Your story "Most return assumptions not dropping with bear market," July 8, page 3, rightly calls attention to issues regarding the corporate reporting of pension income, but perhaps goes too far by insinuating that executives are using pensions to further cook the corporate books. While we agree there is the potential for mischief, we do not believe the situation calls for immediate reform.
On the other hand, 2001 pension disclosures combined with the continued fall in stock values may jeopardize the future of defined benefit plans just when their advantages are again understood.
We've been collecting pension data from annual reports on all Standard & Poor's 500 companies with defined benefit plans - of which there are 334 - for several years. The combined market value of assets for all 334 companies was $1,024 billion at fiscal 2001 year-end. Liabilities totaled $1,001 billion or $23 billion less than assets. Unfortunately, the $23 billion in excess assets is down from $237 billion in fiscal 2000, due in part to a composite 2001 asset return of -7.6%. Furthermore, we estimate the poor stock returns during the first six months of 2002, if not reversed, will cause a combined underfunding that will exceed $100 billion for fiscal 2002.
Have corporations in general been dealing fairly with this changing investment reality, particularly as it relates to calculating pension income (expense)? We start with annual accruals for new benefits earned during the fiscal year - called "service costs" - that totaled $23 billion, or 10% of net income for the 334 companies. If companies were funding pensions directly from corporate operations, that number would most likely be the 2001 pension expense.
However, companies pre-fund pensions in segregated trusts and current pension accounting requires additions to (subtractions from) service costs that reflect (1) pension funding status (assets minus liabilities) and (2) the assumed return on assets vs. the assumed interest cost on liabilities. For fiscal 2001, the 334 companies reported pension income, not expense, equal to $489 million, or less than 1%, of the combined $224 billion in corporate net income for those same companies. The $23 billion service cost was reduced to a minimal pension income number because (1) on average, assets exceeded liabilities by more than $100 billion during the 2001 fiscal year, and (2) the median 9.25% assumed return on assets exceeded the median 7.25% assumed interest cost on liabilities.
Some are criticizing companies for artificially producing profits by maintaining investment return assumptions averaging 9.25% in the face of growing asset losses. This may be true for the recent past, but the Trust Universe Comparison Service reports the median corporate total fund return has averaged 11.5% per year from 1989, when current pension accounting rules were first fully implemented, through 2001. Pension income may be overstated now, but has been understated for much of the 1990s. Despite its many faults, our conclusion is that pension accounting in aggregate has had a small and unbiased affect on corporate earnings over time.
More important to current and future beneficiaries, and their corporate sponsors, are the funding status of corporate plans and the likelihood of future cash contributions. The weighted average funded ratio for corporate pension plans in aggregate has deteriorated rapidly over the last three years, although it remained fully funded at 1.03 at fiscal year-end 2001.
But by totaling pension assets and liabilities, it appears a few large plans mask some significant funding problems among midsized and smaller companies. The median percentile funding ratio of assets to liabilities is 0.93, well below the aggregated or weighted average of 1.03. A quarter of corporate pension plans has funding ratios below 0.81, and 17 corporations have funding ratios below 0.64.
The funding situation certainly will get much worse. Fund returns are down 7% to 9% this year while liabilities continue to grow. As a result, even the better-funded corporations will have difficulty maintaining funding ratios above 1.0.
Cash contributions totaled a modest $12 billion in 2001, but will jump significantly in 2002. For the first time in a decade, many companies are finding they must make sizable cash contributions to their pension plans. And, unlike pension accounting, the rules governing corporate contributions are far more explicit and onerous.
The real issue facing defined benefit plans is not whether return assumptions should be 9% or 7%, but rather the increasing prospect that most companies again will have to allocate substantial cash flow to support them. Just when the public is reminded of the advantages to the defined benefit formula, companies may find that real cost - cash, not expense - is too great. That would be unfortunate.
Stephen L. Nesbitt
senior managing director
Wilshire Associates Inc.
Santa Monica, Calif.
