Ask a Benefit Actuary

Q: What might the next round of pension accounting reform mean to my company?

A: Just as pension plan sponsors have been getting accustomed to recent reforms--funding reform in the Pension Protection Act and accounting reform in the recently implemented Statement of Financial Accounting Standards No. 158--another, possibly more significant reform is on the horizon: Phase II of the Financial Accounting Standards Board's two-phase accounting reform project on post-retirement benefits (including both pension and retiree medical and life insurance plans).

According to Michael Moran, a vp and investment analyst at Goldman Sachs & Co., "Of the three reforms--funding, FASB Phase I and FASB Phase II--it is Phase II that would likely have the greatest impact for investors."

In the Phase II project, the FASB will undertake a comprehensive review of all income statement and balance sheet post-retirement benefit accounting standards. The initial meeting on Phase II is scheduled to occur early this year. As the FASB will spend the next few years evaluating how to account for these plans in financial statements, plan sponsors should be proactive in understanding the issues the FASB will consider and manage their plans accordingly.

One important issue that the FASB will consider is balance sheet consolidation. While SFAS 158 puts the only the net funded status of pension plans--the difference between liabilities and assets--directly on the balance sheet, a "consolidated" accounting requirement would put the pension assets on the asset side of the balance sheet and the liabilities on the liability side.

For example, if a pension plan has $1 billion in assets and $1 billion in liabilities, thus having an unfunded liability of zero, SFAS 158 would put the zero on the balance sheet. But if the FASB decides to consolidate the pension plan reporting, both the $1 billion pension asset and the $1 billion pension liability would be recorded on the balance sheet. That is, there would be extremely large amounts on opposite sides of the balance sheet, rather than the SFAS 158 requirement to net the assets and liabilities first and put the smaller net amount on the balance sheet.

This could have dramatic effects on plan sponsors' views about the impact their plans have on corporate debt. For example, consider a plan sponsor with $1 billion in pension assets and liabilities--thus its plan is exactly 100% funded with zero unfunded liability. We also assume that the sponsor's market capitalization is $5 billion, and the sponsor has $2 billion in corporate debt.

We will examine the plan sponsor's debt-to-market capitalization ratio, a metric commonly used by credit analysts to assess a company's level of debt and financial risk, to see how treatment of the pension plan affects corporate risk metrics. Using the net funded status incorporated into SFAS 158, no adjustment is needed to the debt ratio because the pension plan has a zero unfunded liability. So the debt-to-market capitalization ratio is simply $2/$5 = 40%. If we consolidate the pension plan and view the entire liability as debt, the plan sponsor would have a total of $3 billion in debtlike obligations: $2 billion in traditional debt and $1 billion in pension obligations. Thus the sponsor's debt-to-market capitalization is $3/$5 = 60%. The difference between 40% and 60% is quite substantial, which illustrates how important the issue of balance sheet consolidation will be for plan sponsors with pension plans that are large relative to the size of the plan sponsor.

So which debt-to-market capitalization risk metric is a better measure of corporate finances: the "net" metric of 40% or the "consolidated" metric of 60%? The answer is that it depends on the plan's asset allocation.

If the plan's assets are invested 100% in bonds that match the expected benefit payments of the liabilities, then the plan sponsor can generally expect lower returns relative to equity investments. But the sponsor is insulated from the majority of financial risks since it has used its assets to hedge their liability risks. Because of this, the net risk metric of 40% is the better risk measure for the sponsor investing in all bonds.

On the other end of the spectrum, if the plan's assets are invested in 100% equities, there is full asset-liability mismatch and the sponsor is exposed to a full range of financial risks (and returns). This asset-liability mismatch can be thought of as financial leverage, so the "consolidated" risk metric of 60% is the better risk measure for the sponsor investing in all equities.

Most plans invest their assets in a mix of debt and equity, so the appropriate economic risk metric would be in between the two extremes.

Of course, when reviewing asset allocation strategies, plan sponsors must review both risk and return metrics. The important thing is to consider both within an enterprise risk management framework--that is, looking at risk and return within the context of how they impact the plan sponsor's entire enterprise, rather than looking at the pension plan in isolation. And the pension investment policy can be thought of as a capital structure decision that affects the debt-to-market capitalization ratio, shareholder returns and other metrics.

Asset allocation has always been an important decision for plan sponsors, and is becoming more important with the Phase II project. Rather than waiting several years until the FASB finalizes the Phase II changes, plan sponsors may want to be proactive and consider implications for plan management in advance.

This month's column on actuarial questions in the benefits field is written by William J. Miner, an actuary with Watson Wyatt Worldwide in Chicago. For more information on the implications of the FASB Phase II project, please contact Watson Wyatt Worldwide at 312-525-2298. Mr. Miner was assisted in the preparation of this column by Eric Friedman, an actuary in Watson Wyatt's Chicago office.