The juxtaposition, though completely circumstantial, is delicious. A day after Warren Buffett released his annual letter to Berkshire Hathaway
Buffett, a long-term finger-wagger at the pitiful state of corporate ethics and conduct, had this suggestion for investors: "Beware of companies displaying weak accounting. If a company['s] ... pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely that they are following a similar path behind the scenes."
While I wouldn't call GE a "severe accounting abuser," its labyrinthine business leaves plenty of room for earnings management, something the company has done unabashedly in the past. This past year, GE CEO Jeffrey Immelt intimated that those demanding increased disclosure of operations should be careful what they wish for, as the company could provide mountains of information.
That didn't happen, fortunately. But GE did seem to conform to the letter of the accounting law, and not the spirit, by burying in a footnote that its pension fund lost more than $5 billion in 2002, even though it reported more than $800 million from pension fund gains. Under pension accounting treatment, companies are supposed to report actuarial returns, not actual ones. Dollars above the fully funded pension amount can be counted toward ordinary earnings. GE's expected returns were estimated to be 8.5%, so the fact that the fund actually lost more than 11% didn't matter.
(And people say stock options accounting would "distort" GAAP earnings. Pffffft.)
This multibillion-dollar actual loss equals 30% of GE's reported earnings for the year. Moreover, the company will have to adjust all of its actuarial tables to recalculate for the loss in principal. GE's 500,000 pensioners need not worry about their retirement; the company reports that it's still overfunded.
Yes, but overfunded how? Companies are allowed to set their own expected returns for pension assets. GE recently dropped its expected return from 9.5% to 8.5% per year. Now, 8.5% returns may not seem like a lot, but remember, it's not like these funds can just roll the dice in the stock market -- they are widely diversified among stocks, bonds, and government paper.
GE's useful investment avenues are minimized by the fact that doubling a $100 million investment means next to nothing; 8.5% is a fairly high hurdle, and 9.5% is nuts. In the past, Buffett has suggested that a 6.5% maximum return is safest. But companies have incentive to maintain higher expected rates because the "overfund" can be counted as earnings. In such an environment, "safety" becomes tertiary. Change the percent just a little bit, and the overfunded portion rises dramatically. It's the law of compounding turned sinister.
GE handled this disclosure properly. But did they handle it well? Certainly not. It's nowhere in the annual report's "Management's Discussion and Analysis" section. Yes, GE is extraordinarily complicated, but a $5 billion loss of capital seems to warrant at least a mention, doesn't it?
Starting this year, the SEC has asked companies to provide improved disclosure of actual pension performance after a 2002 study of more than 500 annual reports showed a general deficiency and a poor reflection of financial reality. GE's discussion of its pension returns falls far below this goal.
Buffett's remarks may have been targeting much less reputable companies, but he appears to have hit General Electric right between the eyes.
Bill Mann owns shares of Berkshire Hathaway.
