If someone promised annualized returns of 9% to 10% in today’s economy you’d be right to be skeptical. So why are big companies such as General Mills (NYSE:GIS), First Energy (NYSE:FE), Johnson & Johnson (NYSE:JNJ) and Honeywell (NYSE:HON) assuming such a high level of return on their pension funds? Audit Integrity’s Jim Kaplan gives his opinion in this guest post excerpted from his latest Chairman’s Corner.
The front page article in the October 16 Wall Street Journal, “Pension Funds Flee Stocks in Search of Less-Risky Bets,” was a real eye-catcher.
I can understand the motivation to reduce risk in view of the fact that Funds generally have taken on far more risk (or blame) than good judgment dictates. The eye-catching part of the headline, however, is the disparity between risk reduction and the increased Return on Assets (ROA) assumptions that many Funds are declaring. If they have found a low-risk, high-return alternative, I’m certain the rest of us would be eager to know about it!
The reasons this doesn’t make sense are twofold. Pension Plans are reducing risk and, by implication, reducing their potential rate of return. Secondly, expected returns on investments are approaching a historic low. By what logic are companies using return assumptions as high as 10%?
The table below represents some (but not all) of the companies that, ignoring market conditions, have ROA far in excess of market averages. Some have even had the audacity to raise their ROA in 2010. None of the companies listed has a portfolio asset allocation that would be considered high risk/high return; most have equity exposure less than 70% of total assets and realistically should expect a long-term return lower than 7%.
What does this mean to the investor? An unrealistic return assumption could be masking operating problems, or could be indicative of accounting games.
Raising the appearance of profitability in the short term only increases damages down the road when pension expenses increase. I strongly suggest that stakeholders carefully assess their holdings to ensure that they are not basing their expectations on improper representation of the companies they own.
Investment in a 30-year bond, assuming no default, yields 4%. Stocks, a far riskier asset class, bring expected returns to no more than 7%. It is not reasonable to expect long-term return on assets to exceed a rate somewhere between 4% and 7%. Based on quantifiable facts, corporate Pension Plans should be reducing the long-term expected ROA to reflect market conditions. Instead, many corporations have elected to maintain or raise their return assumptions to outrageous levels. Why?
The answer is obvious. Higher return assumptions reduce current pension expenses, raising earnings.
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