There has been a significant but mostly unnoticed shift in the way big U.S. companies account for the pensions on their books.
On the face of it, this appears to be little more than a change in arcane bookkeeping procedure. But it could be a sign that corporate America is betting on rock-bottom interest rates and a continuing economic rebound through this year and next.
United Parcel Service Inc. (NYSE: UPS) is the latest company to embrace this trend. In January, the global delivery giant announced it was joining the ranks of brand-name companies such as International Business Machines Corp. (NYSE: IBM), AT&T Inc. (NYSE: T) and Intel Corp. (NASDAQ: INTC) by switching to mark-to-market accounting for its $23.3 billion pension program.
Under this approach, rather than smoothing out the impact of gains and losses in pension programs by amortizing them over many years, the true value of pension investments is recognized and accounted for once a year.
Because equities usually represent 50 percent or more of the assets in a typical corporate pension plan, in practical terms this means that if the stock market goes up, the value of the holdings in a company's pension plan will get an immediate boost at the end of the year.
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There are any number of motives for companies to adopt mark-to-market. For one thing, international standards already require it, although those who set U.S. accounting rules are still resisting the change, making it somewhat ironic that American companies are doing so now (due to bullishness about global economies and markets).
Just after changing to mark-to-market, UPS Chief Executive Scott Davis told analysts on a Jan. 31 conference call that there's a more optimistic tone in the United States and he forecast continued modest improvement through 2012.
In late 2010, Honeywell International Inc. (NYSE: HON) became the first major U.S. business to announce a move to mark-to-market pension accounting. Since then a few companies have followed suit and most experts believe that the number is likely to grow relatively quickly.
We will continue to see a handful of companies switching each year, said Jon Waite, head of investment management advice and chief actuary for SEI Institutional Group, an investment-services provider. It's certainly possible that the organizations adopting it have more of an upbeat view on where the economy is going to be going.
Companies can use a stock market-induced boost in their pension funding. Up to 97 percent of pension plans at companies in the Standard & Poor's 500 index are underfunded, according to a January report by Credit Suisse analyst David Zion. The median funded rate at the end of 2011 was only 72 percent, down from 84 percent the year before.
Under the U.S. Pension Protection Act, companies must contribute for each employee the normal cost of the plan plus the amount of any funding shortfall amortized over seven years, with interest. Required contributions are typically due 20 1/2 months after the plan is measured, at the beginning of the plan year. However, a company may have to start making quarterly contributions sooner if its pension plan's funding falls below 80 percent, which is generally considered a healthy or minimum level.
Lagging Bond Market
In recent years, persistently low interest rates in the bond market have been a drag on pension funds.
Under the traditional formula, companies determine the value of their pension plans and their pension liabilities based on a discount rate pegged to bonds. With bond interest rates falling more than 1 percent between December 2010 and December 2011, the ostensible returns on pension plans fell and, hence, companies' pension liabilities may have increased by as much as 20 percent.
A very tiny change in interest rates can be a huge change in what your liabilities look like, said Deborah Forbes, executive director of the Association for Financial Professionals' Committee on Investment of Employee Benefit Assets, which represents more than 115 of the largest pension funds in the U.S.
She pointed out that the U.S. Federal Reserve has made it pretty clear that interest rates aren't going up for quite some time.
Banking Hope on Better Returns
By contrast, the stock market has been on a tear lately.
Last week, the Dow Jones Industrial Average closed above 13,000, its highest level since May 2008. The wider S&P 500 also hit a four-year high, while the tech-heavy Nasdaq composite briefly crossed the 3,000 mark Wednesday for the first time in 12 years.
This upward equities bounce has already had a big impact on pension solvency. In January alone, higher equities prices were responsible for a 1.7 percent increase in the funding of the typical U.S. corporate pension plan, according to BNY Mellon Asset Management.
Businesses that have adopted mark-to-market are clearly counting on more of the same -- especially since recent economic data is outpacing expectations by a significant amount.
The Citigroup Economic Surprise Index, a closely watched, weighted index that measures the deviation between economists' forecasts of all major economic indicators and actual results, is currently at 65.5. A reading above positive 50 means real data is beating expectations by what the index publishers call a wide margin.
Companies that are looking at the investment world are thinking that equity returns, especially relative to interest rates, are going to be good going forward, said Evan Inglis, principal and chief actuary for Vanguard Strategic Retirement Consulting.
What It Means for Investors
In the short term, investors will enjoy relatively better earnings results from companies that have switched to mark-to-market pension accounting, because the method removes the drag of billions of dollars in old pension losses from current and future income statements.
For example, UPS recorded an $827 million pretax charge in the fourth quarter when it changed to the new pension accounting program, which UPS spokesman Norman Black said would result in simpler, more transparent financial reporting.
Other companies revised past financial statements retroactively under the accounting change to recognize the losses as if they had occurred in prior years. In this way, Verizon recorded a total loss of $22 billion; AT&T, $17 billion; and Honeywell, $5.5 billion.
They just recognize it all at once, get this bad news behind them and go forward without this big pension anchor weighing down their earnings, said UBS accounting expert Janet Pegg in a November report.
Many more companies could benefit from this. As many as 39 businesses still have unrecognized pension losses of more than 25 percent of their market capitalization, Credit Suisse's Zion wrote in a January report.
Spot-Rate Option 'Doesn't Make Any Sense'
Not everyone is a fan of the mark-to-market trend.
Some experts say the old approach protected employees better because companies have to cover the liabilities over many years, and thus quick, volatile movements in stocks or bonds don't overly influence the required contributions.
However, under the new method, when the stock market goes up in a given year, the pension fund would record an immediate gain and look well-funded. But if, for example, the market crashes in the following year, the fund could instantly go deep under water.
Assuming it's an ongoing plan, it doesn't make any sense to use a spot rate, said Forbes, of the financial professionals' group.