Saturday, September 18, 2010

Pensions... will Batman save us?

There's an interesting article in the Wall Street Journal today about pension assumptions in accounting, and another one in the NY Times (links below). Both hit close to home, because I see pension accounting as rather equivalent to Gotham city, this place with both nice skyscrapers and lots of dark alleys to hid in and meet with sketchy mob bosses. Why over-dramatize pensions into a city in need of a Batman-like rescue? I think there are a lot of things about pension expenses that the average American doesn't know (but should).

I realize that this is the moment where the eyes of most of my friends in the 40-and-under range usually glaze over and they quietly mutter to themselves 'who the heck cares about pensions?' Well, I do. And you should. Pension costs affect expenses for both companies and governments, and this in turn affects their stock prices (or in the government's case, our taxes). Thus pensions affect all age brackets, even those decades from retirement.

Ok, fine. Maybe I've convinced you to keep reading and maybe I haven't. But what I think people should realize is:

The time value of money [said in a booming James Earl Jones voice]

A common concept in finance is the time value of money. This is the idea that money appreciates over time if you invest it. Let's say 8-year-old Timmy has a keen investment sense, and wants to buy a $100 bicycle in 3 years. Timmy could put $100 under his mattress and wait 3 years, but since Timmy is finance-savvy he'll invest the money in a CD/money market/stock/whatever and it will appreciate. If Timmy earns 10% each year on his money, he only needs to save $75 now to buy the $100 bike in 3 years. The critical piece is estimating what % return you will receive. If Timmy earns only 2% a year instead of 10%, he needs to save $95 now rather than 75%. The % makes a huge difference.

Pension accounting relies heavily on the time value of money theory, because companies are trying to estimate how much money they need to save now to pay for pensions later on. I think it's a good thing that companies are required to include pension expenses on their balance sheet (they didn't use to be). But what I find rather deceiving is that each company gets to PICK what return rate they want to use. There's no industry or government standard required. So if Ford wants to estimate a 10% yearly return, they are free to do so (they have to disclose the % rate they use but it's buried deep in the 10K footnotes that most people skim or don't read). Most companies/governments use 7.5-9.5% return assumptions in order to minimize the "how much do we need to save now" cost number. But who the heck is earning 8-10% returns? CDs from banks are about 1% now. Stock market returns for the last decade are flat at 0%. Even if you take an average over the last 60 years, the S&P 500 (a benchmark of the average stock market performance) has earned about 7%. And even a small change in estimated returns makes a big change in cost today (as poor Timmy discovered).

So what's the real point? Be aware that the billions of pension expenses discussed by companies/governments in the news are just estimates, and they are estimates that (at least in my opinion) often fall short of what the cost will really be down the road. Companies/goverments' pension plans are grossly underfunded now, and would be even more so if return %'s were more realistic.

So, if you're thinking about investing in stock/bond for a company that offers pensions, check out their pension accounting footnote first! You can find company 10K yearly earnings filings here:
http://www.sec.gov/edgar/searchedgar/companysearch.html

And once you're there, the pension footnote is usually called "Retirement Benefits" or something similar. You're looking for the return % that is called "Expected Return on Assets"

Ford looks like this (the US Plan column is the main one... do you see the 8.25%?)



Pension Benefits









U.S. Plans


Non-U.S. Plans


U.S. OPEB



2009


2008


2009


2008


2009


2008

Weighted Average Assumptions at December 31 (a)


















Discount rate


5.86 %

6.50 %

5.68 %

5.95 %

5.74 %

4.95 %
Expected return on assets


8.25 %

8.25 %

7.17 %

7.11 %




4.67 %
Average rate of increase in compensation


3.80 %

3.80 %

3.15 %

3.13 %

3.80 %

3.80 %
Initial health care cost trend rate (b)

















5 %

























Assumptions Used to Determine Net Benefit Cost for the Year
























Discount rate (c)


6.50 %

6.25 %

5.93 %

5.58 %

4.95 %

5.81 %
Expected return on assets


8.25 %

8.25 %

7.11 %

7.26 %

4.67 %

7.17 %
Average rate of increase in compensation


3.80 %

3.80 %

3.13 %

3.21 %

3.8



You can also tell how underfunded a company is in another chart in the same footnote (again, this one's from Ford).

Look about 2/3 down the chart to "Funded status at December 31" --- for 2009 it's (6,181). Since the report is in millions, this means Ford is $6 BILLION underfunded... ie, even if they did earn 8.25% every year, they'd need to be saving $6B more now than they have to be able to pay pension expenses down the road! Yikes!
Pension Benefits









U.S. Plans


Non-U.S. Plans


Worldwide OPEB



2009


2008


2009


2008


2009


2008

Change in Benefit Obligation (a)


















Benefit obligation at January 1

$ 43,053

$ 44,412

$ 20,382

$ 25,558

$ 19,065

$ 28,096
Service cost


343


378


251


301


408


326
Interest cost


2,693


2,682


1,193


1,321


899


1,456
Amendments





4


(54 )

117


(175 )

(928 )
Separation programs


12


334


121


42


2


13
Curtailments








(19 )







(1 )
Settlements








(1 )

(58 )

(13,637 )


Plan participant contributions


27


25


80


101


40


42
Benefits paid


(3,908 )

(3,960 )

(1,456 )

(1,380 )

(1,673 )

(1,628 )
Medicare D subsidy














67


68
Foreign exchange translation








1,927


(4,779 )

253


(478 )
Divestiture











(6 )





Actuarial (gain)/loss and other


2,418


(822 )

921


(835 )

804


(7,901 )
Benefit obligation at December 31

$ 44,638

$ 43,053

$ 23,345

$ 20,382

$ 6,053

$ 19,065
Change in Plan Assets (a)
























Fair value of plan assets at January 1

$ 37,381

$ 45,696

$ 14,707

$ 21,396

$ 2,786

$ 3,875
Actual return on plan assets


4,855


(4,480 )

1,692


(2,036 )

792


(1,011 )
Company contributions


136


138


968


1,209






Plan participant contributions


27


25


80


101






Benefits paid


(3,908 )

(3,960 )

(1,456 )

(1,380 )

(62 )

(77 )
Settlements








(1 )

(58 )

(3,517 )


Foreign exchange translation








1,581


(4,510 )





Divestiture











(3 )





Other


(34 )

(38 )

(7 )

(12 )

1


(1 )
Fair value of plan assets at December 31

$ 38,457

$ 37,381

$ 17,564

$ 14,707

$

$ 2,786

























Funded status at December 31

$ (6,181 )
$ (5,672 )
$ (5,781 )
$ (5,675 )
$ (6,053 )
$ (16,279 )

























Amounts Recognized on the Balance Sheet (a)
























Prepaid assets

$ 13

$ 15

$ 101

$ 53

$

$
Accrued liabilities


(6,194 )

(5,687 )

(5,882 )

(5,728 )

(6,053 )

(16,279 )
Total

$ (6,181 )
$ (5,672 )
$ (5,781 )
$ (5,675 )
$ (6,053 )
$ (16,279 )
Amounts Recognized in Accumulated Other Comprehensive Loss (b)
























Unamortized prior service costs/(credits)

$ 1,895

$ 2,268

$ 433

$ 557

$ (2,799 )
$ (3,510 )
Unamortized net (gains)/losses and other


5,705


4,858


6,100


5,163


1,772


611
Total

$ 7,600

$ 7,126

$ 6,533

$ 5,720

$ (1,027 )
$ (2,899 )
Pension Plans in which Accumulated Benefit Obligation Exceeds Plan Assets at December 31 (a)
























Accumulated benefit obligation

$ 25,686

$ 24,975

$ 16,707

$ 11,649








Fair value of plan assets


20,248


20,044


12,034


7,171

































Accumulated Benefit Obligation at December 31 (a)

$ 43,756

$ 42,279

$ 21,975

$ 19,197






Ok, that's it for the accounting standards soapbox. But maybe one soul in a million will check out a footnote one day and make this rant worth it :o)


The news articles mentioned above:
WSJ
NY Times

2 comments:

  1. "Be aware that the billions of pension expenses discussed by companies/governments in the news are just estimates, and .....often fall short of what the cost will really be down the road."

    Excellent, well-thought out analysis! There is much to be concerned about regarding 'future pension debt'. This will affect us all e.g., prices of goods (for companies with excessive debt) and for government retirement systems: where there is no end to their ability to tax the populace to make up for 'shortfalls'.

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  2. I am just catching up on your old blog posts, but the unknown pension debt factor makes me giggle. My grandfather is 94, going strong, and has been collecting a pension for like 40 years! Poor Kodak never saw that coming.

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