High pension returns claimed by firms in play

It's an open secret that companies manipulate their earnings assumptions by using unrealistic pension fund return assumptions. But a new study now suggests that companies also do this in connection with mergers and acquisitions.

According to the study, "Earnings Manipulation and Managerial Investment Decisions: Evidence from Sponsored Pension Plans," companies' long-term rate-of-return assumptions for their pension fund assets are almost 30 basis points higher during merger years than during other years.

The study was sponsored by the National Bureau of Economic Research, Cambridge, Mass. The authors are Joshua Rauh, professor at the University of Chicago School of Business, and Daniel Bergstresser and Mihir A. Desai, both professors at Harvard Business School, Boston.

In the past few years, companies' use of overly aggressive pension fund assumptions has been widely criticized. This study is likely to provide more ammunition for critics of high assumptions.

"There has been a powerful tendency to raise rate-of-return assumptions because of the impact it would have on short-term earnings," said Robert Arnott, chairman of Research Affiliates LLC, Pasadena, Calif., and one of the most prominent and vocal critics of companies' use of overly aggressive pension fund assumptions.

Although he said he hadn't seen the study, Mr. Arnott thought that the 30-basis-point average increase for firms during merger years "would suggest that a small minority of firms make that adjustment during merger years. If a handful of firms make a 150-basis-point change in their assumptions, it would average out to a 30-basis-point change for all firms."

Mr. Rauh said in an interview that he thinks the idea of a 150-point hike is too high. "Not too many firms would do that," he said.

But Mr. Rauh believes a 30-point hike average by individual firms during years when they are making acquisitions is more realistic, according to the calculations in the study.

"If companies have something going on (such as an acquisition) that requires a strong equity price, they could do this," said one pension actuary who declined to be named.

However, the actuary added: "I'm not aware of any companies that have wrongly increased the rate of return on their pension assets to prop up their stock price before an acquisition."

The study also investigates the degree to which managers are opportunistic with the assumed rates of return on pension assets.

One of the areas the researchers evaluated is the extent to which choices on assumed returns intersect with the firms' merger activities. Messrs. Bergstresser, Desai and Rauh created a measure of the sensitivity of a firm's overall profits to the assumed long-term rate of return on pension assets. They showed that this sensitivity measure is an important determinant of the levels of, and the changes in, assumed rates of return.

Specifically, a firm whose pension assets are twice as large relative to its operating income as the median firm in the sample makes a long-term rate-of-return assumption that is, on average, approximately 10 basis points higher than the median. A firm in the 90th percentile of sensitivity, on average, has a long-term rate-of-return assumption that is 40 basis points higher than a firm in the 10th percentile. Such differences in return assumptions can have a significant impact on reported earnings for these firms.

The researchers further show that firms make particularly high return assumptions in periods leading up to the acquisition of other firms. This relationship is especially strong for firms whose reported income is the most sensitive to pension assumptions.

"The fact that the magnitude of the estimated effect is higher at firms with higher pension sensitivity implies that the earnings generated by opportunistic adjustments to the long-term rate-of-return assumption around acquisitions are greater than would be the case if the magnitude of the effect was the same across different levels of pension sensitivity," the study said.

"Comparing two firms in the same industry and the same year, one of which makes an acquisition and the other of which does not, the result says that the acquirer's expected long-term rate of return is 34 basis points larger," the study said.

The rate-of-return assumptions "by firms that acquire other firms in a given year are clearly higher," said Mr. Rauh. "Firms with earnings that are more sensitive have assumptions that are even higher."

However, Shlomo Benartzi, assistant professor of accounting at The Anderson School, University of California at Los Angeles, who has also written about companies earnings' manipulation using aggressive pension fund assumptions, said he doesn't think it is a big problem in the mergers and acquisitions area.

"A company would have to predict its mergers and acquisitions decisions (before they actually make them) because when you increase rate-of-return assumptions, it doesn't affect earnings until the following quarter," said Mr. Benartzi.

The real cause of the problem, according to another source, is the accounting rules that allow the manipulation to take place.

Keith Ambachtsheer, president of KPA Associates Inc., a pension consulting firm in Toronto, said accounting rules allow firms to factor the rate-of-return assumptions on their pension assets into their company's reported earnings.

"When a company is making an acquisition or if a company is being acquired and wants to make the (stock price) picture as positive as it can … there are accounting rules to help them make things look as positive as possible," he said.