With the domestic equity market now apparently heading for its fourth straight year of big losses, any assumption of a positive rate of return on corporate pension plan assets might seem overly optimistic, considering that the bulk of most retirement fund assets is in stocks.
In light of the continued market slump, the Securities and Exchange Commission's new concern over high rate of return assumptions for pension assets, especially for those corporate pension plans that are assuming 9% or more, is appropriate.
But let's keep in mind that the assumed return is supposed to be a long-term projection, not based on last year's market returns or this year's market forecast. It would be as big a mistake for the SEC to encourage companies to adopt very low projections for pension fund returns based on the current bear market as it was for the companies to adopt overly optimistic ones during the bull market.
Many corporations have abused pension accounting to give investors the illusion of huge corporate profits when much of those earnings came from pension income, which shareholders generally cannot easily assess.
The amounts were often huge. A survey cited last year by Pensions & Investments found that the return assumptions used by the 50 largest U.S. companies would have produced a $54 billion total gain in 2001, when those funds actually lost $36 billion.
But forcing companies to adopt unreasonably low return assumptions may distort reported earnings in the other direction. Companies may report losses even though there are real operating profits after pension fund contributions, which once again, investors may misinterpret.
Already companies have begun reporting losses because of their pension funds, distorting their current and near-term outlook.
Corporations, on average, are reducing their assumed returns. But how much of a reduction would make the SEC or informed investors comfortable? One major consulting firm recently reported that the average long-term return assumption for its corporate pension plans has fallen to 8.81%.
But a rate of 8.8% really shouldn't make anyone feel more confident than the 9% or higher assumed rate the SEC is challenging.
Two things are needed. First, companies need realistic assumptions of long-term investment returns based on more than simply recent market performance, or even long-term historic returns. As economist Paul Samuelson noted many years ago, we have experienced only one of many possible versions of market history. The future may not look at all like the past. Return assumptions should be derived based on economic fundamentals and an understanding of what factors contribute to long term returns.
Perhaps the SEC's new rules requiring senior corporate officers to certify that the financial statements are correct will provide pressure for the adoption of realistic rate of return assumptions.
Second, accounting rules for pension costs need to be improved. Unfortunately, that will likely be a long-term project.
The latest SEC concern seems something of a repetition of the recent past. In 1999 and 2000, the agency focused on pension income. Concerned over inflated profits coming from pension earnings that shareholders couldn't realize, the SEC then told companies to better disclose to investors the extent to which pension income contributed to corporate earnings.
The SEC should then have challenged corporations about high return assumptions.
Corporate financial statements should explain in more detail their rationale in using the assumptions they choose, and what impact those assumptions have on corporate earnings.
The issue isn't a precise number for the return assumption. The assumption will at some level be subjective. Rather, the issue is an economically valid process for determining the assumption.
SEC scrutiny should ensure better estimation of the return assumption, better reporting and, ultimately, better understanding by investors of the importance and effect of the assumption on reported earnings.