Get used to it. Thanks to the PPA and accounting rule changes, finance executives in charge of pension plans will now have to start thinking of themselves more as risk managers than investment strategists, as pension funding levels and costs move from the footnotes to balance sheets–and perhaps soon, to the income statement itself. "These events combined to shine a spotlight on pension funds as risky investments," says Joe McDonald, head of Hewitt Associates global risk services.

And it is likely to get worse before it gets better, given pending FASB proposals and recent discussions with the International Accounting Standards Board (IASB) on reconciling the U.S. accounting system with the one used in most of the rest of the world. The ticking timebomb, of course, is Phase II of FAS 158, which would record fund gains and losses as part of net income. This has the potential of creating swings of hundreds of millions in dollars in earnings. Phase II could come as early as 2010, says Peter Proestakes, manager of FASB's post-retirement project. "We are actively considering the portion of Phase II that deals with the aggregation of the cost components," says Proestakes. "Ongoing meetings with the board should begin in the next couple of months."

When, and if, Phase II is implemented, companies, consultants and investment advisers unilaterally expect to see dramatic disparities between operating income and net income, a development that industry watchers consider nothing less than revolutionary. "When that penny drops, it will change the pension world," says Andy Hunt, senior strategist in BGI's strategic solutions group. William McHugh, chief pension strategist at JP Morgan Asset Management, amplifies the alarm: "We are looking at the most dramatic changes in pension accounting since ERISA (the Employee Retirement Income Security Act of 1974)," says McHugh.

If that sounds like hyperbole, there is data to back it up. Average operating earnings would have been 51% lower in 2002 and 10% higher in 2006 if pension assets and liabilities were included, according to Charles Mulford, an accounting professor at Georgia Institute of Technology. Mulford says the data argues against a unilateral earnings change in the second stage of 158. While shareholders and analysts should be able to clearly see pension gains and losses, he suggests that gains and losses resulting from fair value pension accounting are not equivalent to gains and losses incurred in selling products and services.

Indeed, in some instances, portfolio movement could affect earnings more than business operations. "It could result in an inverted yield curve," explains Hewitt's McDonald, as it has in the U.K., where regulators are about three years ahead of FASB in implementing disclosure rules.

FASB's Proestakes isn't concerned. "We as an organization are not trying to drive any type of behavior," Proestakes says. "We just want to make sure that DB accounting reflects underlying economics."

As FASB heads toward Phase II implementation, it is also monitoring the impact of FAS 158′s first stage. So far, that change–which took effect with calendar year 2006 financial statements–barely moved share prices. But it has shown up in shareholder equity, or book value–making some companies big winners and others big losers, according to data compiled by Standard & Poor's Compusat in a study of 297 Fortune 500 companies that had DB and other post-retirement benefit plans in calendar year 2006. The change in shareholder equity was $136.8 billion in reductions and $5.7 billion in gains, Compustat reported. At General Motors Corp., for example, shareholder equity showed a deficit of $5.4 billion in 2006, versus a gain of $14.9 billion a year earlier after reporting the funded status of post-retirement benefit plans on the balance sheet. Compustat attributed about 75.7% of that change to the new accounting rules, with the rest linked to unrelated financial factors. In contrast, Qwest Communications International Inc. reported a $1.08 billion gain in shareholder value over 2006, compared to $3.2 billion deficit in 2005 .

Slowly, corporations are waking up to the risk and are looking at other alternative investments to hedge interest rates and volatility, including options swaps, longer duration bonds, real estate and PPA-approved 130/30 hedge funds. (A 130/30 ratio implies shorting stocks up to 30% of the portfolio value and then using the funds to take a long position in stocks the investor feels will outperform the market.) "Investment policy has started changing to move out of public equities," says Mark Ruloff, director of asset allocation at Watson Wyatt Investment Consulting.

More sophisticated investment options, such as interest rate derivatives and longevity indexes, are already proving successful hedges and prudent investments in the U.K, which is about three years ahead of the U.S. in implementing accounting changes, says BGI's Hunt, an Englishman brought over from London by BGI to help build U.S. pension LDI strategies. In fact, a few multinationals are evaluating the strategies of their U.K. units with an eye to borrow them for U.S. operations, Hunt notes.

Watch out, however, because FASB is watching that trend as well. Already, as companies move to alternative investments to hedge risk, the agency has worries that "current disclosures of plan assets are not detailed enough to determine what types of assets are held in post-retirement benefit plans," according to a FASB staff memo. "Disclosure of more specific asset categories would enable users to better assess the timing, uncertainty and amount of future cash flows related to an increase or decrease in the value of plan assets," the memo stated.

An increasing number of companies at least appears to be aware of the need to review investments. A Hewitt survey of 190 mid- and large-size companies with pension plans suggests that the speed of DB plan closures is slowing, and one of the reasons: "We see companies investigating alternative methods of improving pension plan management, which mitigates financial and other risks," says Alison Borland, defined contribution consulting practice leader at Hewitt. If they make the right choices, DB plans won't be so volatile.

About 85% of the companies surveyed say they won't modify DB plans this year, twice as many as last year. Only 3% said they are very likely to close their plans and only 2% said they are very likely to freeze them. And even those that haven't cut back on equities are considering taking action now. Thirty percent said they plan to perform an asset liability study, 29% said they are very likely to assess the risks that their pension plans are running based on current strategies and 63% said they are very likely to perform funding and accounting projections. "Every company is at least revisiting its posture now," says McDonald. "But not all of them will take steps to reduce risk."