Heightened Pensions
Reminder to Verizon Communications
shareholders: You should send a thank-you note to the company's pensioners.
Those dusty, old defined-benefit plans helped turn a down year into a
profitable one.
How's that possible?
The numbers tell the story: In 2001, the telecommunications behemoth reported a
profit of $389 million, not bad considering the year brought substantial
operating losses and a 5 percent decline in Verizon's
stock price.
The pension plan,
it appears, came to the rescue. According to the annual report, income from Verizon's pension plan totaled $1.8 billion. The pension
plan, the report states, earned an impressive 9.25 percent return in 2001.
Verizon,
mind you, isn't doing anything criminal; this is no Enron. It's perfectly legal
for companies to add income from investment gains in their defined benefit
pension plans to the bottom line. Nor do they hide that fact from investors;
it's an assumption written directly into annual reports (although sometimes you
have to go hunting through footnotes and appendices for the details).
What's unsettling,
though, is that Verizon's pension plan didn't really
earn 9.25 percent last year. The pension actually lost money-$3.1 billion, to
be more exact.
That's because Verizon, like many other companies, is allowed to assume an
expected rate of return for its defined benefit pension plan. Informally known
as "smoothing," it's a method of ironing out the good years and the
bad to guarantee a consistent rate of return. The theory is that in the long
run everything will balance out. Income from pensions is understated in years
when the stock market is strong --as in much of the go-go 1990s -- and
overstated when the market is down, as it is now.
Such assumptions,
however, aren't always reasonable. That's an issue brought to light in a
compelling recent study by Milliman USA, a benefits
consulting firm. The study looks at the assumed rate of return for 50 of the
largest
That said, some big names are on the list, with expected rates of
return as ambitious as Verizon's. IBM's expected
return on its pension plan was 10 percent in 2001. Ford's,
9.5 percent. Coca-Cola? A
mere 8.5 percent. The average for all 50 companies was 9.38 percent.
Most companies Milliman studied kept their rates of return the same from
year to year. A few, such as gas and oil giants Phillips Petroleum and ChevronTexaco, lowered their expected rates of return in
2001, anticipating a rough year in the market. Given the S&P 500 was down
13 percent, I'd say they were onto something.
Eight companies, on
the other hand, actually increased their expected rate of return in 2001, by as
much as 100 basis points. Such expectations, Milliman's
study concluded, are "optimistically high." There's an
understatement! Based on these assumed rates of return, the 50 companies
studied reported a combined $54.4 billion of profits from pension fund investments.
In reality, those pension funds lost $35.8 billion -- a difference of more than
$90 billion. That's the problem with real earnings; they just never sound as
good as manufactured ones.
We'll have to wait
and see what happens in 2002, but so far the estimates are at best mediocre:
According to benefits experts Mercer Human Resource Consulting, the median
corporate pension plan earned 1 percent in the first quarter of 2002. I've said
it before: A market doesn't bottom at six- or 12-month lows,
it bottoms with 10- or 15-year lows.
Shareholders have a
right to be upset. Many companies claiming to have earned profits actually may
have lost money. Remember that management bonuses and stock option contracts
are often tied to profit levels. Adding pension income into the equation is
just another way to jack up earnings results and, in turn, the bonuses. It's an
even bigger concern for those 15 million people who currently live on their
pension plan, not to mention those who expect to. My own father collected a
pension from Borden Company, then a diversified corporation, for 17 years until
he passed away.
People with pensions from the
companies in Milliman's report may not be so lucky.
These funds made substantial gains in the 1990s, finishing the decade in
surplus. Only eight pension plans among the 50 companies surveyed were underfunded in 1999. By 2001, more than half were in the
red.
The folks at Milliman aren't worried that these pension funds will go
bankrupt, but I'm concerned just the same. Companies believe their assumed rate of returns reflect historical figures, but they quickly
forget there have been long periods of time when the stock market did
absolutely nothing. In 1966, for instance, the Dow Jones Industrial Average was
trading around 1,000. By 1982, it was down to 800. It's hardly surprising that
during the 1970s and 1980s, many companies had seriously underfunded
pensions.
Unless something
changes, these pension plans will only become more underfunded.
Some companies may be forced to cut back on defined-benefit plans or infuse
large amounts of money into pension funds to pay out current retirees. That's
going to be an enormous drain on profits and earnings. Don't forget one of the
reasons the steel industry is in so much trouble today is the massive pension
obligations built up over decades.
In the post-Enron
era of transparency and honest accounting, it's good to see these games are
under scrutiny. Recently, the debt-rating agency Standard & Poors announced it would start calculating a new type of
core earnings that deducts the expenses associated with employee stock options
and pension income. As a result, many companies will find their earnings are
much lower than current calculations would have us believe. Cisco Systems, for
instance, would have lost more than twice as much as it reported last year,
using the S&P's new formula.
It still shocks me that more isn't done about
common practices that short change investors. Regulators spend so much time
looking for major offenses that they can neglect smaller, more-insipid ones
that chip away at confidence in our economic system every day.
Updates are available at http://www.jimrogers.com/.
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