3 June 2002 - Heightened Pensions

            Reminder to Verizon Communications shareholders: You should send a thank-you note to the company’s pensioners. Those dusty, old defined-benefit plans helped turn a down year into a profitable one.

            How’s that possible? The numbers tell the story: In 2001, the telecommunications behemoth reported a profit of $389 million, not bad considering the year brought substantial operating losses and a 5 percent decline in Verizon’s stock price.

            The pension plan, it appears, came to the rescue. According to the annual report, income from Verizon’s pension plan totaled $1.8 billion. The pension plan, the report states, earned an impressive 9.25 percent return in 2001.

            Verizon, mind you, isn’t doing anything criminal; this is no Enron. It’s perfectly legal for companies to add income from investment gains in their defined benefit pension plans to the bottom line. Nor do they hide that fact from investors; it’s an assumption written directly into annual reports (although sometimes you have to go hunting through footnotes and appendices for the details).

            What’s unsettling, though, is that Verizon’s pension plan didn’t really earn 9.25 percent last year. The pension actually lost money-$3.1 billion, to be more exact.

            That’s because Verizon, like many other companies, is allowed to assume an expected rate of return for its defined benefit pension plan. Informally known as “smoothing,” it’s a method of ironing out the good years and the bad to guarantee a consistent rate of return. The theory is that in the long run everything will balance out. Income from pensions is understated in years when the stock market is strong –as in much of the go-go 1990s — and overstated when the market is down, as it is now.

            Such assumptions, however, aren’t always reasonable. That’s an issue brought to light in a compelling recent study by Milliman USA, a benefits consulting firm. The study looks at the assumed rate of return for 50 of the largest U.S. corporations offering defined-benefit-pension plans. Many major companies, such as Walmart, weren’t on the list because they don’t offer a defined-benefit plan. These companies more often offer defined-contribution plans, like 401(k)s, which dictate the amount of money you can contribute into your plan, but not the amount you’ll be paid when you retire, as with pensions.

            That said, some big names are on the list, with expected rates of return as ambitious as Verizon’s. IBM’s expected return on its pension plan was 10 percent in 2001. Ford’s, 9.5 percent. Coca-Cola? A mere 8.5 percent. The average for all 50 companies was 9.38 percent.

            Most companies Milliman studied kept their rates of return the same from year to year. A few, such as gas and oil giants Phillips Petroleum and ChevronTexaco, lowered their expected rates of return in 2001, anticipating a rough year in the market. Given the S&P 500 was down 13 percent, I’d say they were onto something.

            Eight companies, on the other hand, actually increased their expected rate of return in 2001, by as much as 100 basis points. Such expectations, Milliman’s study concluded, are “optimistically high.” There’s an understatement! Based on these assumed rates of return, the 50 companies studied reported a combined $54.4 billion of profits from pension fund investments. In reality, those pension funds lost $35.8 billion — a difference of more than $90 billion. That’s the problem with real earnings; they just never sound as good as manufactured ones.

            We’ll have to wait and see what happens in 2002, but so far the estimates are at best mediocre: According to benefits experts Mercer Human Resource Consulting, the median corporate pension plan earned 1 percent in the first quarter of 2002. I’ve said it before: A market doesn’t bottom at six- or 12-month lows, it bottoms with 10- or 15-year lows.

            Shareholders have a right to be upset. Many companies claiming to have earned profits actually may have lost money. Remember that management bonuses and stock option contracts are often tied to profit levels. Adding pension income into the equation is just another way to jack up earnings results and, in turn, the bonuses. It’s an even bigger concern for those 15 million people who currently live on their pension plan, not to mention those who expect to. My own father collected a pension from Borden Company, then a diversified corporation, for 17 years until he passed away.

People with pensions from the companies in Milliman’s report may not be so lucky. These funds made substantial gains in the 1990s, finishing the decade in surplus. Only eight pension plans among the 50 companies surveyed were underfunded in 1999. By 2001, more than half were in the red.

            The folks at Milliman aren’t worried that these pension funds will go bankrupt, but I’m concerned just the same. Companies believe their assumed rate of returns reflect historical figures, but they quickly forget there have been long periods of time when the stock market did absolutely nothing. In 1966, for instance, the Dow Jones Industrial Average was trading around 1,000. By 1982, it was down to 800. It’s hardly surprising that during the 1970s and 1980s, many companies had seriously underfunded pensions.

            Unless something changes, these pension plans will only become more underfunded. Some companies may be forced to cut back on defined-benefit plans or infuse large amounts of money into pension funds to pay out current retirees. That’s going to be an enormous drain on profits and earnings. Don’t forget one of the reasons the steel industry is in so much trouble today is the massive pension obligations built up over decades.

            In the post-Enron era of transparency and honest accounting, it’s good to see these games are under scrutiny. Recently, the debt-rating agency Standard & Poorsannounced it would start calculating a new type of core earnings that deducts the expenses associated with employee stock options and pension income. As a result, many companies will find their earnings are much lower than current calculations would have us believe. Cisco Systems, for instance, would have lost more than twice as much as it reported last year, using the S&P’s new formula.

It still shocks me that more isn’t done about common practices that shortchange investors. Regulators spend so much time looking for major offences that they can neglect smaller, more-insipid ones that chip away at confidence in our economic system every day.