The mechanics aren’t that complicated. Pension managers make a number of assumptions when they estimate the size of their pension liability, such as how long employees will work, what their annual pay increases are likely to be, whether they’re married, and how long they’ll live. One of the most powerful assumptions used to determine the size of the pension obligation is the “discount rate.” A lower discount rate produces a higher liability, because if a company assumes that the assets in the pension plan will grow at a rate of 5 percent a year, it will need more money in the fund today than if it’s assumed to grow by 7 percent.
Pension managers can’t just pull any number out of a hat; they generally use a rate based on long-term, high-grade corporate bonds to calculate their benefits obligations. But companies have some wriggle room, and even seemingly small differences can have a big impact. In 2009, for instance, Lockheed decreased its discount rate from 6.4 to 6.1 percent, which boosted its pension obligation by $1.7 billion.
Great Expectations
Another key assumption is the “expected rate of return” on pension assets. This isn’t the assumption used to measure the size of the liability; it’s the assumption used to measure the pension plan’s impact on quarterly income. Odd as it may sound to people who hear about it for the first time, accounting rules permit pension managers to use hypothetical or “expected” returns on their pension assets—instead of the actual returns. This is intended to smooth out the impact of the investment returns, so that a year of large increases or decreases doesn’t affect earnings dramatically. This “smoothing mechanism,” which employers insisted on having when the rules were developed, gives companies a great deal of control over the amount of pension income or expense.
Researchers at Harvard University and MIT analyzed filings from more than 2,000 companies and found that companies near critical earnings thresholds had boosted their estimated returns the prior year. One of the companies was IBM. As its operating performance was deteriorating in 2000 and 2001, in the wake of the tech bubble bust, the company raised its expected return from 9.25 percent to 10 percent. The increase in the assumed return accounted for nearly 5 percent of IBM’s pretax income in 2000 and 2001.
The researchers also found that firms used higher expected returns on pension assets prior to acquiring other firms. “Managers may want to raise reported earnings… both to boost the price of stock that might be used as currency in such transactions and to generate greater bargaining power in the bidding process,” they concluded. In addition, they found that firms raise their assumed returns when they issue equity and when their managers exercise stock options.
Using expected returns to boost income isn’t the only way companies can use pensions to manage earnings, but these other ways have received little or no scrutiny. For example, underestimating the return on the pension assets can also render a benefit. For much of the nineties, the average expected rate of return companies used was 9 percent, even though returns were usually in the double digits, and exceeded 30 percent in some years. When the assumed (i.e., “expected”) return is lower than what the pension assets actually return, the excess gains—the amount that exceeds the expected returns—are set aside. Over time, companies add some of these excess gains into future years’ earnings calculations, a process called amortizing. By 2000, there were billions of dollars in “actuarial gains” sitting in reserves. When pensions had huge losses in the early 2000s, companies used these gains to cushion and delay the impact on earnings. (The reverse is also true: If losses are greater than the expected returns, the excess losses are parked on the sidelines and get added to the income calculations in subsequent years.)
Contributing Factors
Stuffing money into a pension plan is another way companies manage the timing and size of an income boost. When Lockheed Martin contributed $2 billion to its pension in 2010, the 8 percent expected return on assets guaranteed the aerospace-and-defense giant a $160 million boost to the bottom line in 2011, regardless of whether the company made any money selling jets. And because pension contributions are deductible, Lockheed was able to shave $64 million from its taxes.
The accounting and tax breaks explain why companies with well-funded pension plans happily shovel money into them. Why let a billion dollars in cash sit around unproductively when parking it in the pension can be so rewarding? Being able to park money in pension plans has so many rewards that employer groups have perennially lobbied to be allowed to put as much as they’d like into the plans. (Current law doesn’t let companies deduct contributions to pension plans once the level of assets reaches 150 percent of the plans’ liabilities.)
Companies also have a variety of reasons to adjust their assumptions to make their pension appear less well funded, or even terminally ill. This might be helpful prior to union negotiations or layoffs.
Mergers and acquisitions can offer companies an opportunity to monkey with the numbers. Prior to putting itself up for sale, a company may want to cut benefits or take other actions to make itself look more profitable.
Or perhaps it might want to sell some of the surplus. This was a common enough scenario that it was the topic of a panel at an annual actuaries conference in Colorado Springs in the summer of 1996. The panelists put on a skit involving a company that has asked its actuary to help increase the liability for the pensions of the transferred employees and retirees, so the company can justify transferring more assets than necessary and get cash in return, built into the sales price. The actuary does this, but is later called before a standards board and asked to justify the assumptions he used.
The “prosecutor,” played by the chief actuary at the American Academy of Actuaries, asks the actuary to defend his decision to use a 1951 mortality table to calculate the liability.
PROSECUTOR: Didn’t you choose these assumptions… so you could transfer as much money as possible to the buyer?
BAD ACTUARY: No, these are miners, so their life expectancy is not nearly as great as that of the general population.
PROSECUTOR: How much did you get for them in the purchase price? Is it 80 percent or 90 percent?
BAD ACTUARY: Well, it turned out that way in this transaction.
But he defends his actions saying he was just doing what his client wanted.
The skit concludes with the “prosecutor” telling the “bad actuary” that he’s done a good job. “Someday the PBGC is going to… make an example of somebody. So when you get involved in these areas, make sure you’re ready to answer all those questions. Have your answers ready.”
None of this was illegal, but it shows how routine these sales transactions were.
ACCRUAL WORLD
The pension income charade began to change after the market tanked in 2001. When the market was rising in the nineties, few analysts noticed that falling pension obligations and 30 percent investment returns were fluffing up profits, and companies didn’t go out of their way to call attention to it, preferring instead to let investors give company executives all the credit.
But when pension plans began losing money from 2000 through 2002, in part because managers had loaded them up with stock to boost pension income, companies quickly blamed the pension plans for their financial woes. Securities analysts who had been oblivious when pensions were pumping up income began cranking out reports dissecting the many ways pension plans were hurting earnings. These newly minted pension critics didn’t notice that companies could manage earnings by adjusting discount rates, dumping money into the plans, or cutting benefits. But they did notice that companies were using expected returns of between 8 percent and 10 percent. In 2002, for example, GM assumed a 10 percent return, even though assets actually lost 5.2 percent. Companies had been using the same 8 to 10 percent assumptions for years, including those when assets were earning 30 percent, but analysts acted as if they’d discovered the next Enron, and they cranked out even more reports. Even Warren Buffett, chairman of Berkshire Hathaway, weighed in, scolding companies for
“legal but improper accounting methods used by chief executives to inflate reported earnings. The most flagrant deceptions have occurred in stockoption accounting and in assumptions about pension-fund returns. The aggregate misrepresentation in these two areas dwarfs the lies of Enron and WorldCom.”
The market plunge had smoked out accounting innovations at Enron, Lucent, Nortel, Tyco, Waste Management, and WorldCom, most of which involved management efforts to bump up the share price by manipulating earnings. Many of these practices involved “accrual accounting,” i.e., the way companies report such things as debts and reserves. Retiree benefits are a form of accrual accounting, too, subject to the same manipulation but not to the same scrutiny.[9]
Chapter 4
HEALTH SCARE
Inflating Retiree Health Liabilities to Boost Profits
COMPANIES HAVE BEEN PLAYING even more elaborate games with their retiree health plans. These health plans are essentially medical pensions that employers have promised to decades of workers. If someone worked long enough to earn retiree health benefits, then, when he retired at fifty-five or later, his employer’s medical plan would continue to cover him until he qualified for Medicare at age sixty-five. Some plans, particularly for unions, provided a Medicare supplement, covering things like prescription drugs.
And then, in 1992, companies began sending letters to hundreds of thousands of retirees, all of which contained eerily similar messages: “Health care costs continue to skyrocket,” wrote McDonnell Douglas. Health care costs were “skyrocketing,” wrote R.R. Donnelley. In these letters, Sears, Caterpillar, Unisys, and scores of other employers, citing “spiraling” health care costs, all informed retirees that, regretfully, they had no choice but to cut benefits.
The companies blamed a new accounting rule—FAS 106—for the changes. The rule was similar to the one employers had adopted with pensions a few years earlier in that it required companies to estimate their obligations for the health coverage they would provide to retirees—current and future—and report the obligation to shareholders. When the companies did this, they claimed to be shocked to find that the costs were so high. This, they said, called for hard choices, and regretfully, they would have to cut benefits. It was a matter of survival.
Though corporate America acted as though it had just discovered it was sitting on a neutron bomb, CFOs knew well ahead of time what the charges would be. Major companies, including IBM and GE, had worked with the Financial Accounting Standards Board (FASB) to create the rules, as they had with the pension rules, and had persuaded the accounting board to build in as much flexibility as possible. As with pensions, companies had substantial leeway to raise or lower their obligations by changing the assumptions they used, including interest rates, expected returns on assets, employee turnover, marriage rates, retirement age, and mortality rates. But companies had another powerful lever for manipulating the numbers: the health care inflation assumption (also known as a “health care trend rate”). Despite its name, this isn’t an actual measure of inflation in the cost of hospital stays, premiums, or prescription drugs. Rather, it’s simply a company’s estimate of the increase in what it might pay, based on undisclosed factors. In other words, they can pretty much make it up.
With so much control over the size of the liability, one might expect employers to use a low health care inflation rate, since this would make their obligations look smaller. But many companies did just the opposite, choosing to assume that double-digit health care inflation would persist for decades. They did this even though most experts at the time believed that the worst period of health care inflation was over and the rate of increase was declining, thanks to the spread of managed-care programs, which were intended to reduce unnecessary health care costs. (By 1995, in fact, health care costs were flat, before trending upward again.) Among the pessimists who continued to predict steady inflation were Kimberly-Clark (16 percent), Teledyne (11.5 percent), and Allied-Signal (12 percent).
These high inflation assumptions, combined with other assumptions, including that benefits plans would never change and that the retirees would live a really long time, led to whopping obligations. As the companies had hoped, the media was awash in stories about this new, unexpected threat to the viability of the nation’s largest companies. A sample from late 1991: “Automakers Face Massive Charges” (Associated Press); “Rude Awakening on Health Costs…. The numbers are shocking many” (Los Angeles Times); “New Medical-Benefits Accounting Rule Seen Wounding Profits, Hurting Shares” (The Wall Street Journal). The industry-funded Employee Benefit Research Institute estimated that the total impact on companies could be as great as $2 trillion.
There was little downside to putting huge retiree liabilities on their books. Securities analysts and shareholders tend to ignore earnings hits that are the result of accounting changes that all companies must adopt. Speaking candidly to consultants at an actuarial conference in 1996, Ethan Kra, then the chief retirement actuary at William M. Mercer, summed up Wall Street’s sentiment: “The Street views FAS 106 obligations as ephemeral.”
Reporting a giant retiree liability was also an opportunity for some big-bath accounting, a process in which publicly traded companies pile a lot of bad items into a single year, so subsequent years’ income will look better by comparison. It could also be called “you can’t fall off the floor” accounting. Expecting costs from layoffs? Need to write off that bad loan? Doing badly anyway? Get all the bad news out of the way at once, so when net income rises in subsequent quarters, even if only a little, management will look like a hero for turning things around.
PUMP AND DUMP
McDonnell Douglas was one of the first companies to claim the sky was falling. In 1991, the giant aerospace-and-defense contractor lost a lucrative Department of Defense contract to develop a stealth aircraft because of perpetual delays and cost overruns. It was in need of an earnings lift, and FAS 106 came at a fortuitous time. McDonnell Douglas adopted the new accounting rule in January 1992, estimating that health care costs would rise 15 percent a year and that the benefits would remain unchanged. This produced a shocking obligation, for which the company took an immediate $1.5 billion after-tax charge.
But just nine months later, McDonnell Douglas pointed to those whopping costs and announced it would phase out all health coverage for its twenty thousand nonunion retirees. “Health care costs continue to skyrocket,” explained John McDonnell, then the company’s chief executive, in an October 7, 1992, letter to retirees, adding that there was also a new accounting standard that “threatened to deal a heavy blow to our bottom line.”
I’m writing to tell you we’ve found a solution. It may seem complicated at first glance, but, when all is said and done, you will have the same coverage under the new plan…. So here’s what we’re going to do. First, health care coverage provided by McDonnell Douglas to non-union retirees will end Dec. 31, of this year, and retirees are then responsible for obtaining and paying for their own coverage. BUT, second, as of that date, coverage identical to what you have had (but arranged by McDonnell Douglas, rather than provided by McDonnell Douglas) will be made available to you.
What was really happening: McDonnell Douglas would be paying for the additional coverage—using pension assets—for four years. After that, well, the retirees would pick up 100 percent of the costs (with their premiums being subtracted from their pensions). McDonnell maintained in his letter that this plan, which supposedly would enable retirees to continue their benefits “without denting your pocketbook,” would save the company millions. In fact, McDonnell Douglas’s pump-and-dump maneuver gave it a pretax gain of $698 million. Without the gains from cutting retiree medical benefits, the company would have had a loss for the year. Companies could take the gains all at once, even if the cuts wouldn’t take effect until later; the bigger the bath, the bigger the pile of gains.
CFOs and consultants didn’t call attention to this, and most analysts were oblivious to the way non-cash gains from benefits
plans were enhancing income. But one prescient observer, Jack Ciesielski, an independent accounting analyst in Baltimore, warned in a 1994 client newsletter that the new rules gave employers an incentive to inflate their liabilities. “Companies that were the most adversely affected may have made the most dire assumptions in setting up their postretirement benefits liabilities—and thus have the largest ‘reserves’ to call upon should they need a little earnings help in the next economic downturn,” he wrote. “It’s programmed-in earnings improvement…. By bulking up their assumptions, they created a piggy bank of earnings improvers.”
McDonnell Douglas illustrates another key difference between pensions and retiree health plans. While federal law dictates that companies can’t cut pensions that have already been earned, this is not the case for health plans. Unless the benefits were protected by a union contract (and sometimes not even then), companies could pull the plug on benefits that employees, including retirees, had already earned.
McDonnell Douglas’s profits came at the cost of thousands of retirees like Robert Taylor, who joined the company shortly after the Second World War and retired in 1979. He died four years later, at age seventy-nine, just when the company started passing the costs on to the retirees. As the company phased out its share of the coverage, the retirees’ share grew, until they were paying 100 percent of the costs. Rhada Taylor, Robert’s widow, continued to get the coverage, which supplemented Medicare and covered such things as prescription drugs. Initially, the premium she paid for this was $168. As is common practice, the company deducted the ever-increasing premium from her widow’s pension of $420 a month. The premiums increased bit by bit each year, and by 2000 her pension had disappeared altogether, leaving her with only a Social Security check of $1,009 a month to live on.
Retirement Heist Page 7