By Howard Silverblatt On Nov. 10, the Financial Accounting Standards Board (FASB) unanimously voted to add pension and other postretirement benefits (OPEB) to its agenda. We at Standard & Poor's believe this project will have a significant impact on equity valuations as well as income and balance sheets, and will turn into the major issue in financial accounting over the next five years.
The board outlined a two-step process. The first, expected to take about a year, will add the net pension fund status and OPEB to the balance sheet.
MASSIVE IMPLICATIONS. The second, which would actually change the methodology of pensions accounting, will likely take at least three years.
As outlined, the project will constitute the most comprehensive and important one the FASB has undertaken since its inception in 1973. For most companies, pensions and OPEB represent a major obligation -- one upon which millions of current and future retirees depend. Any change to pension accounting will have wide financial and political implications.
S&P will release an updated pension report containing a current analysis, as well as estimated 2005 and 2006 pension funding status, by the first week of December. Interest rates continue to show little change (10-year-note yield is around 4.56%, vs. yearend 4.22%; 30-year-note yield is 4.75%, vs. 4.82%), which will weigh heavily on liability levels.
BALANCE-SHEET ADDITION. And the market (year-to-date gain of the S&P 500 is only 1.57%) still stands a long way from producing the pension return of 8.27% that companies offering pensions predicted for 2005. At this point, it would appear S&P 500 companies may have to add another $40 billion to $50 billion to their pensions. It also appears that funding levels, which were expected to slightly improve this year, will deteriorate.
FASB's first step will likely wrap up by the end of 2006, although implementation may be delayed beyond that date. During the first phase, companies will have to add an item to their balance sheets representing the net (assets less obligations) pension funding and OPEB.
Unlike pensions, OPEB is not usually funded, making it a pay-as-you-go cost. This component is likely to be very large. Bear Stearns estimates that the 2004 aggregate OPEB net liabilities on the balance sheets of S&P 500 companies would have been $128 billion higher under the proposed FASB phase-one treatment than the recorded 2004 liability. S&P expects this to come as quite an eye-opener for investors.
"SMOOTHING" OF EARNINGS. However, adding net pension funding and OPEB liabilities to the balance sheet will cause shareholder equity to change. For the 308 companies in the S&P 500 that currently have underfunded pensions, equity would go down. For the 50 that have overfunded pensions, it will be increased. The OPEB costs will reduce equity for all but a few issues.
While the change will highlight data that are already disclosed, it will change ratios. With generally reduced equity values, valuations that utilize returns, book value, and leverage will change. This difference could weigh heavily, because most companies have outstanding debt and bank loans that contain covenants tied to equity and leverage ratios. Secured and backed debt instruments usually have leverage-ratio limitations. Additionally, some states have regulations regarding dividend payouts based on shareholders equity. These would all change.
In the second phase -- the guts of the proposal -- FASB will address the methodology of pension accounting. This task starts with asset and liability evaluations and ends with the value of earnings that are added into the income account. The most noticeable, and widely criticized, current practice is the smoothing of earnings. This permits companies to report gains in their earnings, even when they had an actual loss.
WHO'S IN TROUBLE? This issue, however, comes as secondary to the methodology used to determine the assets and liabilities, S&P's believes. These evaluations derive from current estimates of what returns and interest rates will amount to over decades. Estimating and agreeing upon fourth-quarter 2005 numbers already presents enough of a challenge -- predicting statistics for the fourth quarter of 2035 sounds like nothing but a guessing game.
While FASB hopes to see this task completed in three years (it starts after the first phase), the issues remain very complicated and political, with wide implications. We suspect 2009 will prove too early a deadline for FASB to gather facts, conduct research, hold discussions, set new rules, and implement.
Some of the companies with the biggest gap between pension obligations and pension funding include: Ford Motor (F
; ranked 3 STARS or hold; recent price: $8), General Motors (GM
; ranked 1 STAR or strong sell; $25), International Business Machines (IBM
; ranked 3 STARS, $85), Lockheed Martin (LMT
; ranked 3 STARS; $59), Boeing (BA
; ranked 3 STARS; $66), Raytheon (RTN
; ranked 3 STARS; $37), DuPont (DD
; ranked 3 STARS; $42), United Technologies (UTX
; ranked 3 STARS; $53), Goodyear Tire & Rubber (GT
; ranked 3 STARS; $16), and Pfizer (PFE
; ranked 3 STARS; $22).
Silverblatt is equity market analyst for Standard & Poor's