Brace yourselves, investors. There's another big earnings booby trap lurking out there. Like other recent market stunners, companies set this one for themselves during the late 1990s when their traditional pension plan investments were earning outsize returns. Thanks to the wizardry of pension accounting, companies could apply those gains to their bottom lines, where they worked wonders on stock prices. Now, of course, most pension-plan returns stink. And the effect on corporate profits will be anything but wonderful. Stock prices are already signalling the message: Poor pension-plan returns will depress earnings for years.
General Electric Co. (GE
), long criticized for using its plan to boost earnings, foreshadowed the trend late last year when it warned in a Securities & Exchange Commission filing that this year's pension earnings would drop between 5 cents and 7 cents a share from 2001. Soon after, General Motors Corp. (GM
) said lower fund earnings were a factor in the quadrupling of pension expenses since 2000. A parade of industrial companies--including DuPont (DD
), Delphi Automotive Systems (DPH
), Dow Chemical (DOW
), Caterpillar (CAT
), U.S. Steel (X
), Exxon Mobil (XOM
), and Ford Motor (F
)--followed suit.
The fall in pension earnings doesn't mean that companies will have trouble paying pensioners. That's because in the looking-glass world of pension accounting, the plan earnings that companies report are based on long-term projections that are not reconciled with actual earnings for years. Many companies say their plans did so well during the bull market that, despite the stock market rout, they won't have to contribute extra money for years.
But the days of flush plans are over for now. And that will hit corporations in several ways. First, some companies will have to start contributing again. More will have to stop tapping surpluses to cover other retiree expenses.
Most important, the post-Enron skepticism about accounting is forcing companies to cut their assumptions for 2002 and beyond. "The auditors are putting a much closer eye to pension numbers," says John Ehrhardt, a principal and actuarial consultant at Milliman USA. Most companies are calculating higher future costs of providing for pensioners and that is hurting their earnings. Such a change accounts for about one-fourth of Delphi's higher pension expense in 2002, says John D. Blahnik, treasurer at the General Motors spin-off.
Companies are also basing projected returns on smaller portfolios--though they still haven't fully marked them down to their current market value. That's because they can average the value of portfolios over five years, so 1999 stock prices are still inflating some returns.
An even touchier issue is the assumption companies make on how much their pension portfolios will earn. GE decided in November to trim its rate to 8.5% from 9.5%. Sounds small, but that cut could cost GE more than $550 million, a hit of 2% to pretax income.
Dow Chemical Co. says it cut its assumed rate of return to 9.25% from 9.5% last year, helping knock $100 million off its pretax results in 2002, vs. a $45 million boost in 2000. Whirlpool Corp. (WHR
) said in a Feb. 5 conference call that it had cut its rate to 10% for 2002 from 10.5% last year. If the 50 biggest companies with pension plans all sliced one percentage point from their projections, their collective pretax income would fall $5.2 billion, according to consultants Milliman.
Why are companies fessing up to poor pension results only now? After all, the bear market started 23 months ago. The reason is that accounting rules let companies delay reporting big changes in pension earnings for several years. But with plans losing value in 2001, many companies decided it was safer to come clean about the widening gap between pension projections and reality.
The pension rules are a chief financial officer's dream--and an investor's nightmare. Each year, executives project a long-term rate of return for plan investments. The higher the rate, the cheaper the cost of providing the plan. In fact, if pension earnings exceed costs, the CFO can add the surplus to the bottom line. In 2000, about a third of the companies in the Standard & Poor's 500-stock index did so, boosting pretax income 12% on average, says Jane B. Adams, accounting analyst at Credit Suisse First Boston,
Companies can get away with off-base projections for years, and they can trickle out the adjustments over about 15 years. They argue the rules are good because they keep pension-plan returns from causing wild swings in earnings. But critics, including investor Warren E. Buffett, say companies abuse them to gussy up weak results. Actuary Adrien R. LaBombarde at Milliman says, "You're delaying the inevitable and when it catches up to you, the change may be severe."
Pension accounting frustrates even the most inquisitive investors because most companies don't disclose clearly the assumptions they've used until after the yearend. Pension analysts say many companies are sticking to optimistic assumptions despite the stock market weakness in the past two years--though in fairness, most underestimated pension returns in the 1990s. The companies in the S&P 500 projected 9.18% on average in 2000, a survey by consulting firm Watson Wyatt & Co. shows, and probably stuck with that in 2001. But the top plans eked out 1.3% gains in 2000 and lost about 8% in 2001.
Investors will start to get the bad news about pensions in the next few months as companies file their annual reports with the SEC. In a sign of things to come, Deere & Co. (DE
), the tractor company, reported that its pension investments lost $1.3 billion for its fiscal year ended Oct. 31, when it had figured they would appreciate by $600 million.
Deere will likely be the first of many to deliver nasty surprises to shareholders. Auto parts maker Delphi, which employs 200,000 people, says pretax pension expenses will rise nearly 75%, to $300 million from $173 million, in 2002. Its plan assets contracted by 6% in 2001. Delphi posted a pretax loss of $528 million for 2001 after restructuring charges. While about one-fourth of the added pension expense comes from early retirements, half reflects shrinking plan assets, says Blahnik. Caterpillar Inc. says diminished pension-plan assets are a factor in shaving $121 million, or 35 cents a share, from earnings in 2002. DuPont says its plan will chop about $155 million from earnings this year after adding $65 million in 2001 and $105 million in 2000. In 2001, stainless-steel maker Allegheny Technologies Inc. (ATI
) booked $53.1 million in pension income and still reported a $25 million loss. This year, plan income will fall by half, adding to the red ink.
Some companies say they won't change the assumptions about returns on their pension plans just because of a few bad years in the market. "We're saying where we think returns are headed over the next 30 years," says Delphi's Blahnik. The company is sticking with its 10% assumption, which proved conservative over the last 10 years when its plans earned 12.8% per year on average, he says.
Still, predicts Milliman's Ehrhardt, more companies will follow GE's lead to avoid criticism. If he's right, the impact will be worse in 2003. Ehrhardt expects companies will try to offset the hit to earnings by cutting employee benefits. Because of the arcana of pension accounting, the bear market will take a toll even after it's over.
By David Henry in New York and Michael Arndt in Chicago, with Diane Brady in New York and bureau reports
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