by Alvin D. Lurie

Soon You’re Talking Real Money--Pretty Damn Soon--When New Pension Accounting Rules Take Hold

With new and potentially very costly developments bearing down on pension plan sponsors from all sides, it has become almost as difficult to figure out what poses the greatest current threat to pensions as to walk down the street in Baghdad or Tel Aviv trying to anticipate where a sniper may be lurking. By my count there are presently four matters any one of which has the clear and immediate potential to destroy what’s left of the defined benefit pension regime: the pending pension reform legislation that the conference committee in Congress has been attempting to craft for over one month at this writing; the revised rules of accounting for pension liabilities proposed by the powerful Financial Accounting Standards Board in an exposure draft released March 31^st; the decision of the 7^th circuit court of appeals in the IBM cash balance litigation that could be announced any time now; and, though not directly affecting qualified pension plans, the proposed regulations issued by Treasury and IRS under Code section 409A governing nonqualified deferred compensation arrangements.

The first two will greatly increase the costs (at least the visible, transparent costs) of maintaining a defined benefit plan, to the point of causing termination or freezing of numerous plans by sponsors already disenchanted with and leery of the financial risks of carrying such plans, and driving countless companies towards, and even into, bankruptcy as a result of the immediate liabilities and balance sheet impact of the emerging rules.

The IBM appeals court decision, if it sustains the trial court’s holding that the company’s cash balance and pension equity plans were violative of the age discrimination prohibitions of federal law, will surely accelerate the dropping of such plans that 70 percent of the S&P 500 companies had gravitated towards in the past decade as a way of escaping the unforgiving and unpredictable liabilities of their previous traditional defined benefit plans; and it will surely prompt many other companies that had considered adopting cash balance plans to abandon that course, because when employers have no way to insulate themselves from the worrisome exposure to which they can be subjected under traditional defined benefit formulas, such plans will disappear, except where imposed by collective bargaining or other special circumstances.

The impact of the 409A regulations on defined benefit plans is less obvious, inasmuch as the statute explicitly excludes them from its coverage. But the impact is nonetheless discernible, since resort to nonqualified compensation arrangements has often been a satisfactory way to compensate executives and other highly compensated employees without enriching the benefits of rank-and-file employees under a qualified plan; so companies have been content to maintain an affordable defined benefit or other types of qualified plan for employees across-the-board as long as the complementary NQDC approach was also available to satisfy the requirements of executives they sought to recruit. Hence, the great popularity of excess benefit plans and SERPs. But the new 409A rules are so fraught with complexity and, indeed, uncertain, if not unexpected, application in many cases, which the proposed regulations have not abated – in fairness, often cannot abate (without doing violence to the presumed legislative intent) -- that many companies, especially in the small business sector, will no longer turn to the NQDC approach, and, not having that as a partial escape hatch, will doubtless be less inclined to provide a qualified plan -- except, perhaps, a 401(k) plan wholly or mainly funded by employees’ pre-tax contributions.

GM Hits A Speed Bump

The title of this piece surely telegraphs to the reader of these lines that its topic is the newly proposed pension accounting rules. Of the above listed four threats to pensions – more accurately, threats to plans sponsors themselves – the FASB exposure draft has received the least attention in the press and is certainly the least known to plan sponsors. But it carries the greatest possible risk for corporate sponsors. A recent headline in the Wall Street Journal captures that point arrestingly:

For GM, Pension-Accounting Shift Could Dwarf Gain on GMAC Deal Wall Street Journal 4/5/06, p. C3

As everyone who reads the financial pages knows, GM is reeling from a string of blockbuster losses – most recently and spectacularly, last year’s $10.6 billion loss – as well as long-standing employee retirement benefit liabilities (so-called legacy costs), and bloated labor costs from bitter labor-management battles of bygone years (one drawing particular criticism now, the "jobs bank", assuring workers of pay for non-work or make-work during long intervals when there is no work for them to perform), all of which is compounded by the success on GM’s home turf of that pesty competitor from the Pacific Rim that has stolen market share and is about to overtake GM’s long-time standing as the #1 auto maker in the world. These have brought the one-time colossus to the point that its bonds now rate the inglorious "junk" designation, and whispers of its imminent bankruptcy have turned to shouts. And, so, much relief, not just in the GM boardroom, but on the N.Y. Stock Exchange floor and in financial houses on the streets that surround it, greeted the sale of a majority stake in the company’s crown jewel and only current profitable unit, GMAC, yielding the parent a hefty $10 billion in the current year, with more to follow in the out years.

But ironically, if not cruelly for GM and its rooters, that FASB exposure draft hit the street almost simultaneously, and with it came the realization – at least among financial mandarins – that the company’s liabilities for underfunded pension and welfare plans – a staggering $68 billion figure -- if required to be recorded as liabilities on the balance sheet at the end of this year, would not only erase the benefits of the GMAC sale, but actually turn a multibillion dollar stockholder equity into a negative $43 billion equity deficiency, according to the Wall Street Journal piece. The potential cascading consequences of this for the once giant from Detroit are legion: declining credit rating, slumping stock value, increased borrowing costs, an already dicey financial condition, and the prospect of inability to honor future obligations as they mature – the law’s classic definition of insolvency. These, already southbound, one would have to think, will not stop their dash until reaching the Deep South and beyond.

A Problematic Solution

Barring forces that I cannot possibly forecast – like a government bailout such as accompanied the meltdown of a previous major U.S. auto maker – these would seem a not unlikely scenario to follow from the FASB’s high-minded goal, inter alia, of enhancing the "employer’s ability to carry out the obligations of its plans," by making the supposed (we will get to that momentarily) true state of the company’s funding, or insufficient funding, of pensions and other post-employment benefits transparent to its benefits plan participants, stockholders and other interested observers, principally by dredging such numbers up from the footnotes, where they currently reside, and on to the balance sheet proper, or by converting footnote information into balance sheet values. In the main, the FASB proposals are not seen as increasing the actual long-term costs of a plan, but merely treating the deferred funding of those costs as liabilities directly on the company’s balance sheet; "merely", however, is the wrong word for something with the dire consequences already noted.

Besides, it is problematic whether recording unfunded pension benefit obligations as balance sheet liabilities overcomes the problem identified in the FASB press release accompanying its exposure draft, that "current incomplete accounting makes it difficult to assess an employer’s financial position. Labeling as a "liability" an obligation to pay benefits for perhaps hundreds of thousands of participants at a future time, out of a pool of assets that will rise and fall with the vagaries of the stock market and will be regularly enhanced by contributions geared to continuously changing actuarial assumptions as to interest rates, deaths, retirements, quits and possibly other factors pertinent to a particular business from time to time, can be more misleading to the uninitiate (which includes practically everyone except the actuaries involved) than not putting on the balance sheet what appears like a hard number but is at most an educated guess. Recent experience with the "perfect storm" several years ago – low interest rates and a bear market – that wreaked such havoc with pension "liabilities" is still fresh in the minds of most people in the field, but will quickly be forgotten as the raging bull of a market and rising interest rates wipe out most of the scary funding deficits that had appeared so ominous.

I can attest to how impenetrable, even to a lawyer in the field, is the current method of reporting, not just because of the obfuscation facilitated by footnoting, and the near impossibility of tying the balance sheet numbers to the footnote commentary, but also because there is a disconcerting disparity between GAAP methodology and actuarial modalities in the matter of pension liabilities, in large part because the standard accounting practice has been to consider as accruing periodically over future years liabilities that will not have to be satisfied until projected retirements and, therefore, filtering the resulting fractionalized liability into the balance sheet over time. This was brought home forcefully to me some years ago when I observed the polite dueling between two fine practitioners of those learned disciplines as they endeavored to explain to my client and me, from the vantage points of their disparate perspectives, the condition of the client’s plan and the corporation’s resulting financial exposure. The seeming disconnect between the balance sheet and the message in the footnotes, whether or not the product of deliberate obscurantism, only adds to the confusion.

Cost Matters

In weighing the merits of the FASB proposals, one must factor in the enormous accounting costs that will be entailed in complying, should the new proposals be adopted. It must be understood that numerous other compatible accounting accommodations to the accelerated recognition of benefit liabilities rule will be required under the proposal, including restatement of prior years comparative balance sheets and of retained earnings, as well as changes in the so-called other comprehensive income (OCI) account, in which are recorded such things as unrecognized prior service cost and actuarial gains and losses (very meaningful to actuaries, much less so to the rest of us), revised statements of shareholders’ equity, e.g., to reflect new charges to equity and possible valuation allowances affecting equity and net income. Expanded footnote disclosures are also to be mandated, for example, to deal with periodic benefit cost in the following year arising from delayed recognition of actuarial gains and losses, and also with prior service costs and credits. There are more, like the requirement to tie liability measurements to the date of the statement, rather than a date months before.

The transition alone from present to proposed practice requirements will pose its own difficulties. While income statements per se are not affected by the current proposals, the requirement to restate balance sheets prospectively will, it appears, necessitate in many cases revision of prior income statements. These all involve complicated and costly accounting procedures. GM can deal with that, you might properly observe. But multiply the GM restatement experience by hundreds of thousands of employers, some large, many more small, who be unable to handle the accountant’s fees, let alone the hit to their financials, with the attendant consequences noted above.

Nota bene: the FASB announcement does not speak to additional funding to ameliorate the underfunding. That is outside the province of the accounting standards body (and of this little essay); but can one doubt that spelling out and spotlighting the funding shortfalls on a company’s financial statements will lead to pressures, at the least from its plan participants, to make up the perceived underfunding?

Besides, underfunding is very much in the province of the congressional conferees engaged in reconciling the pension reform legislation of the two houses, and a matter of concern to the Administration, that has already spoken forcefully to that very point, even threatening a presidential veto if the legislation does not meet the White House’s criteria. That legislation, if ultimately passed into law (still not a certainty), will decidedly add to the financial burdens of the remaining, albeit ever shrinking body of, DB plan sponsors, compounding the unhappy prospects already touched upon above, again in the name of assuring that pensioners get their promised benefits.

Pressing Policy Question

Who would not want to see pensioners get their pensions? But there is a policy question to be resolved when the means to that end carries the very real potential for destruction of the pension provider and thus of the plan itself, so that not only are future pensions imperiled, but the jobs on which such pensions depend are lost, as the sponsor goes down the tube. No goose, no golden eggs. I am often struck by the seeming overreaction of the stock market to bad news (a lost patent suit, a failure to hit one’s sales or earnings projections by fractional percentages, the indictment of a CEO) affecting just one listed company. Can you imagine if the potential impact of the proposed accounting rule changes were to be replicated for, say, just five listed companies, let alone for hundreds of thousands of companies across the land.The Milliman actuarial firm, in its just released annual survey of the 100 largest plans, states that the pre-tax charge to stockholders’ equity would have increased by $222.2 billion last year, if the FASB proposal, presently scheduled to be in force in CY 2006 (or fiscal years ending after 12/15/06), had been in effect in 2005. I did say soon you’re talking real money (make that " a real crash" of the order of 1929).

The FASB has announced it will take comments until May 31^st, with the object of issuing its final Statement of Financial Accounting Standards on this subject in September. The congressional conference committee chairman, Sen. Mike Enzi, was looking to complete the work of the conference this past April 7^th, timed to precede the imminent pension contributions due in mid-April. That obviously didn’t happen.

Nor, it is becoming increasingly clear, is it likely to happen any time soon. As I write this, I have on my desk a remarkable statement by Rep. Harry Reid, the House Minority Leader, that appeared in print April 11, expressing his concern with "the lack of progress being made in conference on reaching a final agreement on the pension reform bill." In fact, he says, "To this point, little movement has been made to bridge the differences between the House and Senate bills." I’d say that is very encouraging. (You read that right.) There are indeed vast, fundamental differences between the two bills. They will not be satisfactorily dealt with under the pressure of a timetable that was originally established, as we have seen, with the view to providing legislation in time to permit it to govern the first quarter’s pension contributions due April 15, 2006.

It turns out that that was not really so critical, since plan sponsors can base all their quarterly contributions for 2006 on their 2005 minimum funding requirements. There is now no other real or even colorable pressure to produce a bill by any date certain before 2007. If it appears that some temporary safe-harbor measure might be needed to facilitate contributions for some categories of plan sponsors pending final legislative action, that can readily be accomplished.

A Word To The Wise

It would be best if everyone involved in the reform efforts, from the Congress, to the White House to the FASB, stepped back and took the time necessary to get all of this right the first time around. If they don’t, the second act could be ugly. "Right" by my lights means don’t focus so intently on "protecting" participants by stringent rules of dubious efficacy that you risk crippling the plan sponsors on whose financial wellbeing rest the survival of the plans, the participants’ jobs, the plan sponsors themselves, and ultimately the economic health of the nation. Minority Leader Reid put it very well:

"The conference agreement should strike a proper balance between improving

pension funding and keeping these plans an attractive benefit option for employers.

While there is a trend away from defined benefit pension plans and this trend is likely

to continue, rules should not be enacted that exacerbate this problem."

I couldn’t have said it better.