The topic of defined benefit plans, pensions for retired employees, is not as glamorous as discussing earnings, earnings growth, return on assets, return on investments, cash flows, etc. But it is an integral part of the day-to-day operations of companies that offer them and deserves a more in-depth look. After reading over the SFAS 87, I realized the process of accounting for pensions is incredibly arbitrary and misleading, and allows companies to keep losses off of the income statement for indefinite periods of time. The FASB has a long-standing history of bowing to corporate interests and their pet politicians when writing new accounting standards, and current pension accounting standards are no different.
Current Pension Accounting Standards
I am not going to go into the nuts and bolts of current pension accounting standards as that would cause this article to be way too long, and would probably put most of you to sleep. Instead, I will go over the basic problems that are inherent in accounting standards for pensions.
- Losses/gains attributed to an increase/decrease of the pension liability (due to changes in actuarial assumptions -- i.e., if life expectancy decreases, this would cause the liability to be reduced due to fewer expected payouts) are not recognized on the income statement. Instead, they are shoved into an Accumulated Other Comprehensive Income account called AOCI.
- Current pension expense is reduced by the expected return on pension assets. Yes, you read it right: Expense is reduced by a percent of pension assets that is deemed reasonable by whoever manages the pension.
- Any returns that are higher or lower than the expected return are added into the AOCI account, and netted with the losses and gains from the pension liability.
- If a company wants to increase its defined benefit payout formula (theoretically a firm could decrease it, but this is uncommon), the extra cost of increasing the pension liability is put into another AOCI account called Prior Service Cost (PSC) and is then amortized (recognized through pension expense) over the average expected employment duration of all employees -- i.e., total PSC/average years of employment expected = amount recognized in pension expense each year.
- The net loss/gain in AOCI can only be recognized if it is greater than 10% of the pension liability or asset, whichever is greater. Then the difference is amortized over the average expected employment duration of all employees until the net loss/gain is less than 10% of whichever account is greater.
Basically, companies are allowed to defer losses and gains (mostly losses) associated with pensions indefinitely. This accounting does not show the true economic situation of companies, and is extremely misleading. To prove my point, here are some real-world examples:
On pg. 120 of the company's most recent 10-K, it currently has a $2 billion loss in its AOCI account, half of which was incurred in 2011. This is about 25% of 2011 net income. Coca-Cola only had to recognize $135 million of this loss in its income statement.
Page 97 of PepsiCo's most recent 10-K shows that it has a $4.4 billion loss sitting in its AOCI account, two-thirds of its total 2011 net income. PepsiCo only had to recognize $145 million of this loss in its income statement.
General Motors (NYSE:GM)
Page 144 of GM's most recent 10-K shows a $1.3 billion loss in its AOCI account, about 13% of its total 2011 net income. Not as big of a number as I was expecting, considering the company's total pension liability is over $100 billion.
Current pension accounting standards need to be completely overhauled. Allowing companies to "smooth" their income by keeping real pension losses and gains in an equity account is mind-boggling. These standards are a product of the intense political and corporate pressure that is applied to the Financial Accounting Standards Board when executives don't want their bonuses put in jeopardy. In my world, economic reality is preferable to blissful ignorance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.