Pension prop-up disclosure urged

The booming stock market, and changes in pension plans, are boosting the earnings of some companies, and the Securities and Exchange Commission wants investors to know about it.

Just in time for annual report season, it is reminding companies that it expects them to discuss upfront the extent to which pension fund earnings boost their bottom lines.

The SEC warning comes as scores of large companies have retooled their pension plans into cash balance plans, frequently cutting pension liabilities in the process.

At the same time, the exuberant stock market has boosted pension fund assets, producing huge pension surpluses for hundreds of companies.

Consequently, many companies are reporting higher earnings, not from operations, but because they are able to include pension surpluses in their income.

Current accounting rules permit this and don’t require a discussion beyond a footnote in financial reports. The SEC is putting companies on notice that it expects those with sizable pension income to discuss it in the text of annual financial reports, in the management’s discussion and analysis of financial conditions and results of operations section.

In a Dec. 22 letter to the American Institute of Certified Public Accountants, SEC chief accountant Lynn E. Turner wrote: “If a company has made a change in its pension plan, or activity in the plan itself, such as gains or losses on investments, are reasonably likely to have a material impact on financial condition, liquidity, or results of operations of the company, then that information should be disclosed in the MD&A.”

That section of the annual report, Mr. Turner’s letter explained, focuses on “material events” that would cause the reported financial results to not necessarily predict the company’s future operating results or financial condition.

Thus, the SEC wants companies to discuss if they have converted their plain vanilla pension plans to cash balance plans or altered their pension plans in any way that would result in lower pension liabilities or reduced contributions. Also, the SEC wants companies to discuss pension liabilities that have shrunk because of the booming stock market.

Although the SEC did not spell it out in its letter, companies should be prepared to discuss changes in pension assumptions that could result in higher pension earnings, says Jack Ciesielski, president of R.G. Associates Inc., a Baltimore-based investment research firm.

“This is not a paint-by-numbers exercise. They are not going to tell you everything, but logically that is something that ought to be mentioned,” says Mr. Ciesielski, who also publishes the Analyst’s Accounting Observer newsletter.

Keith Ambachtsheer, president of K.P.A. Advisory Services Ltd., a Toronto-based investment research and consulting firm, agrees.

numbers without substance

By fiddling with their assumptions about how much they can expect to earn on their pension assets, or the interest rate they use to discount their liabilities, companies have a lot of room for using “good-looking numbers that are not going to create sustainable earnings and that should be pointed out to investors,” he says.

Moreover, companies should be prepared to disclose if their pension income or expenses — and therefore the bottom line — were affected by a one-time event such as shutting down a pension plan, explains Peter Knutson, associate professor emeritus of accounting at the University of Pennsylvania’s Wharton School in Philadelphia.

The SEC’s directive was not unexpected. Alarmed at the number of companies that have benefited hugely from their pension income in recent years, SEC officials had been looking at this issue for some time.

And while only a handful of companies so far have discussed their pension income in their annual financial statements, many more should be prepared to do so as a result of the SEC’s new initiative.

One company that has been forthright about its considerable pension income propping up its bottom line is the U.S. Steel Group of USX Corp. in Pittsburgh. The company, whose work force has dwindled to around 20,000, has a sizable pension fund supporting its nearly 100,000 retirees and, in essence, makes more from its pension fund than from selling steel.

The company logged a $373 million pension credit in 1998, up from $287 million in 1994, which enabled it to record a $201 million credit — instead of reporting any selling, general and administrative expenses — in fiscal 1998.

Moreover, the company is frank in telling shareholders that its earnings could drop if its pension income falls. “To the extent net pension credits decline in the future, income from operations would be adversely affected,” the company states in its discussion of financial results.

Lucent Technologies Inc. in Murray Hill, N.J., also discussed its pension income at length in its 1999 annual report, issued in October.

It told shareholders that its pension liabilities fell as a result of a change in the way it accounts for its pension and retiree health care costs. Moreover, the company said its pension income “is expected to continue in the near term.”

Lucent’s pension fund contributed 15% of its operating income in 1998, according to a September 1999 analysis by Pat McConnell of Bear Stearns Cos. Inc. in New York.

Northrop Grumman Corp., which has reported steadily growing pension income in recent years –$266 million in 1998, up from $39 million in 1996 — and told investors that its pension income was due to the booming stock market, also plans to discuss the effect of its pension fund on its bottom line this year, according to Bob Bishop, a spokesman.