U.S. companies have no shortage of reasons for wanting
to phase out their traditional defined benefit (DB) pension plans in favor of less expensive alternatives. Now, add putting a sizable chunk of shareholders' equity at risk to that list.
In November, in response to criticisms about murky disclosures on the funding status of retirement plans, the Financial Accounting Standards Board (FASB) voted unanimously to issue new guidance that would ultimately compel companies to include the difference between their assets and accrued liabilities from pension plans and retiree medical and life insurance plans on corporate balance sheets rather than handle them, as they have, in innocuous footnotes. Although companies do not have to abide by phase one of the new rules until they file yearend 2006 statements, studies are already indicating that the likely impact of the FASB's tougher stance could be a serious reduction in shareholders' equity.
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A broad study by Watson Wyatt Inc., the Arlington, Va.-based consultancy, considered the balance sheet accounting for the 1,000 largest U.S. public companies, just less than 600 of which have retirement provisions that would qualify for the new accounting treatment. It found a reduction in shareholders' equity of 9.5%, or $312 billion when taken together. Those findings were further substantiated by a smaller survey conducted by professional services firm Towers Perrin in which the 78 largest public U.S. companies that sponsor defined benefit plans would stand to lose as much as $180 billion in shareholders' equity, a 9.3% hit.
Admittedly, these liabilities are made public in footnotes, and many equity and credit analysts already make adjustments to the balance sheets of those companies that would be most affected by the first phase of the FASB proposals. That doesn't mean some shareholders won't be caught off guard by in some cases, dramatic reductions in shareholders' equity, but at least large institutional investors should not be. "Hopefully, investors have factored this in already, but we won't know until companies start complying with these changes," says Ken Steiner, resource actuary at Watson Wyatt.
The impact of the balance sheet changes will vary widely by industry. Manufacturers of durable goods that sponsor DB plans could see as much as a 25% hit on their shareholders' equity, according to Watson Wyatt estimates, with service sector companies, and those in transportation, communications and the utility sectors also suffering double-digit percentage losses. Phase II of the proposed FASB rules are meant to close the gap between U.S. and international accounting standards, and may be several years away. Changes being considered include new guidance on how to recognize and report benefit plan costs on the income statement and how to measure obligations.
The impacts of the Phase I balance sheet changes could trigger other issues as well. "By the end of 2006 for these companies, the appropriate financial ratios, such as debt-to-equity, for bond ratings are likely to change," says David Chittim, senior vice president, investments at Mellon Asset Management in Pittsburgh. "You will not have historical comparability."
He adds that the asset management for pension plans will have to be more coordinated with the financial characteristics of the company. "It may be a catalyst to increase demand for types of strategies that better align assets and liabilities to offset interest rate risks," says Chittim.
A sizable reduction in shareholders' equity could also force companies into new negotiations with bank lenders. "If there are loan arrangements whereby there are certain requirements in shareholders' equity, loan covenant language could cause lenders to perhaps call in loans they may not feel as comfortable with," says Steiner of Watson Wyatt. "Most lenders are savvy enough to know nothing really has changed, but some may have covenants that allow them to call in those loans." Whether these changes are enough to drive major corporations away from traditional DB plans probably depends on other factors, including pending pension reforms being hammered out by Congress and the White House. They probably won't help, however. "It's certainly possible that CFOs will view this as adding to the potential volatility of having these types of plans," says Steiner.
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