America's Other Pension Problem

Shortfalls in funding post-retirement health plans could hit Corporate America -- and investors -- hard when new accounting rules go into effect

Companies' financial obligations to retiring workers -- in the form of pensions -- have come into the spotlight recently. And despite concern that the pension plans of many companies suffer from underfunding, Americans can take some comfort in the fact that pension funding is regulated by the government and financial accounting oversight bodies. But another, lesser-known obligation may pose an even bigger problem for Corporate America -- funding shortfalls for post-retirement health plans.

Other post employment benefits (OPEB), as these benefits are known, are receiving greater attention from lawmakers and regulators. On Nov. 10, 2005, the Financial Accounting Standards Board (FASB) unanimously voted to add pension and OPEB treatment to its agenda. Its two-step approach will move the posting from the footnotes to the balance sheet and then address the methodology. At Standard & Poor's, we believe this FASB project will have a significant impact on stock evaluations, income statements, and balance sheets, and will turn into the major issue in financial accounting over the next five years.

NO LEGAL REQUIREMENT. Under the Employee Retirement Income Security Act of 1974 (ERISA), companies must create a separate entity dedicated to funding pension benefits for current and future retirees. Both ERISA and FASB regulations describe methodology, funding, and reporting requirements for the pension trust. At the close of 2004, the S&P 500's defined-benefit plans as a group had $1,265 billion in assets and $1,430 billion in liabilities. The underfunding of $164.3 billion barely changed from the $164.8 billion underfunded position a year earlier. S&P expects yearend 2005 underfunding among the 500 to increase to $182 billion.

But employers have another, less publicized extended obligation to employees. OPEB obligations consist mostly of medical costs paid to insurance companies (or special accounts for the self-insured) and pharmaceutical outfits for the benefit of retired workers. These benefits may be contractual or implied, and usually require retiree contributions in the form of monthly premiums and direct co-payments for services and products rendered.

Unlike with pensions, which are regulated, companies have no legal requirement to create a trust entity to fund the current or future OPEB costs. Additionally, specific tax treatments and credits set up to encourage pension funding do not exist for OPEB funds. For these reasons many companies have not created trust accounts to fund their OPEB obligations, and those that have done so fund them to significantly lower levels than required under current pension funding rules.

COMPLEX MATH. Pensions, while underfunded, have 88.3% of their obligations set aside in pension trusts, compared to 21.7% for OPEB obligations. The result: The underfunded OPEB liability of companies in the S&P 500 is significantly larger than the pension underfunding. For the 337 companies in the S&P 500 that offer OPEB, only 282 provided sufficient information for estimates. Those 282 had OPEB assets of $82.2 billion and OPEB obligations of $379 billion, resulting in an underfunding balance of $292.2 billion, 95.1% higher than the current $149.8 billion of unfunded pensions among this group of companies.

While the magnitude is troublesome, the inability to compute and compare issue information is also alarming. Specific data in annual reports and Securities & Exchange Commission filings are complicated and often come with little or no explanation for the values and assumptions presented. In short, while aggregate data are reliable, the ability to break out OPEB obligations in a similar manner to that of pensions remains elusive.

Under current accounting rules, the footnotes of a company's annual report disclose the status of pensions and OPEB. Pensions and OPEB share many accounting treatments (FAS 87 and FAS 106) with respect to smoothing, discounting, and rate assumptions. Unfortunately, these same accounting rules often conceal the true status for several years. By that time significant damage can have occurred, and the options available to the company, employee, and retiree are limited.

ROOT OF THE PROBLEM. A fundamental difference between pensions and OPEB are that pensions have required funding and the Pension Benefit Guaranty Corp. (PBGC) behind them, while OPEB have no such requirement or quasi-government backing. Another dissimilarity: Over the last two years, additional disclosures for pensions have been added to assist investors in evaluations, while similar disclosure has not been enacted for OPEB.

The underfunding of both pensions and OPEB stems from a combination of low interest rates and specific accounting methodologies designed to smooth out market volatility. Pensions and OPEB, like debts, must be paid if a company is to remain credible. Their obligations are imperative in analyzing and evaluating ongoing concerns.

The FASB initiative's first step, expected to take about one year, will add the net pension and OPEB status to the balance sheet. The second would actually change the methodology of pensions and OPEB, and that will likely take at least three years.

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