Questioning the basic assumptions.

Author:Leib, Barclay T.

For years, many corporations have been using a lofty presumed return rate for their pension investments. Such returns are highly unrealistic these days, and the fallout from years of unmet targets could be catastrophic.

When Fortune magazine editor Carol Loomis sat down for an interview with Warren Buffett late last year, the conversation could have led in many directions: the economy, the stock market or the tenets of value investing. Instead, it mostly led in just one: U.S. pension fund accounting and the current pension return assumptions underlying it.

Buffett espoused in that interview (and has continued to espouse since) that pension accounting is likely to blossom into yet another scandal besmirching America's corporate boardrooms -- and is a problem potentially far larger than the accounting shenanigans caused by companies such as Enron Corp. or Adeiphia Communications.

"I invite you to ask the CFO of a company having a large defined-benefit pension fund what adjustment would need to be made to the company's earnings if its pension assumptions were lowered to 6.5 percent," Buffett stated. "And then, if you want to be mean, ask what the company's assumptions were back in 1973 when both stocks and bonds had far higher prospective returns than they do now."

According to Ryan Labs Inc., a New York-based quantitative asset management firm, the average major U.S. corporation maintains a longterm pension fund return assumption of approximately 9.25 percent a year. Many corporations set this return assumption using a five-year moving average of recent annual returns, but the Financial Accounting Standards Board makes no explicit requirement to reveal what methodology is used -- asking only that the approach be consistent over time.

Under the rules of FASB 87, which became effective in 1986, if pension returns are realized above the assumed rate, and pension liabilities remain static, companies may accrue the excess returns directly to earnings over the average life of a pension plan. If returns fall short of the assumed return, the loss does not have to be realized right away, but again, can be accrued over time.

Either way, the "smoothed" accrual typically shows up either within the Gross Income line of the balance sheet or as a part of Sales and General Administration expense. Many Wall Street analysts bemoan this practice as a potential obfuscation of true operating earnings, but the accounting community has long since signed off on either treatment.

But Buffett believes a 9.25 percent annual return assumption in today's world is just dead wrong, and to not admit that keeps corporate earnings artificially higher for a longer period of time -- something potentially deceiving and dangerous. "Companies with return on asset assumptions above 6.5 percent are not facing reality, and anyone choosing not to lower assumptions -- CEOs, auditors, actuaries all -- is risking litigation for misleading investors," Buffett argues. "And directors who don't question [this] optimism simply won't be doing their job."

By comparison, far more conservative assumptions existed in past years. In 1982, for example, corporations were using an average 6.5 percent future return assumption -- a number that represented just half of the then-current bond yield and was barely higher than then-current equity dividend yields. The current 9.25 percent assumption, on the other hand, represents almost twice the recent yield on T-bonds and eight times the dividend yield on stocks.

A Huge Issue

But how can accepted financial accounting standards cause such potential problems? And nine months after Buffet's comments, have we started to see more signs of this problem manifesting itself? At least one Baltimore-based actuary, Thomas Lowman of Bolton Offutt Donovan Inc., struggles...

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