Armchair Economists

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By howardroark
February 25, 2002

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Oh, things to do on a Saturday afternoon...let's see...paint shopping with the 400th NY Times article in as many weeks days on a new sliver of hope for peace prospects in Angola, Sri Lanka and Bruce Willis in a film well known as "Not Diehard" on TNT...actually utilize non-metacarpal body parts in strange place known as (?!)...converse with myfavoritemartian on the nuances of pension accounting disclosures? No brainer.

Still not sure about the 105. And I'm not sure about these numbers. If the net under funded cost of the plans went up from 282m to 587m why wouldn't the real charge to net income be 305m?

Here's the brief, simplified course in pension accounting that you always wanted for Christmas instead of that Sarah Jessica Parker tie (ok, so I'm splitting between the Willis flick and the pension banter).

Pension accounting is largely actuarial, which means it is largely theoretical. Pension costs, usually embedded in G&A on the income statement, reflect in part assumptions about how things were expected to go in the given period and not necessarily how things actually went. The reason for this is accounting's sometimes view of itself as the wise but benevolent normalizer. That is, it aims to smooth out a "typical" or "average" pension cost so that earnings aren't violently thrown around by volatile (and actual) market results.

Take a look at the components of Continental's pension expense last year of $127 million. There are five:

Item                                    Amount
Service Cost                                  $ 94
Interest Cost                                 $117
Expected Return on Plan Assets               ($118)
Amort. of Prior Service Costs                 $ 22
Amort. of unrecognized net Actuarial Loss     $ 12

You can also call this the parade of guesses.

Service Costs during 2001 are an estimate. They estimate the amount of additional pension liability CAL incurred during the year, because employees had benefits vest and salaries increase. But the $94 million isn't any sort of cash charge, but rather an estimate of how much present value of projected benefit obligations increased during the years. At the end of 2000, CAL projected the present value of all of pension liability (the discounted stream of cash it would probably have to pay out to employees under the terms of the pension contract, making guesses about certain things to determine this amount). Through things like vesting and salary increases, that PV increases, and that increase is the "service cost."

Interest Costs are also an estimate. Like Service costs, they reflect an estimated change in the present value of projected benefit obligations from 2000 to 2001. Instead of costs incurred from employee vesting and salary increases, though, interest costs just reflect the hypothetical obligation increase cause by the time value of money. How are these determined?

Continental makes a key assumption about the rate at which it could settle of all of its pension obligations today, known as the discount rate. They disclose this rate below as 7.5% for 2001. This assumption is important not only for interest costs, but also for determining the amount of the entire projected benefit obligation in the first place. When you estimate that you will have to pay out X amount over Y years to employees, you need a rate to discount those payments back to today to get a single "debt" or obligation value. This is that rate.

Notice that the higher the discount rate, the lower the pension debt and the lower the interest cost, since as we know higher discount rates reduce present value. Getting back to interest costs, your pension obligation increase every year (even if there are no additional or "service" costs) at the rate of the discount rate, just as any future debt obligation increases every year at the interest rate, so that's what the $117 million interest cost is.

Actual Return on Plan Assets is the king of the guesses. Here, Continental estimates its expected pension results and assumes that's what happened to its portfolio in 2001. Using its disclosed assumption of 9.5% returns, that means that a hypothetical $118 million is added back to its pension costs, as putative increases in plan assets to offset interest costs. Notice that this amount is greater than the interest cost, even though Continental started the year with fewer plan assets than obligations. The reason for this is of course that Continental, like most but not all firms, assumes that its return on plan assets will exceed the discount rate it uses to reduce its obligations to present value.

Since the actual return on plan assets, also disclosed, was ($81) million, there is a $199 million discrepancy between the guess and reality. Of course, if Continental had hired Peter Lynch to manage its pension fund last year and returned $400 million, it still would only have recognized the "estimated" $118 million; the smoothing works both ways.

The Amortization of Prior Service Costs gets a little more arcane. Sometimes, usually upon a change in the terms of the pension plan, there is a large change in service costs in a given year. For example, if the company reduced vesting requirements for all employees, service costs would skyrocket. Those increased costs are amortized, similar to how a capital expenditure would be amortized. So Continental's $22 million expense represents the amortization of what had been $178 million in "unrecognized prior service costs" in 2000. Note that this unrecognized prior service cost is also generally not recognized on the balance sheet as a liability until it is actually amortized.

Finally, the Amortization of Unrecognized Net Actuarial Loss is where the "smoothing" function of the accounting treatment is slowly brought towards reality. When the guesses listed above turn out to be wrong, the difference between the guess and reality is tucked away for safe keeping. For example, the difference this year between Continental's recognized return on plan assets of $118 million and its actual portfolio loss of $81 million is recorded, like the unrecognized prior service costs, and when it gets big enough, it is also amortized over the expected service lives of employees. So large discrepancies in year 1 slowly affect years 2 through 10 through amortization charges or benefits. You can see how this creates a smoothing, lagging affect on the financial statements.

[Aside on the $106m I credited as the "pretend" GAAP gain from Continental's pension portfolio you asked about: This is the $118m hypothetical gain minus the $12 million Actuarial Amortization, since that amortization basically reflects the smoothing mechanism of GAAP and thus can be seen as reducing the expected return line item in this case]

So you can see that in 2001, Continental's income statement paid the price of previous unrecognized losses (compared to estimates) in the form of that $12 million current period amortization. But because the shortfall was so large in 2001, the unrecognized losses got much larger, and so future amortization will also be larger.

Aside from increased amortization costs, Continental's pension expense will also increase in other ways because of 2000 and 2001's bad portfolio performance. Specifically, its "expected return on plan assets" will decrease somewhat, because the market value of its portfolio declined; even though the expected return is merely an estimate (9.5%) it uses the actual plan assets as the base (9.5% * plan asset base), so fewer plan assets going forward will mean lower expected returns and higher pensions expense.

Don't be spoiled, though, by the simplicity and prurient excitement of the P&L treatment of pension compensation, because the B/S treatment is slightly complex and sometimes even slightly boring in comparison. I will try to be brief here, in the interests of the angry mob that may be forming and the impending danger of the Bruce Willis film festival giving way to a Steven Seagal montage, so feel free to ask follow up questions after you've woken up.

The balance sheet treatment basically reflects all of the smoothing used in the income statement treatment, but includes an adjustment to make sure that large liabilities don't simply sit off the balance sheet completely. If not for this "minimum pension liability" requirement, enormously under funded pension would be ignored by the balance sheet. Think about it. If a pension portfolio had a couple of sucky years (accounting term) in the market, the company would build up a large "unrecognized net actuarial loss" (as Continental has of $507 million) due to the difference between expected return and actual return. Since that $507 is unrecognized on the income statement, it can't just make an appearance on the balance sheet because of that pesky double entry thing.

So the balance sheet rule says that in certain cases, when the pension is under funded, you need to basically ignore the P&L treatment and adjust the balance sheet to show the liability. Because of double entry, though, the increased liability that's accrued, since it isn't showing up as an expense, has to be added to the balance sheet somehow. This is done in the most complex way that a human brain could conceive, by first creating a fake intangible asset to match the increased liability and then when a certain "cap" is reached on the intangible asset, by creating a contra-equity account through a decrease in accumulated other comprehensive income (which is another way of saying, "losses not recognized in net income.")

The real balance sheet risk comes because the treatment doesn't really create a raw liability representing the true under funding because (1) the full liability need not necessarily be accrued under complex rules and (2) much of the liability is often countered with a B/S intangible, and most important b/c the liability that is accrued is sometimes hidden in line items that don't immediately look like interest-bearing debt, which is the economic reality.

What is the best way to handle the under funded pension? Add 587m onto to long term debt?

Oh, is that all you wanted to know? This is actually a tough question. There's a potential to double count a little between the pension deficit and the pension expense, but it's not worth the time to fix. I recommend in general considering pension under funding as LTD for valuation purposes, but not for short-term liquidity tests (since the full debt isn't "coming due" anytime soon in most cases). The bottom line is that under funded pensions must eventually be funded, either be superior pension portfolio performance, surprisingly low future, actual pension costs, or, most commonly, increased cash contribution from the company (shareholders). Aside from this eyeballing and adjusting for the additional debt, it's helpful to keep an eye out for changes in pension assumptions (lower discount or higher expected returns) that might be used to boost the income statement and mask other operational problems in the business.

As always, time isn't unlimited, and excruciating pension detail is rarely the best use of it (now you tell me), but I like to have a handle on the big points for a company with a significant pension, like the actual deficit and the basic P&L impact in the period.

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