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Rewriting Pension History

By Michael Rapoport, The Wall Street Journal

March 9, 2011

 Some big companies are changing how they account for their pension plans in a way that could make their earnings look better in coming years.  

AT&T Inc., Verizon Communications Inc. and Honeywell International Inc. recently ended a longstanding practice in which they "smooth" large gains and losses generated by pension assets into their financial results over a period of years. From now on, these companies will count all such gains and losses in the same year they are incurred.  

While the moves might seem like arcane accounting steps, they have important implications for investors. The companies say the changes will make their earnings reporting more transparent, but they also sweep away tens of billions in past pension losses the companies have yet to smooth into—and hurt—their results. By charging them against their earnings from 2008, when the losses were incurred, they are taking lumps for years that many investors may no longer care about.  

"They'll put the bad news behind them" said David Zion, an accounting analyst with Credit Suisse.  

Still, the accounting change will make it clearer to investors how pension plans' performance affects the companies' income statements, where it is factored into operating earnings. And the current rock-bottom interest rates make it a good time to make such a change. Any increases in rates could improve pension-plan performance, and clearing away the old losses will heighten the impact that better performance has on the companies' earnings.  

Under current accounting rules, companies with defined-benefit pension plans, which promise to pay specified amounts to retirees, have the option to take several years to spread the cost of large pension gains and losses into earnings. That means that when a plan's investment results are much better or worse than expected—as with the 2008 market downturn—it can have a significant effect on earnings for years.  

For that and other reasons, the system of accounting for pension results in earnings long has been widely criticized. The Financial Accounting Standards Board, the U.S. accounting rule maker, has examined the issue before but hasn't made any changes, though they may revisit it soon. AT&T, Verizon and Honeywell changed their accounting methods on their own initiative. While the details differ, all three said they would start recognizing some or all of their deferred losses in the year they occur, through a "mark-to-market" adjustment to fourth-quarter earnings to reflect their pension plan's returns for the year.  

All three assessed the bulk of the change's impact against 2008 earnings, the height of the market meltdown. AT&T, for example, said its 2008 pension costs would increase by $24.9 billion because of the change, compared to a $3 billion increase for 2010. The company reduced its 2008 earnings by $15.5 billion as a result, from a profit of $12.9 billion to a loss of $2.6 billion.

An increase in interest rates could benefit the companies' pension plans if, as expected, they move higher. That is because pension obligations that may be paid out decades into the future are discounted back to their present value. When rates are low, there's less discounting, and the obligations stay relatively high. But when rates rise, the future obligations will be discounted more aggressively, moving their present value lower.  

That means a lower base on which the company has to pay interest costs, which could translate into lower pension costs, improved pension performance and better earnings.  

"Clearly the mark-to-market approach is preferable accounting," said Kathleen Winters, Honeywell's controller. But she acknowledged that "the low interest-rate environment made this a good time to do this."  

Such factors were "not the driving force behind the change," said an AT&T spokeswoman. "It's about more transparency, a simpler accounting method." A Verizon spokesman declined to comment.  

General Electric Co. and International Business Machines Corp. plan a related though less-sweeping step. They will start providing data on their operating earnings with some pension-related elements removed. "We just wanted to take it out," said an IBM spokesman. A GE spokeswoman declined to comment.  

For AT&T, Verizon and Honeywell, the change has a potential downside: Without smoothing of pension results, their earnings may show more year-to-year volatility. A market surge could propel that year's earnings drastically higher, but a plunge could hollow out earnings, leaving investors who don't dig beneath the reported numbers vulnerable to surprises. Though logical for the companies, the change "has a lot of risk" for investors, said Alan Glickstein, a senior consultant at Towers Watson, a human-resources consulting firm.  

Still, others may follow in the footsteps of the three companies. According to The Analyst's Accounting Observer, 74 companies in the Standard & Poor's 500-stock index had both underfunded pension plans and unrecognized losses equal to at least half their pension assets at the end of 2009.

A potential candidate is DuPont Co., which has $9 billion in unrecognized losses. The company's 2010 pretax earnings of $3.7 billion were weighed down by $507 million of past losses that were amortized into its results. Eliminating smoothing would get rid of that weight. Goodyear Tire & Rubber Co. has $3.2 billion in unrecognized losses. Spokesmen for DuPont and Goodyear declined to comment.

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