December 13, 2005
Excerpts: The Battle For The Soul of Capitalism - Part XXIII
Future Pension Fund Returns
Nowhere is the fiction of managed earnings more apparent than in the assumptions of future returns made by corporate pension funds. Over the past decade the yield on the ten-year U.S. Treasury bond has plummeted from 7.9 percent to 4.2 percent—a drop of 45 percent— and the prospective investment return on stocks (dividend yield plus assumed 5 percent earnings growth) has fallen by 15 percent, to 6.8 percent. For a typical pension portfolio (60percent stocks, 40percent bonds), the expected market return would be 5.8percent. Yet in 2004, the average corporate pension fund assumed a future annual return of 8.6 percent, 35 percent higher. To make a bad situation worse, neither return takes into account investment costs, nor leaves a reserve against the unexpected. The fact is that pension funds should probably be counting on future annual long-term returns, net ofinvestment costs, ofsomething like 5 percent per year. (I cover this subject in greater depth in chapter five.)
Manipulating pension returns has played a major role in enabling corporations to manage their earnings, for in few other places on the corporate books are unbridled estimates of assets and liabilities so easy to adjust. Yet, it is only in recent years that pension projections have become the stuff of scandal—“pension deficit disorder,” using the inspired phrase of Morgan Stanley strategist Henry H. McVey—and the Securities and Exchange Commission (SEC) is investigating the issue. We shall learn much more about how corporations—in league with their highly paid actuarial con- sultants—have managed earnings by managing their pension assumptions.
Changing pension assumptions can make an astonishing difference in corporate earnings. Consider this example:
In 2001, Verizon Communications reported a net income of $389 million and awarded its executives bonuses based on that amount. Net income would have been negative, however, had the company not included $1.8 billion of pension income. Thus, Verizon was able to use pension earnings to convert net income to profits, giving the firm cover to provide managers with higher bonuses. It gets worse. It turns out that Verizon’s pension funds did not generate anyreal income in 2001; they had negative investment returns, losing $3.1billion in value. How, then, could Verizon report income of $1.8billion from its pension assets? The company merely increased its projection of future returns on pension assets to 9.25percent, a move allowed under the accounting rules then in effect. Thus, the $1.8billion in pension income used to move Verizon into the black did not even reflect actual returns generated by the pension funds. The pension income was simply the result of a change in the accounting assumptions. This certainly did not create any value for the firm or its shareholders.
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