The backdrop for today’s post is the present dive in stock prices at the same time the Federal Reserve is trying to stimulate the economy by decreasing interest rates. What I’m fixin’ to describe is how it will — and won’t — affect the reporting of pension costs.
The Chasm between the Economics of Pension Plans and their Reported Effects on Income
Most plans, if they have significant investments in equity securities are gonna get clobbered by current developments in the economy. That’s because the asset leg, representing investments set aside to pay pensioners, will go down with the decline in stock prices; and, the liability leg, representing the present value of expected payments to pensioners is going to go up as a lower interest rate is used to discount the expected cash outflows. The chop to both legs is going to push down economic earnings — a lot.
But, as you may already know, owing to rules-based GAAP (IFRS is similar), the effect on reported earnings will be but a wee fraction of the total economic effect — due to an artifice referred to in the trade as "corridor amortization." Maybe a tenth, at most, of the actual loss will get recognized on the income statement. It’s really quite shameful that the gap between economic and GAAP income is like the Grand Canyon; and it’s because the basic principles of pension plan accounting have been willfully ignored by the FASB. These principles are as simple as this:
- Calculate the net pension liability/asset as the difference between the fair value of plan assets and the actuarially determined projected benefit obligation. This number goes on the balance sheet.
- Report the change in the net pension liability/asset on the income statement.
As I reported in an earlier post, FAS 87, the grandaddy of pension accounting rules, was a blatant and outright rejection of principles. It was passed by a 4 – 3 vote and was an unmitigated disaster — an artifice designed to appease the country’s largest employers by hiding liabilities and overstating income. But, predictably, and undeniably, FAS 87 allowed companies to pretend to ignore the risky and ultimately dire straits their pension plans were in until the companies, along with their plans, became insolvent. How much wealth destruction and personal hardship would have been prevented if one more member of the FASB had voted against FAS 87? Somebody should be losing sleep over it.
Now comes a study by Charles Mulford, a professor at Georgia Tech, et. al. showing for the largest of these companies that if the change in the net pension amount were reported on the income statement, then reported income would be much more volatile. Big Duh. That’s why FAS 158, though fast-tracked to avoid the appearance of a complete sham, stopped well short of a comprehensive fix. I’m guessting that many of the companies Mulford and his colleagues studied were among the major whiners for the FASB to protect their income statements.
Phase 2 of the Pension Project Hasn’t Left the Gate
This I guarantee (but can’t prove): if timely recognition of losses on pension plans were required by accounting standards, pension portfolios of today would be less volatile, and interest rate risks would be hedged; and the exposure of wage earners to the crisis that the economy now faces would be less. FASB members past and present know this reality — that accounting actually affects cash flow, and not just the other way around.
So, you would think that Phase 2 of the project should be fast-tracked as well. Actually, it is being hobbled by diversionary tactics. I’ll let the minutes of the FASB’s August 2007 meeting speak for themselves concerning the issues the FASB says they will address in Phase 2:
"a. How changes in postretirement benefit assets and obligations should be reported in the context of the presentation framework and principles being developed in the joint financial statement presentation project. That is, the Board will identify the discrete items that cause changes in plan assets and benefit liabilities and analyze how each item should be presented, in the period they occur, within the framework of the joint financial statement presentation project. That framework presumes that the concepts of other comprehensive income and recycling have been eliminated. Once those standards are developed, the Board will consider whether some or all of them should be implemented before the financial statement presentation project is completed and any new standards become effective.
b. How the reporting of an employer’s obligations associated with participation in a multiemployer plan might be improved. The Board expressed tentative support for the staff’s recommendation that phase 2 initially focus on improving disclosures in the notes to financial statements, pending the staff’s additional analysis of reasons for that recommendation (that is, the staff’s rationale for initially focusing on disclosure rather than recognition and measurement of plan obligations).
c. Whether and how to improve disclosures about risks inherent in plan investments, for example, sponsor’s use of derivatives. This step would reexamine the guidance in FASB Statement No. 132…."
Why do these lower-priorty and loosely related issues like income statement presentation, disclosure, esoteric forms of pension plans, and even convergence with IFRS (elsewhere in the minutes) have to be resolved at the same time as the glaring wart of failure to recognize the full amount of pension costs in income? The answer is so obvious that it may explain why we haven’t heard a peep out of the FASB since that August meeting. No tentative decisions on any of these issues have been announced.
Even "glacial speed" is too generous a description of the FASB’s progress on the putative second phase of their pensions project. "Frozen in time" seems dead on.