Robert B. Cavanaugh, executive vice president and chief financial officer of J.C. Penney Co. Inc., recently mentioned an encounter with CFOs of other companies that indicates the troubling state of pension accounting.
“They all chuckled that Penney was on mark-to-market” accounting, Mr. Cavanaugh recalled in a June 18 webcast. “This one gentleman said, 'Imagine this, we get to recognize income on assets that don't exist ... It's all condoned by the accounting ruling-making bodies, the SEC and FASB by design ... There is just one problem, those assets don't exist'.”
Penney viewed its use of mark to market as a “weakness” in perceived comparisons with other companies, Mr. Cavanaugh noted. But “actually for us it always drove us ... to be aggressive in our funding position, which is really helping now relative to the average company.”
“The accounting rules are so far off track with reality and the simplicity of the mission of a pension plan ... to have enough money set aside to deliver” pensions.
The Financial Accounting Standards Board ought to pay close attention to how Penney manages its pension plan. As the FASB struggles with overhauling pension accounting rules, Penney could provide guidance on how better accounting can lead to more secure pension plans.
The FASB is moving too slowly. It completed the first phase of its remaking of the pension accounting rules in 2006, but it hasn't announced a timetable for issuing a proposal on the second and last phase, even though corporations and investors need clarity on pension accounting standards.
The International Accounting Standards Board, which might eventually set the accounting standards for U.S. companies as countries pursue the goal of converging accounting standards worldwide, also is moving to mark-to-market accounting, and its action is serving as a guide to the FASB.
Still, the FASB's foot-dragging is unacceptable, especially considering it issued the first modern pension accounting rules in the 1980s, and has more than 20 years of experience with their use and misuse.
Companies, for their part, could do more on their own to improve their pension accounting to reflect better economic reality, as Penney does. But many prefer to mask that economic reality, and in the end, most companies will need a push from the FASB.
One thing the 2008 market meltdown should have taught corporations and investors, although they really should have learned it in school, is that market returns can be fleeting. Even the market gains in the middle of this first decade of the 2000s have vanished. Management of pension policy, contributions, investing and disclosure should reflect such reality.
Penney has for years ignored the use of accounting valuation for managing its pension plan, and instead looked at economic reality for determining its pension expense.
This mark-to-market approach could have put Penney at a disadvantage as investors looked at its perceived financial condition in market downturns compared with companies using traditional accounting to smooth market fluctuations, recognizing gains and losses over a period of potentially five years.
But it has helped Penney better understand how to deal with these market fluctuations, and time its contributions to fund its plan. As a result, it has maintained a plan that has consistently been well managed and overfunded. On a projected benefit obligation basis, which includes projected pay increases, the plan has been overfunded every year since at least 1987, except for 2008 when the market meltdown caused funding to fall to 93% — still one of the highest among U.S. plans. This year the funding level has risen to about 105%.
The mark-to-market approach is an indication of Penney's commitment to secure its pension benefits in a financially sound way. In the webcast, Mr. Cavanaugh referred repeatedly to pensions as a “promise.” That statement too is an indication of how seriously Penney takes its commitment to meet its obligations to its employees.
He described the Penney approach as “competitive value delivery” for its employees and investors.
In managing its pension plans, Mr. Cavanaugh said, “The accounting liability has it all wrong. The tax liability has it all wrong. Those are not the real liabilities. The economic liability ... is the liability we always managed to.”
Yet even good funding can't save a plan. Penney closed its plan to new entrants starting in 2007, because the cost of pensions was making it uncompetitive with other companies' benefits and with contemporary demographics favoring portability.
Many other companies, whose defined benefit plans often are less funded than the Penney plan, also have curtailed their plans in recent years. Maybe if those companies had used Penney's approach, their plans would have been better funded and better able to overcome the competitive cost pressure and even helped set the competitive standard for attracting employees.
By the time FASB completes its long-needed pension accounting changes, there will be fewer defined benefit plans left to value, diminishing the power of the rule to improve pension management, investor perceptions and employee benefit choices.