Earnings estimates getting real

NEW YORK — Wall Street firms might be beating the Financial Accounting Standards Board to the punch in implementing mark-to-market pension accounting.

The equity research desks of Morgan Stanley and Goldman Sachs & Co. are developing techniques to estimate the actual earnings — as opposed to the smoothed earnings — of pension plans of the companies they cover, according to money managers familiar with both firms.

The move would follow in the footsteps of Bear Stearns & Co. and Standard & Poor's, which in 2003 were the first high-profile companies to begin estimating the actual earnings of companies' pension funds.

If enough Wall Street firms follow suit, companies could be forced to pay closer attention to actual funding levels of their pension plans and could move toward liability-led investment strategies.

One money manager, who requested anonymity, said Morgan Stanley's equity research desk has been actively pitching the accounting method to investors. "This is something that equity analysts should have been doing all along, but the issue of pension funding didn't really come in to play until 2001 and '02," said the manager. A Morgan Stanley spokeswoman said firm officials declined to comment.

Another money manager, who also requested anonymity, said Goldman's equity research desk will begin estimating actual earnings of pension funds in all market sectors in the coming months. Ed Canaday, a Goldman spokesman, said the firm's equity research unit currently estimates the actual pension returns of companies only in troubled sectors, such as the auto and airline sectors. He could not offer further details.

"I haven't seen this being done by any research firms," said Nick Galluccio, chief investment officer and small-cap value portfolio manager at TCW Group's New York office. "This is somewhat innovative and would certainly give Morgan Stanley a little bit of an edge."

Howard Silverblatt, equity markets analyst at Standard & Poor's, New York, said more research firms are beginning to look at actual pension fund earnings in light of the terminations of underfunded plans in the past three years. "Pension underfunding levels got more attention in 2002 as effects of the market began to show up in pension plans. But despite market conditions, with the current accounting procedures, companies were posting gains in the market at a time when nobody was making gains."

Mr. Silverblatt cautioned, however, "You can only do so much when making an estimation. You can never have the actual breakdowns of where the cash flows are coming from at a company. The estimation is based on a lot of assumptions."

Actuarial smoothing —in which companies can shift gains or losses in their pension plan from one year to the next — has been controversial because it allows companies to avoid reporting the full extent of pension plan losses during a down year. Invariably, smoothing has an effect on the perceived funded status of a pension plan.

Most industry practitioners favor moving to a mark-to-market accounting standard. "We believe that the smoothing mechanism should be removed and that reporting should be based on fair value, with changes recognized as they occur," said Rebecca McEnally, director of the capital markets policy group of the CFA Institute Center, Charlottesville, Va.

Regarding the moves by Goldman and Morgan Stanley, she added, "If an analyst believes the assumptions of a company are overly aggressive, then we would expect that the analysts would make appropriate adjustments. Making those adjustments would be difficult as the analyst would have to gather a lot of information, but it could be done."

Dane Mott, an accounting analyst at Bear Stearns, said: "Basically if you look at the disclosures of a plan's assets and its obligations, you can estimate its real value fairly accurately."

Bear Stearns' model found the average funding level of the pension plans of companies in the S&P 500 went from 1% in 2001 to -12% in 2004. Mr. Mott said Bear Stearns analysts consider the ratio of underfunding to market capitalization to measure the short-term risk that a company's pension plan may pose to the company's overall health. Kurt Winkelmann, managing director and head of global investment strategy at Goldman Sachs Asset Management, New York, said if enough equity analysts calculate the real economic value of pension assets relative to liabilities, it could be another factor in helping to spur more pension plans to examine liability-led investment strategies.

If mark-to-market accounting does become a reality, the funded status of corporate pension plans could become more volatile. If a pension plan were to align its assets to its liabilities, it would help ease that volatility.

"Every little bit helps push the discussion of whether to go into liability-led investment strategies," said Mr. Winkelmann. "I think this would help continue the debate among CIOs."