WASHINGTON - Verizon Communications Inc.'s pension fund lost $3.1 billion in 2001, but reported $1.85 billion in pension income that boosted the company's pre-tax operating profit to $2.77 billion.
Verizon's trick? An accounting rule lets companies take their assumed rate of returns on their pension assets into account in calculating the fund's financial impact on its bottom line. Then, the company used this inflated net income as the basis for calculating incentive pay for top management.
Verizon wasn't the only blue-chip company to pull this off. But the jig may be up for Verizon, as well as for Qwest Communications International, International Business Machines Corp. and General Electric Co. This quartet of big companies is facing the ire of angry employee and retiree shareholders demanding an end to this practice.
Angry employee and retiree shareholders have filed proposals at these companies demanding they stop including pension income in bottom-line calculations for determining "performance" pay for top management.
McDermott International Inc., which faced a similar shareholder proposal this year, already has agreed to exclude pension income from the computations for top management's incentive pay.
In their battle, the disgruntled shareholders have the support of most investment analysts and pension actuaries who maintain that Financial Accounting Standard 87, the accounting rule that governs pensions, is flawed, and companies should not be allowed to include earnings on pension assets in operating income.
"In principle, the resolutions that the stockholders are making is correct. Earnings upon which executive compensation is based should be operating earnings, absent (pension income)," said Douglas A. Love, chief investment officer and treasurer at Investors Guaranty Fund Ltd., Hamilton, Bermuda. Executives, Mr. Love said, should be rewarded for managing companies, not managing pension assets.
Jeremy Gold, an independent New York-based actuary, concurs. "It is not in the shareholders' interest to pay management to generate pension earnings," he said.
Retiree shareholders, in particular, are incensed that top executives at these companies have been collecting hundreds of millions in bonuses and incentive pay based on the fattened pension surpluses and distorted earnings, instead of using a portion of the surplus pension assets to give cost-of-living increases to beneficiaries.
Some also are concerned that the companies are using pension income to disguise that income from underlying operations has dropped, and the stocks are flailing.
Plus, the collapse of Enron Corp. has focused investors' attention on accounting shenanigans, and drawn the scrutiny of investment analysts who pitch these companies to investors.
Many companies can expect dwindling pension surpluses in coming years, thanks to the downdraft in the stock market and lower interest rates, and face the very real possibility of the pension income morphing into a pension cost - which then could penalize executives' pay.
"If they have a pension expense, are they going to include it in the computations of net income on which executive pay is based? Of course not," said Nelson Philips, president of the Denver-based Association of US WEST Retirees, which is presenting the proposal at Qwest's June 4 annual shareholder meeting. (US WEST merged with Qwest on June 30, 2000, and took the Qwest name.)
Paul R. Edwards, chairman of the Springfield, Mass., Coalition for Retirement Security, calls the inclusion of pension income for calculating executives' performance pay an "obscene" practice.
The shareholders' campaign at Verizon also has spurred Institutional Shareholder Services, an influential Bethesda, Md., firm that advises some of the nation's largest public and corporate pension funds on proxy voting, to recommend a vote for the proposal by a member of the Association of BellTel Retirees seeking to exclude pension income from executive pay determinations.
"Since the company would have reported a significant and material net loss for fiscal 2001 had it not included over $1.8 billion in pension income in its calculation of net income, and since earnings per share is one of the factors used by the company to determine the at-risk portion of executive pay, we believe this proposal warrants shareholder support," the ISS analysis stated.
ISS recommended shareholders vote against the proposals last year when they first appeared on the ballots at Verizon and Qwest. In 2001, the proposal received around 19% of votes at Verizon and 16% at Qwest, where insiders control more than 20% of the outstanding shares.
The Council of Institutional Investors, the powerful Washington-based activist shareholder group, does not have a policy on the issue, according to Ann Yerger, director of research service.
In its rebuttal of the shareholders' proposal, Verizon noted that in order to determine incentive executive pay, the company compares actual performance, including financial results, to the corresponding targets. The pension fund lost $3.1 billion in 2001 instead of earning the $4.8 billion it had anticipated earning, based on a 9.25% assumed rate of return. Still, said Mark Menchin, managing director of risk management at Verizon Investment Management Corp., which manages the pension fund, the incentive pay to executives was justified because the pension fund outperformed its benchmarks by one to two percentage points.
Shareholders last year failed to get a similar proposal on the ballot at IBM after the company successfully convinced the SEC that the proposal was a matter of "ordinary business" that could be excluded from the proxy. Big Blue reported surplus pension assets of $956 million, and pension income of $1 billion in 2001, on pre-tax income of $10.95 billion, or just under 10% of its earnings. Assuming a 10% return, the computer company had anticipated earning $4.2 billion on its pension assets, but in fact, lost $2.4 billion in 2001.
(The proposal was sponsored by Donald S. Parry, a member of the IBM Employee Benefits Action Coalition. It was rewritten this year as a more obvious executive compensation proposal. The SEC has said executive compensation is a policy issue that doesn't fall under the rubric of ordinary business.)
Carol Makovich, a company spokeswoman, declined to comment on the shareholder proposal, other than to refer to the company's rebuttal in the proxy. Contrary to the shareholders' contention, "IBM does not manipulate its pension plan to create profits for the company or to enrich its executives," according to the company's statement asking shareholders to vote against the proposal.
At Qwest, the company's pension income of $360 million actually helped reduce the company's pre-tax loss to $3.95 billion. The pension fund lost $851 million on its investments, instead of the expected gain of $1.1 billion, based on a 9.4% assumed rate of return. In its recommendation to investors to vote against the shareholder proposal, Qwest noted "we believe that our assumptions on investment returns are realistic, and are consistent with those utilized by other large communication companies and S&P 500 companies."
At General Electric, the shareholder proposal is being offered by the Communications Workers of America Pension Fund, which owns 91,000 shares. The conglomerate's pension fund had a surplus of $14.6 billion at the end of 2001, and reported pension income of $2.1 billion that was included in the company's bottom line. Its assumed rate of return was $4.3 billion, assuming a 9.5% return, but in fact lost $2.9 billion last year.
While it agrees with the proposal that pension income should not be used to boost executive pay, ISS recommended shareholders vote against this proposal, noting the pension income contributed only 11.43% of pre-tax earnings, slightly less than the average 12% contribution to S&P companies.