and a 6% equity premium, a company with 50% of its pension fund assets in stocks should assume no more than a 9% return, said Jeremy Gold, a New York-based consulting actuary.
But in fairness to future generations of investors, Mr. Gold would assume only the return from risk-free securities, or about 6%.
"I do not think it is good finance to anticipate risky returns in advance of the risk being taken. To do so is to provide greater income to present shareholders, and leave future shareholders with the risk," he said.
But the problem is that many companies are arriving at their assumptions by looking at the 15%, 20% or 25% returns they earned on their pension assets in the past five years, instead of looking ahead.
"Companies that are using a 10.5% or 11% assumption are booking profits that are arguably not going to be there," Mr. Ambachtsheer said.
Companies "are not using too high a rate by everything I can see. If they never earned more than 5% or 6%, you'd say a 9% or 10% (assumption) would be hokey," said Jack Ciesielski, president of R.G. Associates Inc., a Baltimore-based investment research firm.
Bill Miner, the retirement practice leader in the Chicago office of Watson Wyatt, concurred: "For the past four or five years you have had returns in excess of 20% and you don't see 20% return assumptions out there. I don't believe the assumptions are unduly recognizing the bull market."
To be sure, even if the stock market tanks and investment earnings on pension assets plummet, it could still be a few years before the impact shows up on a company's bottom line. In fact, it was precisely because of the fear of the volatility in pension expense or earnings that accounting rules let companies assume a long-term rate of expected return, rather than using actual returns on their pension assets.
Moreover, many companies protect their bottom lines by applying the return assumption not on the actual market value of their pension assets, but on to a portion of the assets, usually about 85%, giving themselves a 15% cushion, so a drop in the stock market would not show up in a company's bottom line overnight.
"Smoothing is the prevalent practice," said Adam J. Reese, a consulting actuary in the Arlington, Va., office of Towers Perrin.
PPG computes its expected long-term return on pension assets by examining historical returns and anticipated future changes in the pension fund's investment portfolio.
"The weighted average long-term rate of 10.9% at the end of the year was justified on that basis," said a company spokesman. PPG's pension fund has earned in excess of 11% on its pension fund assets during the latest one-, six-and 10-year periods, he noted.
American General raised its assumption a notch last year to 10.35% from 10.25% the previous year. But that reflects its pension fund's slightly higher target allocation to equities -- to 75% of total assets from 71%, said Nicholas R. Rasmussen, chief financial officer.
Pension assets matching its liabilities are split between equities and fixed income while surplus pension assets are invested solely in equities, he said.
The company continues to be bullish about the prospects for stocks. "We made the decision that they are not going to be lower. It's as simple as that," Mr. Rasmussen said.