For many Americans, the thought of receiving a monthly pension check for life is quite comforting. In fact, it is one of the primary reasons that many individuals choose to work for a big company. There, particularly in "old economy" industries such as basic manufacturing, automotive, and telecommunications, where union leaders have battled hard to preserve such benefits, workers’ financial security traditionally has come in the form of guaranteed pension benefits (so-called "defined benefit plans"). Over the last two decades, however, newer "defined contribution" retirement plans (401k plans and the like) have gained popularity, as many companies have attempted to transfer the burden of retirement savings and investment risk from themselves to their employees. Today, more than half of all corporate retirement savings is held in such plans. Nonetheless, defined benefit plans still represent obligations for over 70 percent of the companies in the S&P 500 Index and millions of American workers still count on them. As has been widely reported in the press, many of these plans are in poor financial shape. This fact has important implications for investors and employees alike. In order to understand the scope of the problem, one must first venture into the sometimes arcane world of pension accounting.

In theory, a company should reserve an amount annually to cover the expected pension benefits of each employee upon retirement. The challenge of pension accounting begins with the complex calculation of this projected benefit obligation (PBO). The PBO represents the present value of the aggregate projected payout of pension benefits to all eligible employees over time. In order to calculate the PBO, a company must make certain heroic assumptions that can have a substantial influence over the size of this figure. The three most critical assumptions are: 1) the life expectancies of the plan’s beneficiaries; 2) the expected annual rate of increase in employee compensation; and 3) a discount rate that adjusts these figures for the time value of money. Due to accounting standards that provide companies huge leeway, small adjustments in any of these numbers can dramatically affect the contributions that a company is required to make to a plan and even the earnings that companies report to investors. It should come as no surprise that many companies have used this leeway to keep contributions down and earnings up.

Throughout the bull market of the 1990s, pension plan assets soared in value relative to underlying pension obligations. In aggregate, the difference between the fair value of plan assets and the PBOs of the companies in the S&P 500, known as the funded status, rose to approximately $272 billion by the end of 1999. Furthermore, due to the spectacular returns of pension assets and aggressive accounting assumptions, pension plans frequently became a large source of reported earnings and stronger balance sheets for many U.S. companies. To take just one example, General Electric, which is by most measures the largest U.S. corporation, ended 1999 with a funded status that totaled $24.7 billion. The contribution to GE’s reported earnings was even more dramatic. By the year 2000, its pension plan generated more than 10 percent of the company’s net earnings.

Unfortunately, the poor performance of equities from 2000 through 2002, combined with a relatively low level of corporate contributions to their pension plans, has resulted in a startling reversal of the aggregate funded status of U.S. corporate pensions. In fact, at year-end 2002, 89 percent of the companies in the S&P 500 had underfunded pensions, with an aggregate underfunded status of $218 billion¾ almost a complete reversal of the 1999 surplus. (The funded status of GE’s pension plan at year-end 2002 had been reduced from $24.7 billion to just $4.5 billion.) For the first time, Wall Street analysts have begun to focus on pension accounting and to incorporate it as a component of their quality of earnings assessments. Ironically, although legendary investor Warren Buffett and other savvy investors have been critical of pension accounting for years, it is only within the last 12 to 18 months that Wall Street analysts have decided that this issue deserves to be examined seriously. One positive development is that the Financial Accounting Standards Board (FASB) has stated that new regulations will soon be introduced which will require companies to disclose far more information regarding their pension plans and plan assumptions.

Employees: Employees clearly face the threat of reduced pension benefits in the future. While companies with solid financials will most likely take steps to secure their pension plans and the benefits of their retirees, others will surely look for ways to reduce the financial burden and uncertainty that accompanies poorly funded plans by paring benefits. Perhaps of greatest concern are the companies with weak financials that may be forced into bankruptcy; despite some government guarantees for retiree benefits, pension and health care benefits may be in jeopardy for employees of these companies.

In recent years, in an effort to make pension costs more manageable, many employers have chosen to convert traditional pension plans to "cash balance" plans. Cash balance plans calculate employee benefits based upon one primary factor: salary (as opposed to traditional defined benefit plans that incorporate salary, age, and years of service in their benefit calculation). This is similar to a 401k plan as it does not matter how old an employee is or how long an employee has worked at a company. However, there are no employee contributions or investment decisions as with a 401k plan. Employers claim that such plans provide enhanced benefits for a wider base of employees by reducing some of the longevity requirements, which is more attractive to today’s mobile workforce. Opponents, however, claim that these plans discriminate against older employees. In a recent high-profile case, a federal court ruled that IBM’s cash balance pension plan was indeed discriminatory. This controversial issue is presently under legislative review and will most likely result in new regulations.

Shareholders: Shareholders must assess the present status of a company’s pension plan and try to determine the extent, and potentially adverse implications, of higher pension liabilities. If companies begin to utilize more realistic pension assumptions, it will most likely lead to universally higher annual pension expenses, and therefore, reduced corporate earnings. Also, under current ERISA regulations, companies are required to make contributions to a pension plan if the fair value of plan assets falls below a mathematically determined percent of projected benefits. Thus some companies may take strong measures to improve the health of their pension plans, which could ultimately lead to lower earnings per share growth and higher debt levels¾ both of which could reduce investment returns.

The future of the U.S. corporate pension system is uncertain. Some companies have stated that they plan to discontinue their pension plan programs entirely and offer only defined contribution plans, especially if cash balance plans are eliminated. Others have taken measures to reduce the level of pension and health care benefits for retirees. At a recent investors’ conference, the CEO of a major U.S. industrial corporation stated that his company planned to continue relocating manufacturing operations to foreign nations in order to not only take advantage of low-cost labor, but also to avoid the costs of increasing pension and health care expenses for its U.S. employee base. Investors and workers alike have reason to urge that pension reform seriously address these concerns. The implications are quite clear: Unless this issue is addressed soon, many more individuals will be displaced from their jobs, while others will witness sharply reduced retirement benefits. —S.Amyouny