pension fund perspective: less than zero

CFA Institute

Pension Fund Perspective: Less than ZeroAuthor(s): Steven BleibergSource: Financial Analysts Journal, Vol. 44, No. 2 (Mar. - Apr., 1988), pp. 13-15Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479098 .

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Patrick J. Regan, V.P., Pension Fund Perspective ~ ~~~~~~~~BEA Associates, Inc.

Steve Bleiberg, Assistant Vice President at BEA Associates, Inc., is making his third appearance as a guest columnist. His survey of the pension costs and liabilities of 100 major firms for 1986 offers some inter- esting findings. For example, while many analysts have referred to the decline in pension expense for 1986, Steve points out that the adoption of FASB 87 was a major factor. Similarly, he shows how pension liabilities have been rising faster than pension assets, contrary to the conventional lore. -P.J.R

Less Than Zero by Steven Bleiberg

As if the world of pension finance were not already exciting enough, the widespread adoption of new pension accounting standards in 1986 created vast changes in the pension land- scape. Pension expense fell dramati- cally at almost every company that adopted the new standards; in many cases, reported pension expenses actually turned into pension income. Furthermore, the new pension accounting rules make it likely that the reductions in pension expense will not be a temporary phenomenon.

This was the major finding of the 1987 BEA pension survey, an annual study of pension expense and pension liabilities that BEA Associates has con- ducted since 1976. The survey, which originally covered 40 firms, was ex- panded in 1986 to include 100 firms that together employ over 10 million people.

FASB 87 After making a cameo appearance in 1985, FASB 87 took center stage in 1986, and its impact was startling. The median change in annual pension expense for the firms in our sample was -27 per cent-the biggest drop we have seen in the survey's 11 years. The aggregate pension expense for the firms in our sample fell even more, by 43.3 per cent. Only 16 firms showed an increase in pension expense in

1986, compared with 42 in 1985. One firm's expense was unchanged, and 83 showed declines.

Most of the drop in pension expense was due to FASB 87. When a company adopts FASB 87, the difference between the firm's projected benefit obligation and its pension fund assets is "frozen," and the firm amortizes that difference to pension expense for a period that can extend for more than 15 years. Most pension plans are over- funded, so we would expect that most firms adopting FASB 87 would experi- ence a reduction in pension expense because of the creation of this annual amortization credit. Conversely, pension plans that are underfunded relative to their pension benefit obligation when they adopt FASB 87 are now faced with 15 years of added expense as they amortize the underfunding.

In total, 61 of the firms in our sample reported that they adopted FASB 87 in 1986. For these 61, the median change in pension expense was -63.5 per cent (compared with the median of -27 per cent for the total sample). Eighteen firms actually recorded pension income. Of the 61 firms, 46 speci- fied what effect the adoption had on pension expense; 42 reported that FASB 87 lowered their pension expenses, three reported no significant effects, and only one, Firestone, reported a positive impact. Firestone, in fact, had the second-largest increase in pension expense among the 100 firms in our sample; its expense rose 67 per cent, from $24 million to $40 million. As Firestone had one of the few plans that was underfunded, we might have expected the adoption of FASB 87 to raise its expense. This is exactly what happened. Firestone reported that the adoption of FASB 87 increased its pension expense by $9 million, which means that under the old rules, its pension expense would have been only $31 million, an increase of 29 per cent instead of 67 per cent.

As a group, the 46 firms that speci- fied the impact of FASB 87 had a

median change in pension expense of -72.1 per cent, based on the reported figures. Adjusting these figures to eliminate the impact of FASB 87 leaves a median change of only -1.0 per cent. Table I gives the firm-by-firm details. It is important to note that adjusting the 1986 expense figures in this way is not irrelevant. The 1985 figures have not been restated to ac- cord with FASB 87, so if we do not adjust the 1986 figures, we are comparing apples and oranges.

Some of the adjustments are quite significant. Philip Morris, for example, reported a 90.5 per cent drop in pension expense. Without the adoption of FASB 87, however, its pension expense would actually have risen by 12.2 per cent. At USX, instead of fall- ing almost 400 per cent, expense would have risen 21 per cent.

For the firms that had still not adopted FASB 87 as of 1986, the median change in pension expense was -5.0 per cent, not very different from the adjusted median of -1.0 per cent for the FASB 87 adopters. These firms will have to adopt FASB 87 in 1987, and some of them estimated what the impact will be. Of the 18 firms that made such estimates, almost every one indicated that the effect will be favorable. In some cases, they said that pension expense or operating expense will be lower. In other cases, they predicted that operating income, pretax income or net income will rise. Only two firms foresaw increases in pension expense-Chrysler and Beth- lehem Steel. As we might expect, these are both firms whose pension plans are underfunded. When they adopt FASB 87, they will have a frozen net liability they will have to amortize, which will increase their expense.

Pension Liabilities The situation in the area of pension liabilities was the complete opposite of what we saw when we looked at pension expense. Pension liabilities actually grew at the fastest rate we have

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 E 13



Table I Impact of FASB 87

Percentage Impact of Adjusted Change

Pension Expense Percentage Accounting Pension From Company Industry 1985 1986 Change Change Expense 1985

Firestone Tire $24.0 $40.0 66.7% $9.0 $31.0 29.2% American Express Finance 42.0 48.0 14.3 Not material 48.0 14.3 Bankamerica Finance 38.0 41.0 7.9 (7.0) 48.0 26.3 Gannett Media 6.5 6.3 -3.1 (3.0) 9.3 43.3 RJR Nabisco Consumer 74.0 71.0 -4.1 (24.0) 95.0 28.4 Federated Dept Stores Retail 34.9 32.7 -6.3 (2.3) 35.0 0.3 Sara Lee Food 22.3 20.3 -9.0 (8.9) 29.2 30.9 Caterpillar Tractor Misc 60.0 51.0 -15.0 (10.0) 61.0 1.7 AMR Transport 102.9 86.7 -15.7 (46.4) 133.1 29.3 American Home Products Drug 26.2 20.9 -20.2 Not material 20.9 -20.2 Cigna Finance 30.7 24.4 -20.5 (8.0) 32.4 5.5 May Dept Stores Retail 24.0 19.0 -20.8 (4.0) 23.0 -4.2 Merrill Lynch Finance 63.2 46.1 -27.1 (19.6) 65.7 4.0 Campbell Food 23.6 16.0 -32.4 (14.5) 30.5 29.0 DuPont Chem (52.0) (69.0) -32.7 (26.0) (43.0) 17.3 Hewlett Packard Office 86.0 56.0 -34.9 (24.0) 80.0 -7.0 Allied Signal Misc 150.0 93.0 -38.0 (55.0) 148.0 -1.3 Borg Warner Misc 27.2 13.0 -52.2 (11.1) 24.1 -11.4 Anheuser Busch Consumer 78.7 36.6 -53.5 (45.2) 81.8 3.9 General Dynamics Aerospace 92.5 36.0 -61.1 (29.3) 65.3 -29.4 Amoco Energy 123.0 42.0 -65.9 (61.0) 103.0 -16.3 General Electric Elect 479.0 143.0 -70.1 (81.0) 224.0 -53.2 TRW Aerospace 72.6 21.1 -70.9 (50.0) 71.1 -2.1 Goodyear Tire 56.5 15.1 -73.3 (40.3) 55.4 -1.9 Sears Retail 319.0 81.0 -74.6 (234.8) 315.8 -1.0 American Brands Consumer 59.2 14.9 -74.8 (43.7) 58.6 -1.1 United Technologies Aerospace 212.2 50.4 -76.2 (94.0) 144.4 -32.0 Georgia Pacific Paper 35.0 7.0 -80.0 (22.0) 29.0 -17.1 Pfizer Drug 48.9 9.7 -80.2 (25.0) 34.7 -29.0 Minnesota Mining & Mfg Chem 61.0 8.0 -86.9 (56.0) 64.0 4.9 Philip Morris Consumer 74.0 7.0 -90.5 (76.0) 83.0 12.2 Texas Instruments Electronics 56.9 0.5 -99.1 (52.9) 53.4 -6.2 Chevron Energy 181.0 (1.0) -100.6 (155.0) 154.0 -14.9 Norfolk Southem Transport 26.3 (6.5) -124.7 (30.4) 23.9 -9.1 Tenneco Energy 107.0 (27.0) -125.2 (115.0) 88.0 -17.8 North Amer Philips Electronics 32.5 (9.5) -129.2 (42.6) 33.1 1.8 AUT Telecom 657.1 (258.0) -139.3 (585.0) 327.0 -50.2 Southwest Bell Telecom 109.2 (58.9) -153.9 (166.8) 107.9 -1.2 Times Mirror Media 31.4 (19.5) -162.1 (50.6) 31.1 -0.9 Pillsbury Food 7.8 (6.2) -179.5 (12.4) 6.2 -20.5 Kraft Food 15.9 (17.3) -208.8 (33.5) 16.2 1.9 Bristol Myers Drug 13.7 (15.9) -216.1 (23.1) 7.2 -47.4 McDermott Energy 4.0 (9.1) -325.6 (27.1) 18.0 347.4 USX Steel 67.0 (194.0) -389.6 (275.0) 81.0 20.9 J.C. Penney Retail (4.0) (22.0) -450.0 Not material (22.0) -450.0 International Paper Paper 4.0 (38.0) -1050.0 (44.0) 6.0 50.0

Median -72.1% -1.0%

seen since the current method of re- porting liabilities began in 1980. The median growth in vested liabilities was 16.1 per cent, compared with figures of between 8 and 10 per cent in earlier years.

One factor in the faster liability growth was the large number of decreases in discount rate assumptions. This is a sharp contrast from last year, when rate increases far outnumbered decreases. Last year's survey showed 34 rate increases and only nine de-

creases. This year, there were only 19 increases compared with 43 decreases. However, the median discount rate was unchanged at 8.5 per cent.

Table II shows why: Most of the firms that lowered their discount rate assumptions had used very high discount rates (i.e., 9 per cent or higher) in 1985. Of the 42 firms that used a discount rate of 9 per cent or higher in 1985, 33 lowered their assumptions in 1986. (Only one firm in this group- Burlington Northern-raised its inter-

est rate, from 9.00 to 9.25 per cent.) The point is that, because most of the

Table II Distribution of Discount Rate As- sumptions

Interest Number of Firms Rate Assumption 1985 1986 Change

6.00% to 6.99% 3 1 -2 7.00% to 7.99% 9 9 0 8.00% to 8.99% 44 64 20 9.00% to 9.99% 32 21 -11

10.00% to 10.99% 6 3 -3 11.00% to 11.99% 4 0 -4

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 0 14



decreases in rate assumptions came from the firms that were well above the median in 1985, the result was not a lowering of the median, but simply a narrowing of the distribution around the median. As Table II indicates, the number of firms with assumptions between 8.00 and 8.99 per cent rose from 44 to 64.

The median growth in fund assets in 1986 was 21.9 per cent. Combined with the 16 per cent median growth in liabilities, this implies that the median funding level should have risen slight- ly. This was indeed the case; the median funding level rose from 143.2 to 153.1 per cent.

Only four firms were underfunded relative to their vested liabilities, down from six in last year's survey (although one of last year's underfunded firms, LTV, was dropped from the sample because of the firm's bankruptcy). Three of the four were holdovers from last year-Firestone, Chrysler and Bethlehem Steel. The fourth, Xerox, was just over the full funding level last year, at 107 per cent. A fifth firm, Bankamerica, was right at the 100 per cent funding level, a significant drop from its position last year of 125 per cent funded.

At the other extreme, 16 firms in our sample were over 200 per cent funded, up from nine firms last year. Texas Instruments led the field with a funding level of almost 360 per cent, thanks in large part to an increase in its discount rate from 6 to 9 per cent.

A major problem in interpreting these figures is that different companies use different discount rates to determine the present value of their liabilities; comparing the stated under or overfunding figures for two companies is misleading. For example, Digi- tal Equipment and Woolworth both had a pension surplus equal to 7.8 per cent of their net worth. But Digital

uses a 6.5 per cent discount rate, while Woolworth uses a rate of 8.3 per cent. If Digital Equipment valued its liabilities at 8.3 per cent, their present value would shrink, and Digital's surplus would grow. Thus the reported sur- pluses at the two firms are not neces- sarily comparable.

It would be helpful if we could find some way to put all the firms on an equal footing by adjusting the liability figures to reflect a single discount rate. To do this with any accuracy, however, we would need to know the dura- tion of each firm's liabilities.

The Pattern of Real Funding Levels There is another major problem with the reported figures. According to the figures, the overall funding situation has been improving steadily, with only very minor setbacks, since 1980. This is an inaccurate picture, however. For most of the decade, the discount rates firms have used to value their liabilities have been unrealistic. To compound the problem, these discount rates were moving upward for most of the last five years at a time when market interest rates were moving down.

The problem began when interest rates rose to double-digit levels in the late 1970s and early 1980s. When this happened, many firms stuck with their 5 or 6 per cent discount rates. At that time, their liabilities were overstated, given the market environment, and funding levels were better than they appeared in the reported figures.

Many companies eventually re- sponded to the run-up in interest rates and began to raise their discount rate assumptions as the 1980s progressed. Unfortunately, just as firms began to raise their discount rates, long-term rates in the marketplace began to fall. This created a lengthy bull market for stocks and bonds, which raised the

level of pension fund assets considera- bly. Simultaneously, the increases in discount rate assumptions made it look as though liabilities were growing very slowly. The huge growth in assets combined with the apparently slow growth in liabilities has created the appearance of rising funding ratios.

In reality, the value of pension liabilities has soared even more than the value of plan assets in the last five years. The liabilities have a longer du- ration than the assets, so a drop in interest rates raises their value more. This means that real funding levels were actually dropping in recent years. Today, discount rate assumptions have converged with market interest rates, so the reported funding level for 1986 is probably a very good representation of reality. In other words, liabilities have gone from being very overstated five years ago to being fairly stated today. This in turn means that funding ratios have gone from being understated five years ago to being fairly stated today.

A recent report from Salomon Brothers attempted to reconstruct what the true funding levels have been since 1980. Salomon estimates that in 1980, when the reported funding level was 99 per cent (not far from the median of 109 per cent in our sample that year), the actual level was 186 per cent, based on market interest rates at that time. The "true" funding level soared to well over 200 per cent in 1981, when long-term rates peaked. Since then, as interest rates have fallen, the true value of pension liabilities has grown faster than pension assets, and the real funding level has fallen. As we mentioned earlier, discount rate assumptions are now pretty close to market rates for the first time in a decade, so today's reported funding levels are probably fairly accurate.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 0 15



pension fund perspective: less than zero

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