FRBSF Economic Letter
2003-19; July 4, 2003
Pension Accounting and Reported Earnings
The bursting of the stock market bubble has left many private defined
benefit pension plans underfunded, raising some concerns about the effects
on cash flows and, for a few firms, on financial soundness (see, for
example, Kwan 2003). However, even as the asset value of corporate pension
funds has eroded, firms sponsoring defined benefit plans have continued
to report unusually low pension costs, because pension earnings have
not fallen as much under the accounting rules for pension funds. Since
the reported earnings and their sources are inputs to stock valuation,
the complexity of pension accounting could blur the transparency of financial
reporting and hinder investors' ability to perform valuation correctly.
This Economic Letter discusses the accounting rules governing
pension reporting and their impact on reported earnings.
The accounting of pension plans must conform to standards established
by the Financial Accounting Standards Board (FASB). Specifically, FASB
statement 87 establishes standards of financial reporting and accounting
for an employer that offers defined benefit pension plans to its employees.
The standards cover such areas as pension cost measurement, reporting
of liabilities, and financial disclosures.
In recognizing the pension cost in the income statement, firms sponsoring
defined benefit pension plans do not record the cash contribution to
the pension plan as an expense. Rather, the FASB requires the sponsoring
firm to expense what is called the net periodic pension cost (NPPC) in
its income statement. The NPPC is equal to the annual accrued costs of
the pension plan minus the expected return on plan assets. The annual
accrued costs include the service cost, the interest cost, and other
costs. The first element, the service cost, refers to the present value
of pension benefits earned by employees during the fiscal year, which
in essence can be viewed as deferred compensation. The second element,
the interest cost, is the annual accrued interest on previously incurred
pension benefit obligations and reflects the increase in the projected
benefit obligation due to the passage of time as employees are getting
closer to receiving their pension benefits. The third element, other
costs, stems from changes in pension coverage, such as plan amendments
or changes in actuarial assumptions.
The accrued pension costs, i.e., the sum of service cost, interest cost,
and other costs, are netted against the expected return on plan assets
in calculating the NPPC. The dollar value of the expected return on plan
assets is determined by multiplying the expected rate of return on plan
assets and the market-related value of plan assets. The expected rate
of return is determined by the sponsoring firm, and, under FASB statement
87, it should be based on the expected long-term rate of return on plan
assets. The expected rate of return is an assumption and could depart
significantly from the realized rate of return; that is, if the pension
plan assumes a 10% rate of return, but in reality experienced a loss
in asset value, the assumed 10% gain still is used to compute the NPPC.
Moreover, in determining the market-related value of plan assets, plan
assets are not marked to market immediately. Rather, changes in the market
value of plan assets are amortized over five years. Hence, a one-time
gain or loss will be spread out over five years in determining the accounting
value of plan assets that is used to calculate the expected return. The
combination of using the expected rate of return and the market-related
value, rather than the realized return and the marked-to-market value,
in computing the dollar return on pension assets has the effect of smoothing
pension earnings over time and, hence, the reported earnings.
Measuring recent pension costs
As in Kwan (2003), I focus on firms in the S&P 500—353 of
those companies have defined benefit pension plans, and 327 firms have
released their 2002 pension information so far. Of these 327 firms, 252
have complete pension data back to 1991, so these will be the subject
of the empirical analysis.
Figure 1 shows that aggregate NPPC from 1991 to 2002 for these firms
began to decline in 1994, turned negative in 1999, and plummeted in 2000.
It stayed negative in 2001, even when stock prices were retreating and
became only mildly positive in 2002. The unusually low pension costs,
and, in particular, the negative pension costs between 1999 and 2001,
effectively boosted reported earnings in those years.
Figure 2 breaks the NPPC for the sample into its components: the aggregate
service cost, interest cost, and the expected return on plan assets net
of other costs. (Both the expected return and the other costs series
are quite volatile but tend to have offsetting effects, so combining
them produces a rather smooth series.) Both service costs and interest
costs rose steadily between 1991 and 2002, reflecting increases in sponsoring
firms' employee compensation. While the net expected return series tracked
the other two cost series fairly closely until 1996, it rose at a much
faster clip between 1997 and 2000, effectively driving down the NPPC.
Why has the expected return on plan assets remained elevated since 2000,
despite the general fall in stock prices? Recall that, for the purpose
of computing NPPC, the expected dollar return on plan assets equals the
expected rate of return chosen by the sponsoring company multiplied by
the accounting value of plan assets. As shown in Figure 3, the expected
rates of return that sponsoring companies used did not change much between
1991 and 2001 and dropped only slightly in 2002. Thus, even though the
realized returns have been negative since 2000, a positive rate of return
has continued to be used to compute the expected dollar return on plan
Moreover, the accounting value of plan assets used in computing the
expected return is marked-to-market only gradually, because FASB 87 requires
asset gains and losses to be amortized over five years. Thus, the run-up
in stock prices during the late 1990s continued to affect the accounting
value of plan assets and hence the dollar expected return for up to five
years. The delay in recognition of some of the past gains in plan assets
offset some of the recent losses.
Implications for reported earnings
The accounting rules governing NPPC, then, are designed to smooth the
impact of changes in the cost of defined benefit pension plans on the
reported earnings of corporations. Pension earnings are calculated using
the relatively stationary long-term expected rate of return, and the
gains on plan assets are amortized over five years. Without the smoothing
effect, using the realized rates of return on pension assets and the
marked-to-market asset values would have driven down the pension costs
and driven up reported earnings even further during the last stock market
boom. By dampening the volatility in pension costs and, hence, reported
earnings, the smoothing mechanism has had its most pronounced effect
on corporate earnings since the stock market decline. With significant
losses in pension asset value, using the actual pension earnings would
have resulted in much higher pension costs that would have further depressed
the already low corporate earnings since 2000. The smoothing effect cushioned
the sharp fall in pension earnings and held down pension costs, giving
a lift to reported earnings even into 2002.
It is unclear what effect the accounting treatment of pension fund earnings
and costs has had on the valuation of corporate stocks. This is especially
true given that the actual economic value of the pension plans is disclosed
only in footnotes of the sponsoring firms' financial statements. In an
efficient capital market, investors would be able to see through sponsoring
firms' financial statements and discount their reported earnings correctly.
That is, in theory, rather than discounting the smoothed pension earnings
or losses on income statements, the value of a pension fund to the sponsoring
firm's shareholders should reflect the marked-to-market value of pension
plan assets net of the fund's projected benefit obligations. However,
there is some evidence that the complexity in pension cost measurement,
and the relegation of the net pension asset value to a footnote, could
compromise financial transparency and lead to misvaluations (see Coronado
and Sharpe 2003).
With that in mind, it is quite likely that reported net pension costs
will rise in coming years, holding back growth in reported earnings of
firms that sponsor defined benefit pension plans. In addition to the
continuing rise in service and interest costs, the expected return on
pension plan assets is poised for a fall on two accounts. First, as shown
in Figure 3, the expected rate of return already fell a bit in 2002.
This trend is likely to continue, as several firms recently indicated
that their assumed long-term expected rate of return on pension plan
assets may have been too optimistic, and they announced plans to use
a lower expected rate of return to calculate pension earnings in figuring
the NPPC. Doing so certainly will drive down pension earnings and drive
up pension costs. Second, due to the amortization of losses in pension
assets incurred in the past three years, absent any significant advance
in stock prices in the near future, the accounting value of plan assets
used to calculate the NPPC would decline from its current level. Multiplying
a lower pension asset value by a lower expected rate of return will result
in lower pension earnings and, thus, to a smaller offset in service costs,
interest costs, and other pension costs.
The accounting standards for defined benefit pension funds are quite
complex, and understanding them is crucial in interpreting sponsoring
firms' reported earnings and financial soundness. In conforming to those
standards, firms sponsoring defined benefit pension plans enjoyed a lift
on reported earnings in recent years, despite the fall in the stock market.
This tailwind to reported earnings would likely turn to headwind in coming
years as some of the positive factors affecting pension cost measurement
Coronado, J.L., and S.A. Sharpe. 2003. "Did Pension Plan Accounting
Contribute to a Stock Market Bubble?" Brookings Papers on Economic
Activity 1 (forthcoming).
Kwan, S.H. 2003. "Underfunding
of Private Pension Plans." FRBSF Economic Letter 03-16