As you may recall, we previously discussed problems in government pension accounting (see “California Budget Woes and Chimerical Pension Beliefs: GASB Could Help if it Had the Will”). In this essay we turn our attention to corporate pension accounting, pension expense specifically, using Weyerhaeuser disclosures as an example.
Let’s begin with a brief review of the FASB’s pension rules in ASR 715. The firm reports pension assets and liabilities in the balance sheet, netted. The entity’s pension assets can include cash, investments, and any other assets that are in the pension plan, and these are valued at fair value. The firm also measures its liability, the projected benefit obligation (PBO), which equals the present value of the estimated pension cash outflows to retirees, which these former employees have already earned. The pension assets and liabilities are then netted against each other, yielding what we actually see on the balance sheet. If assets exceed liabilities, the net amount is displayed in the asset section of the balance sheet. If the liabilities are greater, the net amount is shown in corporate liabilities.
In the income statement, the firm reports pension expense, a complex amalgam quite different from pension contributions. GAAP pension expense is defined as the period service cost (increase in PBO), plus the period’s interest on the PBO, minus the expected (not actual) return on the plan assets, less any amortization of prior service cost, and finally, plus or minus any amortization of pension gains and losses. And as we would expect from our accounting standard-setters, some items bypass the income statement: prior service costs and pension gains and losses. These two items are shown in the shareholders’ equity section of the balance sheet, in accumulated other comprehensive income (loss). Given the complexity of the FASB’s rules, the financial statements are supplemented with an ever increasing myriad of footnote disclosures that describe various details and assumptions so the reader can “better” assess the company’s pension position.
While one can do a lot of analysis when it comes to pension expense, our focus is on the interest cost and the expected return on pension assets components. These two items warrant particular scrutiny given management’s considerable discretion in their measurement, and because changes in their measurements can have major effects on the bottom line and on reported liabilities.
The following analysis relies in part on a very good study written by Nick Gibbons, an analyst at Gradient Analytics. The study is entitled “Pension Issue Commentary #4,” and was published on June 21, 2012. Last year’s report may be found at http://www.earningsquality.com/commentary.do?action=View.
As stated before, the PBO is the present value of estimated future retiree cash outflows discounted at some appropriate rate, and the interest cost component of pension expense is that same assumed rate multiplied by the beginning-of-the-year value of the PBO. Both items depend on the assumed rate that is used. Not surprisingly, higher rates will lower the PBO liability, but increase the interest charge, and related pension expense.
From Weyerhaeuser’s 2011 10-K footnote 8, one sees that the firm applies a discount rate of 4.5% and obtains a PBO of $5,841 (all dollar amounts in millions). (The 4.5% rate is for U.S. plans, while the rate for Canadian plans is 4.9%). In his study, Gibbons created a sample of 354 companies, analyzed their 2011 pension disclosures, and found a median discount rate of 4.75%. So, given the proximity of Weyerhaeuser’s discount rate to the median rate, we are somewhat comfortable with Weyerhaeuser’s choice.
However, if one is uncomfortable with a company’s assumed rate, or if one desires to do a sensitivity analysis, there is an easy tack to employ. Given that pension payouts already earned extend several decades into the future, one can assume the debt is a perpetuity, a stream of cash payments that continues forever. Since the present value interest factors get pretty small 20 years out, and further, the error should be relatively small. Then the value of an “adjusted” PBO would equal the reported PBO times the reported rate divided by the “adjusted” rate believed to be more realistic.
For example, let’s say we question the reasonableness of Weyerhaeuser’s rate…let’s say we think it really should be 3.5%. What happens? Well, the PBO soars by almost 28.6% to $7,510:
(($5,841 X 4.5%) ÷ 3.5%) = $7,510
Conversely, if we believe that the “adjusted” rate should be 5.5%, the PBO liability drops 18.2% to $4,779.
(($5,841 X 4.5%) ÷ 5.5%) = $4,779
And if the “adjusted” rate is assumed to be 4.75% (to standardize everybody’s rate and increase comparability given Gibbons’ study), the PBO value is $5,533. A change of merely one quarter of one percent decreases the liability by $308, a change of 5.3%.
(($5,841 X 4.5%) ÷ 4.75%) = $5,533
These examples demonstrate the impact of the discount rate on the projected benefit obligation and on the pension expense. Given how easily managers can manipulate reported pension liabilities, such a sensitivity analysis is an important aspect of pension analysis.
The second big assumption that managers may not be able to resist “tinkering” with is the expected rate of return on the pension assets. Allegedly, the FASB employs the expected rate of return (rather than the actual rate of return) to try to supply a long-term perspective and smooth the pension costs.
Weyerhaeuser uses an expected rate of return of 9.5%, giving it an expected return of $421, according to its reported pension expense calculation. Unfortunately, according to Gibbons, this 9.5% expected rate ranks in the 99th percentile! In other words, a 9.5% expected rate of return exceeds the rate applied by 99% of the firms in Gibbons’ sample. As the median rate of return is only 7.75% (according to Gibbons), one wonders why management applied the 9.5% rate of return. If management had used a 7.75% rate instead, the Company’s expected return would have been $363. So, that difference would have meant a higher pension cost of $58, and a lower bottom line.
Now to be fair, Weyerhaeuser did lower its expected long-term rate of return at the end of 2011 to 9%. And surprisingly enough, 7.75% was assumed for direct investments, and 1.25% for derivatives…thus, the 9% total.
Clearly, corporate pension accounting is light-years ahead of the governmental world. Nonetheless, there are still some significant soft spots, such as the assumed PBO discount rate, and the assumed expected rate of return. Corporate managers, their accountants, and auditors have a long way to go to live up to the assumption standard outlined in the Modeler’s Hippocratic Oath penned by Paul Wilmott and Emanuel Derman in response to our recent financial crisis:
I will make the assumptions and oversights explicit to all who use them.
In the meantime, investors need to be aware of pension related assumptions and their implications, and should employ sensitivity analysis to better understand corporate financial disclosures.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.