From Smoothing To Market
By: Gary E. Stoller
Much has been said and written about General Motors and the effect of its pension and benefits obligations on its financial reporting and, ultimately, its business operations. GM has stated that US$1,500 of every car sale goes towards its healthcare costs. It is a company with a market cap of US$20 billion and pension plan assets of US$90 billion. So the question then becomes: ‘Is GM a car company that has a pension plan, or is it an insurance company that sells cars?’ The GM example illustrates that pension and benefits plans have become an increasingly important and prominent issue in the 21st century. In retrospect, this occurrence was inevitable given the continued growth in the size of pension plans and the numbers of retirees. Plus the population is aging, and both pension and healthcare costs grow as people get older.
But it has been disconcerting for some in the pension and benefits industry to see these arrangements appear in the headlines of the business news and, sometimes, even on the front page of the newspaper.
The financial position of most Defined Benefit pension plans has deteriorated since the late 1990s. Firstly, three successive years of poor investment returns in 2000, 2001, and 2002 created losses against the anticipated amount of assets available to pay for these benefits. Then, even though returns in subsequent years of 2003, 2004, and, thus far, in 2005 (up to June 30) have generated investment gains, these have been offset by growth in plan liabilities from consistently lower long-term interest rates.
Due to the prevalence of smoothing techniques that are permitted under generally accepted accounting practices (GAAP), these losses could continue to plague company income statements for many years into the future.
The accounting concept of smoothing of financial results for these programs, enabling recognition of losses and gains to be deferred for many years, has been roundly criticized. There is a clear trend toward market pricing of pension and benefit obligations and increased transparency in their reporting. Formal changes in the accounting rules to a mark-to-market approach are inevitable. But to ensure that the financial reporting remains meaningful, operating results should be insulated from capital market volatility.
In the United Kingdom, accounting standards have addressed this by splitting the profit and loss account into three components:
- Operating expense, representing the current cost of benefits, equaling the service cost, adjusted by any additional costs from benefit improvements, settlements, or curtailments
- Financing costs, representing the difference between the interest cost and expected return on plan assets, if any
- Statement of recognized gains and losses, which is the balancing item, reflecting the difference between the actual and the expected return on any plan assets, other experience gains and losses, and the effect of changes in assumptions
This breakdown helps users in isolating operating results (the first two components) from market volatility (the last one).
The Canadian Institute of Chartered Accountants (CICA) has, for the time being, maintained the existing accounting standards under its Handbook Section 3461, which permit smoothing of plan assets and deferred recognition of the costs of benefit improvements and experience gains and losses. It did adopt amendments which, since mid-2004, have required that considerably enhanced disclosures be added to the financial statement notes. These disclosures are intended to help users better assess the financial positions of pension and benefits plans, which may be masked by the permissiveness built into the rules. Perhaps the CICA chose this approach because it is similar to that adopted by the U.S. accounting authorities.
In spite of these recent changes, many industry observers believe they are only a first step. There is still an expectation that market-based pricing of these obligations for financial reporting purposes will eventually be required in both Canada and the U.S. These changes could be linked to an initiative which has undertaken this approach within the international accounting standards under IAS 19 (which apply in many countries that do not have their own accounting rules).
Until these changes are made, users will need to carefully review pension and benefits accounting reported within financial statements. In some cases, they may feel obliged to adjust the figures to gain a better picture of the plan’s financial position and costs and to reflect the possible impact of the plans on the sponsor’s operations. It will only be the ultimate adoption of market- based rules that will bring all users into a level playing field with better information for all.
Gary E. Stoller is a partner at Morneau Sobeco.
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