America's Other Pension Problem


By Howard Silverblatt 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.

UNREALISTIC DEADLINE? The second phase will constitute the guts of the proposal. This starts with asset and liability evaluations, and ends with the value of earnings added to the income account. The most noticeable, the smoothing of earnings, has received wide criticism. It permits companies to report a gain in their earnings when they had an actual loss.

This issue, however, comes second to the methodology used to determine assets and liabilities. These evaluations derive from current estimates of what returns and interest rates will amount to over decades. Agreeing on the current Q4 2005 estimate poses quite a challenge -- estimating Q4 of 2035 would appear to be far less of a science.

While the accounting board hopes this task will finish up in three years (it starts after Phase 1), the issues are extremely complex and political, and have wide implications. Four years (2009) seems like a short time period to gather facts, conduct research, hold discussions, and implement.

DIFFERENT BILLS PASSED. In general, S&P 500 companies have sufficient cash and access to capital markets to easily achieve this task. However, the automotive-related group and airlines will feel the strain of additional contributions.

While a sharp change in interest rates or the equity markets would influence the value, a major adjustment at this point can only come from the U.S. Congress. Current legislation that dictates the discount rate used for determining discounted liabilities expires at the end of the year, but Congress has until Q1 2006 (when payments are due) to pass a bill and make it retroactive (as it did last time). Without new legislation, the rate will convert to the 30-year Treasury, which would cause pension liabilities to substantially rise.

The Senate and House have passed different pension bills, both of which would change the discount rate used for pension liabilities, making it match up with similar maturities rates (the Senate bill would create multiple maturity periods with average rates over a short period vs. the House's three rates, averaging over several years).

"SMOOTHING" RULES. Both would also need additional PBGC premiums and require underfunding to be alleviated in seven years, with an exception in the Senate bill giving airlines up to 20 years to attain full funding. The differences will need reconciling.

The state of OPEB is extremely unsettling. Due largely to the lack of uniform information, analysis and evaluations have limited use, and projections carry large disclaimers. Disclosure requirements date back to FAS 106 of 1992, which drew upon the pension guidelines of FAS 87. However, since OPEB had no funding requirements, the reporting rules became a product of smoothing. As medical and drug costs began to escalate at double-digit rates, the estimated growth rate used in determining the present value of OPEB became the major factor (as did the discount rate for pensions).

Within the S&P 500, 337 companies offer OPEB, with their aggregate underfunding totaling $292 billion. Of the 337 businesses, 133 have an OPEB fund with assets and obligations of $82 billion and $318 billion, respectively. The remaining 149 issues (with data) have obligations of $61 billion with no assets.

CONFLICTING DATA. In the S&P 500, only three companies were overfunded: Comerica (CMA), PerkinElmer (PKI), and Principal Financial. Procter & Gamble (PG), which was known as one of the few companies with OPEB coverage (for fiscal June, 2004, P&G had $3.1 billion in assets and $2.7 billion in obligations), reported an OPEB underfunding in June, 2005 ($2.7 billion in assets and $2.8 billion in obligations).

Annual OPEB cost for S&P 500 companies last year amounted to $25.3 billion, down from $28.9 billion -- and that demonstrates one of the problems. The actual costs for the year did not go down 12.4%, but the reported costs did. The reported number excludes the unrecognized costs of the program, similar in nature to the smoothing in pensions that permits companies to add income from the pension when they actually lost money. The unrecognized expenses vary from year to year, as actual costs and recoveries combine on paper, based on assumed rates.

Of deeper concern: While most of the reported assumed growth rates for short-term medical costs are double-digit, many of the longer term (3-5 years) assumed rates fall into the mid-single-digit range. The lack of reported analysis of the rates leaves investors to consider conflicting national data regarding cost increases, as well as assumptions about the companies' plan coverage or limitation of future benefits. The year-to-year rate updates, while reflecting current projections, can create extreme fluctuation in the calculations, as well as in the earnings.

CARMAKERS' GRIPE. Current medical and OPEB costs have risen substantially over the past decade and now occupy a significant position in U.S. labor contracts. The current public focus has turned to the U.S. auto industry. During more prosperous times, the ability to pass through additional costs to customers permitted increased benefits. However, due to lower market share resulting from lower sales and profits, these benefits now stand out as a major difference in competitive pricing.

The U.S. auto industry has long contended that current medical and OPEB costs have contributed to an international disadvantage in the marketplace. With almost $94 billion in underfunded OPEB obligations, Ford (F) and General Motors (GM) represent more than 32% of the aggregate S&P 500 OPEB underfunding, compared to their 13% of the underfunded pensions. Pensions and OPEB have become the major issue within the telecommunications sector as well.

The PBGC guarantees pensions for 44 million people (34 million under single pension funds, 10 million under multi-employer funds). Each person is guaranteed up to $45,614 per year, which is indexed and adjusted annually. In November the PBGC reported that the plans it has taken over were $23 billion underfunded. While observers expect some of this shortfall to be made up for by increased premiums paid by covered companies (expected to be enacted by Congress), the U.S. government will have to make up any deficit. OPEBs have no such protection or requirement.

CLARIFYING THE RULES. This weighs as an extremely important distinction. The ability of companies to modify their plans (subject to contractual obligations) speaks directly to the extent of their legal obligation to fulfill them. This has been widely discussed for years, with one of the main points being an attempt to measure the extent of a company's OPEB obligation (both as an ongoing concern or under court direction). Within the S&P 500, more than 12 million employees receive coverage from OPEB plans, with multiples of that consisting of either dependants or retirees. The size and potential impact of any change to these programs makes the issue politically charged and relevant to the nation at large.

The change in accounting rules under Phase 1 of the FASB plan will reflect a clearer understanding of the cost of salaries and benefits. While these liabilities always existed, the transfer from the footnotes to the balance sheet will create a greater investor awareness of the obligation, and (we hope) increase participation in the upcoming discussion on Phase 2.

The impact of moving $442 billion onto the balance sheet (regardless of how it is classified) will mean reduced common tangible book value in the S&P 500 by 21%, representing 70% of 2005 expected as-reported income. It would increase several leverage metrics that add such costs into long-term debt by 10%.

SPIRITED DEBATES AHEAD. Long-term OPEB costs have, and are continuing to, increase substantially. Aided by an attempt to reduce the number of employees, many companies have encouraged early retirement, adding to the coverage period. Medical advancements combined with more expensive drugs have also permitted retirees to live longer. These costs will need addressing.

The discussion regarding pensions and OPEB will prove lively, political, and complex. However, for capital markets to function properly, sufficient timely data, similar to earnings reports, are necessary. The complexity of the issue is as enormous as its impact on companies, employees, and retirees. Standard & Poor's is reviewing the FASB proposal and evaluating additional information. Pensions and OPEB have moved well beyond individual companies. Their importance in the global economy is now self-evident.

This report was prepared by the Standard & Poor's Index Analysis & Management Group, which is separate from the Standard & Poor's Credit Market Services Group (fixed income) and separate from Standard & Poor's Equity Research Services. This report does not discuss ratings or credit market aspects and does not make any buy/hold/sell recommendations for any securities.

Silverblatt is equity market analyst for Standard & Poor's


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