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August 19, 2002 01:00 AM

ROSY ASSUMPTIONS: Beware of `pension time bomb,' Connell tells funds

CalPERS and CalSTRS urged against investing in firms that pad bottom line

Joel Chernoff
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    SACRAMENTO, Calif. - California State Controller Kathleen Connell is urging CalPERS and CalSTRS to stop investing in companies that pad their bottom line by using overly optimistic pension fund return assumptions.

    With some U.S. companies using rate of return assumptions north of 10%, Ms. Connell warned of "a pension time bomb," terming the use of inflated pension fund return assumptions as "accounting gimmickry that has to end."

    The U.S. Securities and Exchange Commission should establish guidelines for what is a reasonable rate of return, the Democratic controller said. She added pension surpluses should not contribute to the corporate bottom line and earnings, as they now do under Financial Accounting Standard 87.

    "The last thing we need are any more surprises on the corporate landscape," she added, referring to accounting scandals at Global Crossing Ltd., Enron Corp. and WorldCom Inc.

    If a company uses unrealistic assumptions and then later gets into financial trouble, the effect will be to lower earnings and hurt its share price, thus hurting investors. She said she would like to see the $140 billion California Public Employees' Retirement System and the $97 billion California State Teachers' Retirement System, both in Sacramento, get "ahead of the pack" by tackling the issue.

    Standing fast

    Top corporate executives are sticking with pension fund return assumptions. In recent certifications of their financial statements to the SEC, chief executives and chief financial officers of the companies with the top five highest return assumptions for the pension funds certified to their accuracy. Those companies are: Weyerhaeuser Co., projecting an 11% return; FedEx Corp., 10.9%; Northwest Airlines Inc., 10.5%; and First Energy Corp. and Eli Lilly & Co., both 10.3%.

    Ms. Connell, whose term expires in January, appears to have touched a nerve. Michael Flaherman, chairman of CalPERS' investment committee, said the controller has raised "potentially a very significant issue." He said CalPERS' first-hand knowledge of setting return assumptions gives fund officials expertise in this area, although he believes CalPERS would have more clout as a shareholder by staying invested in companies than by divesting their stock.

    Sherry Reser, a spokeswoman for CalSTRS, said the issue would be discussed at the fund's Oct. 2 investment committee meeting.

    Congress also is concerned. Rep. George Miller, D-Calif., ranking member of the House Education and Workforce Committee, and Rep. Rob Andrews, D-N.J., ranking member of the subcommittee on employer-employee relations, have called for hearings on the security of private pension plans. While the legislators are worried about growing unfunded pension liabilities - which more than quadrupled in the past year to $111 billion, according to the Pension Benefit Guaranty Corp. - part of their concern stems from aggressive rate of return assumptions.

    Public fund demands

    Meanwhile, other public pension officials are eager to restore investor confidence. Last week, pension officials from 17 states and the District of Columbia met in New York City, demanding greater corporate integrity and strengthened accountability to investors.

    The meeting was called by California state Treasurer Philip Angelides, New York Comptroller H. Carl McCall and North Carolina Treasurer Richard Moore. The pension officials discussed adopting principles to eliminate conflicts of interests between Wall Street analysts and investment banks, mobilizing major shareholders to ensure recent financial reforms are implemented and enforced, and condemning the practice by some U.S. companies to move their headquarters off-shore to avoid taxes.

    In an interview, Ms. Connell said companies with high return assumptions - particularly where pension income accounts for more than 50% of corporate net income - are themselves "highly risky investments for a pension fund like PERS or STRS."

    In a later conversation, she clarified that pension assumptions should be one of many criteria used in evaluating stocks, but if companies fail to adopt reasonable assumptions over a set time period, say, 18 months, then CalPERS and CalSTRS should divest their shares of such companies.

    High returns

    A survey issued this spring by Milliman USA, Seattle, revealed that 50 of the largest U.S. corporations have continued to employ high return assumptions for their pension funds despite the battering markets took in 2001. The average expected rate of return last year was 9.39%, virtually the same rate used in 2000.

    Strikingly, that return assumption would have produced an aggregate $54 billion gain last year. In reality, those corporate funds lost $36 billion - a swing of more than $90 billion that is bound to hit 2002 earnings, the survey notes. "Even with asset smoothing, we expect most of the $9.6 billion in pension income for 2001 will be erased in 2002," a Milliman release noted. Nearly 90% of pension plan surpluses have evaporated in the past two years, the firm observed.

    Ms. Connell's criticisms of high projected rates of return also strike close to home. In a letter to CalSTRS Board Chairman Gary Lynes, she questioned CalSTRS' own 8% return assumption, seeking justification for any return assumption greater than 7%. In the interview, Ms. Connell said she might be open to a compromise figure of 7.5%.

    CalPERS, which is going to review its capital-market assumptions later this week,assumes an 8.25% return.

    Ms. Connell also wants the teachers' retirement system - which has slipped from $9.1 billion in overfunding to $2.2 billion in the red during the past two years - to adopt annual actuarial valuations instead of biennial measures, and to conduct an annual review of its expected rate of return. CalSTRS now revisits its assumptions once every four years.

    Ricki Fulman and Vineeta Anand contributed to this article.

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