The present value of future obligations
Each year, the accounting department at most corporations estimates the total amount of benefits it will have to pay out in the future based on expected retirement dates, average life spans of employees, increases in payroll compensation and a number of other variables. It then uses the concept of time value of money to discount these benefits back to today. In essence, the accountants are trying to answer the question, "how much does the company have to invest this year in order to have enough money to meet the pension obligations in the future?"
The secrets are in the footnotes
To spot aggressive accounting, the investor needs to look at three key variables: the discount rate, the return on plans asset assumption and the projected increase in salaries and compensation expense.
Discount rate:
Most of the time, the discount rate companies use is that available on high-grade, fixed income debt securities. An unusually high discount rate (say 10% in a world of 5% interest rates) is call for suspicion. The lower the discount rate, the more conservative the pension accounting; the higher the discount rate, the more aggressive.
The discount rate can have a tremendous influence on the total amount of estimated pension expense. Consider the present value of $1 million discounted over thirty years at 12%, 9% and 6% respectively; the results are not even in the same state, let alone ballpark:
Scenario 1: Present value of $1 million in 30 years discounted at 12%:
$1,000,000 future value ÷ (1.12)30 = $33,378
Scenario 2: Present value of $1 million in 30 years discounted at 9%:
$1,000,000 future value ÷ (1.09)30 = $75,371
Scenario 3: Present value of $1 million in 30 years discounted at 6%:
$1,000,000 future value ÷ (1.06)30 = $174,110
The discrepancy could mean the difference between booming profits and bankruptcy. This can easily become a tool for executives eager to "manage" (i.e., manipulate) earnings.
Return on plan assets assumption:
Over the long run, a pension plan that has a portion of its assets in equities is probably going to earn more than the amount available from high quality, fixed debt securities (i.e., the discount rate.) As a result, corporate accountants must estimate the return the company expects to earn on the assets it has set aside to fund pension obligations. The higher the rate of return a company can earn on these assets, the less it will have to take out of profits. According to Fortune Magazine*, a reasonable rate of return on pension assets is between 6 and 7 percent. Yet, many companies have return assumptions of 9% or more. If GM, Northrop Grumman, U.S. Steel, and Boeing all lowered their return on asset assumptions to 6.5%, the reported earnings for each of these companies’ fiscal year 2002 would have been 35% lower! By increasing the return assumption, billions of dollars can magically appear on the bottom line of the income statement.
Projected increase in salaries and compensation expense:
Many companies base pension benefits on the level of an employee’s salary at the time of retirement; the higher the salary, the greater the pension obligation.
Unfortunately, salary levels are by no means standardized. Instead, an investor must try to discover the projected increase in salaries in leading corporations in the same industry as the company he or she is evaluating. If the computer manufacturing sector, for example, expects increases of 5% per year and the investor is reading the 10K of a company in the industry that only expects 2% increases in annual salaries, an eyebrow should be raised. If there is no compelling reason the company in question can hold down costs, conservatism would require the investor to assume that the pension expenses may be higher than the financial statements reflect.
*Beware the Pension Monster, Dec. 9, 2002
