Accounting reforms touted as underfunding cure

The Financial Accounting Standards Board and the Pension Benefit Guaranty Corp. need to set tougher accounting standards for corporations in order to solve the underfunding crisis that corporate pension plans currently face, according to well-known industry academic Frank Fabozzi.

Mr. Fabozzi, an adjunct finance professor at Yale University, New Haven, Conn., as well as an author of several investment books and the editor of the Journal of Portfolio Management, New York, has thrown his voice to the chorus of calls for pension reform to solve the underfunding problem.

In a paper to be published in the Journal of Portfolio Management next month, Mr. Fabozzi said the underfunding crunch can be solved by outlawing corporations' abilities to hide pension losses and by forcing corporations to show how capable they are of paying off their pension liabilities.

In his paper, titled "Modernizing the Defined-Benefit Pension System," Mr. Fabozzi introduces a quantitative model in which corporate executives can link the management of their pension plans to the overall financial management of their companies. The paper also said the days when corporate pension officials set the asset allocation of their funds based on the traditional "risk/reward" model should come to an end. The paper was co-written by John Mulvey, a finance professor at Princeton University, Princeton, N.J.; William Pauling, an accountant at Towers Perrin, New York; Koray Simsek, an associate professor at EDHEC, Nice, France; and Zhuojuan Zhang, a doctoral candidate at Princeton.

In his paper, Mr. Fabozzi points out that 299 of the 342 companies in the Standard & Poor's 500 index have pension plans that are underfunded by a total of about $210 billion. Companies such as Delta Air Lines, Atlanta, are being forced to consider bankruptcy because they cannot afford contributing to their pension plans to bring them up to an acceptable funding level.

Additionally, in a recent study, SEI Investments, Oaks, Pa., interviewed 100 chief financial officers, 39% of whom said their respective defined benefit plans have become such a headache that they are considering closing them to new employees within the next year. In the same study, 62% of the CFOs said their pension plans dragged down company profits. Last month, IBM Corp., Armonk, N.Y., became the latest major company to act, announcing it would close its cash balance plan to new employees in favor of a 401(k) plan.

Mr. Fabozzi's proposals, if implemented, could have a major impact on the way corporate pension plans set their asset allocations, as most of them simply factor in levels of expected returns in accordance with risk when setting them. Mr. Fabozzi's proposals would also hold corporations accountable for high levels of underfunding — an issue that has only recently grabbed the attention of analysts and shareholders.

Mr. Fabozzi proposes:

• requiring corporations to conduct annual risk-based evaluations of their pension plans that would link pension assets, liabilities and their ability to pay off unfunded liabilities;

• banning actuarial smoothing, a popular accounting technique whereby corporations, on their balance sheets, can spread out strong returns in a good year to offset poor returns in a bad year; and

• imposing higher PBGC premiums on corporations that have consistently demonstrated an inability to fund their pension plans in accordance with ERISA. The PBGC is already considering imposing risk-based premiums and other reforms.

"Why should this be a surprise to anyone that there is a crisis right now?" Mr. Fabozzi said in an interview. "I think there should be an entirely separate set of financial statements that clearly states what impact a pension fund has on a company's balance sheet."

Scott Sprinzen, an analyst at Standard & Poor's who focuses on pension plans, was reluctant to endorse at least one of the paper's proposals. "I think … (analysts) are of mixed minds about banning actuarial smoothing," he said. "We highly value current information. On the other hand, however, marking to market the assets and liabilities of a pension plan leads to volatility that obscures operating performance. From our perspective, some middle ground needs to be created between the two."

Michael Peskin, managing director and head of the Global Asset Liability Group at Morgan Stanley Inc., New York, agreed with Mr. Fabozzi that smoothing should be banned.

But he cautioned that in order for a ban on smoothing to work without creating an inordinate amount of volatility in pension returns and actuarial assumptions, corporations must change their pension investment policies. Mr. Peskin, who has presented pension research to Congress, said that ERISA plans in the United States should consider immunizing their portfolios by matching their liabilities to long bonds. "The reason pension plans are not doing that is because most people believe that interest rates are going to increase, and because it would represent a hit on their corporate earnings sheet," he said.

Mr. Fabozzi's paper coincides with recent reform proposals made by the Bush administration to strengthen the PBGC, which was underfunded by $23.3 billion as of Sept. 30 and is projected to run out of cash by about 2021. The agency is already considering changing the structure of its variable-rate premiums. Currently, the PBGC can charge a company $9 per $1,000 of underfunding in its pension plan on an annual basis, in addition to the annual flat premium of $19 per participant, but the variable-rate premium can be waived if the company brings its pension plan up to a certain level of funding through contributions.

The PBGC is considering linking the variable-rate premium to the consumer price index. "Different variable-rate premiums could be charged depending on the financial strength of the plan sponsor, asset-liability mismatch, participant demographics and the plan's benefit structure, e.g., lump sum payments," according to a Dec. 16 report by the Congressional Research Service.

"The debate on risk-based premiums will happen in Congress and in the public over the next several months," said Jeffrey Speicher, a PBGC spokesman. "I don't want to shut off the possibility that the premium structure could change. I can't speculate on the outcome of that debate."

Jim Morris, senior vice president and head of SEI's retirement solutions unit, said that changing the variable-rate premium structure makes sense. "It's really no different than any other type of insurance or credit," said Mr. Morris. "The more risk you represent, the more you will pay." Mr. Morris oversees SEI's Pension 360, a quantitative service aimed at helping companies integrate their pension management into the financial management of the entire company.

Mr. Mulvey, one of the paper's co-authors, however, said there are dangers in imposing risk-based premiums. "It could potentially worsen the underfunding situation of pension plans," he said.

Christopher Struve, an analyst at FitchRatings, New York, and co-author of the book "Pensions in a Post-Bubble Economy," said, "It's a damned-if-you-do-and-damned-if-you-don't proposal. It assumes that a company running an underfunded plan is (financially) healthy." He added that restructuring variable rate premiums to make companies with heavily underfunded plans pay more could be dangerous because it could place a further burden on financially strapped companies that are struggling to fund their pension plans.