Pension and OPEB plans: accounting, transparency, and compliance.

Introduction

Pension and other post-retirement employee benefit (OPEB) plans are now under extensive scrutiny by lawmakers, regulators, and standard-setters as many companies are failing to contribute sufficient funds to worker retirement plans. Pension benefits are becoming too expensive, and many employees have switched from traditional pensions to so-called defined contribution plans like 401(k). The application of existing accounting standards for pension and OPEB plans has created misleading and meaningless financial statements that often overstate reported total assets. For example, in 2004, the S&P 500 companies reported $99.0 billion in net pension assets on their balance sheets, while their pension plans were underfunded by $165.0 billion, indicating a total overstatement of $264.0 billion. (1) This article's purpose is to examine the funding status and accounting of both pension and OPEB plans and make suggestions for their transparency and compliance.

Funding Status of Pension and OPEB Plans

The two sources for funding retirement are lifetime corporate pensions and private 401(k) employee contribution plans, which are both in crisis as baby-boomers live longer and their income shrinks. (2) Recently it was found that about half of the nation's workforce is not covered by a private-sector retirement plan: 30.0 percent invest in employee contribution plans like 401(k), 10.0 percent have lifetime corporate pensions, and the remaining 10.0 percent have a combination of 401(k) and pension plans. (3) Americans with 401(k) and pension plans need to save 15.0-18.0 percent of their annual salary for 30 years by accumulating at least six to ten times their annual pay before retirement in order to be able to maintain their standard of living. (4) In the past several decades, there also has been a significant shift in the cost and responsibility for retirement saving from corporations to employees.

At the turn of the century (2000-2001), public pension plans held an average of 100.0 percent of the fund required to meet obligations to workers. However, many public pension plans lost money when the stock market dropped. By 2004, the average funding level of these plans had decreased to 87.8 percent, and for some plans to as low as about 50.0 percent funded. (5) Several prominent companies have announced that they will go out of business unless they are allowed to terminate their pension plans. One example is Pittsburgh Brewing, which informed the Federal Pension Benefit Guaranty Corporation (PBGC) that unless its pension plan is terminated, it will not be able to continue in business. (6) On January 23, 2006, Sprint Nextel reported its decision to freeze pension plans for almost half of its 80,000 employees by not offering a fixed retirement benefit to new workers in order to be able to compete with other wireless carriers. (7)

A report issued by the Government Accountability Office (GAO) reveals that more than half of the 29,000 private pension plans insured by the U.S. PBGC are underfunded. This suggests that companies' obligations to their retirees exceed the assets of their defined-benefit plans, and the underfunded pension and OPEB plans have been keeping the off-balance-sheet. (8)

Pensions and OPEB Accounting

Post-retirement benefits, including pensions and their accounting, have been a challenge for public companies and are now becoming a struggle to survive as:

1. Some companies have eliminated, frozen, or amended their plans (e.g., Sprint, Nextel, Verizon, and IBM);

2. Other financially-distressed companies (e.g., United Airlines, Pittsburgh Brewing) have shifted their pension obligations to the PBGC; and

3. The Financial Accounting Standards Board (FASB) has initiated its two-phase project of improving accounting practices by requiring recognition of unfunded pension and OPEB obligations.

Many of the OPEB and pension plans were developed several decades ago with observable costs and obligations for companies, and now fulfilling OPEB and pension obligations diverts companies' operating capital intended for growth, expansion, and operating purposes. To effectively compete in the global market and particularly with companies in countries where labor is cheap and pension and OPEB plans are practically non-existent, U.S. companies may have to reduce employees' retirement benefits and freeze or terminate their defined-benefit plans.

The Financial Accounting Standards Board (FASB) has issued two Statements of Financial Accounting Standards (SFAS), Nos. 87 and 106, to address accounting for pensions and OPEB, including healthcare and related retiree benefits. Both SFAS Nos. 87 and 106, while providing guidance for entities to measure, recognize, and report their pension and OPEB costs, do not require entities to recognize unfunded pensions and OPEB assets and liabilities. Prior to the adoption of SFAS 87, there was little, if any, comparability or consistency among companies and industries regarding reported pension costs. SFAS 87 increased the comparability and understandability of pension accounting by requiring a standardized method for measuring net periodic pension cost and an immediate recognition of a liability when the accumulated benefit obligation exceeds the fair value of plan assets. (9)

SFAS 106 significantly changed the manner in which companies were allowed to account for OPEB. Prior to its implementation, such benefits were accounted for by the "pay-as-you-go" or cash basis method of accounting. SFAS 106 requires that the expected cost of providing post-retirement benefits to an employee and the employee's beneficiaries and covered dependents is to be accrued during the years that the employee renders the necessary service. The FASB promoted the change to enhance the understandability, comparability, and usefulness of the disclosed information in the financial statements. (10)

Dissatisfaction with financial reporting for defined-benefit pensions and OPEB has been growing during the past decade primarily because pensions and OPEB obligations are not fully recognized on the balance sheet. The FASB has recently responded to concerns regarding accounting for pensions and OPEB by undertaking a two-phase project to improve the transparency of overfunded or unfunded pension and OPEB plans. Phase I of the FASB's project would adjust assets (liabilities) for the amount of overfunded (underfunded) pensions without addressing the impact of pension and OPEB costs on the income statement. The second phase is intended to be a complete overhaul of accounting for pension and OPEB plans, which would minimize smoothing mechanisms from pension and OPEB accounting.

In September 2006, the FASB issued its "Statement of Financial Accounting Standards (SFAS) No. 158, Employer's Accounting for Defined Benefit Pension and other Postretirement Plans," which requires companies to recognize on their balance sheet the funded status of their pension and OPEB Plans as of December 31, 2006 for calendar-year companies. (11) SFAS No. 158 will also require fiscal year-end measurements of plan assets and benefit obligations, which will be effective for fiscal years ending on or after December 15, 2008. SFAS No. 158 completes the first phase of FASB's project on Pension and OPEB Plans. The next phase will provide accounting standards concerning measuring plan assets and obligations and the determination of net periodic benefit cost. The FASB is planning to move forward with Phase II of its OPEB and pension project that could result in a comprehensive overhaul of accounting standards for pension and OPEB plans. The proposal is intended to improve the accuracy, completeness, and transparency of financial statements to all users of financial reports including shareholders, creditors, employees, donors, and retirees by encouraging the balance sheet to better reflect the economics of the entity's pension and OPEB plans.

Transparency and Compliance of Pension and OPEB Funding Status

Credit Suisse estimates that in 2005, S&P 500 companies were underfunded $145 billion for pensions and $327 billion for OPEB that was not recognized in their financial statement. Presenting this nearly half a trillion dollars in underfunded pensions and OPEBs on the balance sheets for the S&P 500 companies would reduce their shareholders' equity by about 6.0 percent, or $248 billion, whereas some companies would experience more than a 25.0 percent decline in their shareholders' equity. This substantial decline in the book value of equity could have several effects on companies' key financial indicators. (12) First, declining book values of equity will increase price-to-book ratios, which makes companies appear more expensive based on a price-to-book ratio and could affect the determination of whether the company's stock is a growth index or a value index. Second, such a decline in book values affects the company's debt-to-equity ratio and, thus, debt/loan covenants, which may result in defaults or covenant renegotiations. Third, the recognition of unfounded pensions and OPEB could generate a substantial deferred tax asset for companies. Finally, many companies may choose to fund their pension and OPEB plans in order to prevent adversarial effects on their equity by either borrowing to fund their plans or using the cash that is on their balance sheet.