Accounting rules keeping pension fund losses hidden. (Investments & Finance).

ACCORDING to its annual report released in March 2002, Verizon Communications Inc. had a strong year in 2001. In the opening pages of the report, the company announced an annual profit of $389 million. Only those investors who dug into the small print at the back of the document learned that Verizon' s reported earnings included $2.7 billion in gains from its pension fund investments - profit that didn't really exist. The company pension fund actually lost $3.1 billion in 2001, a footnote on page 58 of the 68-page report revealed.

In reporting gains it hadn't made, Verizon didn't violate any rules. Like other U.S. companies, Verizon was following accounting practices as written in 1985 by the Financial Accounting Standards Board, which sets U.S. accounting standards.

The FASB rules say that in preparing income statements, companies should include estimated gains -- not actual gains or losses -- from pension fund investments. Legal or not, the practice has incensed some investors.

"There's a serious illness pervading a portion of the financial market," said Kathleen Connell, California controller and a board member of the state's two largest pension funds: the California State Teachers' Retirement System and the California Public Employees' Retirement System.

She says accounting rules are allowing cornpanies to artificially increase stock prices. "Phantorn pension earnings are portrayed as income' Connell said. "It's a ticking time bomb!'

As the stock market plunged during the past three years, the pension funds of companies in the Standard & Poor's 500 Index lost more than $200 billion in value, according to studies by actuaries and several investment banks, including Credit Suisse First Boston and UBS Warburg LLC.

Losses weren't reported

Because of FASB accounting rules, many of those losses weren't reported on balance sheets. If pension liabilities had been counted in financial statements, aggregate earnings for the S&P 500 would have been 69 percent lower than the companies reported for 2001, or $68.7 billion rather than $219 billion, the CSFB study found.

"We're starting to see billions of dollars of shareholder equity vaporized because of pension underfunding," said Marc Siegel, a senior analyst at the Center for Financial Research & Analysis, an accounting research firm in Rockville, Maryland. "It's much more pervasive than anything Enron was doing!'

Over the past three years, most companies have allowed their pension fund losses to grow -- out of the sight of balance sheets and investors -- without addressing the problem, says David Bianco, who headed research into the issue for UBS Warburg.

Now, the liabilities have become too big to ignore. Many of the largest companies will be spending hundreds of millions -- and in some cases, billions -- of dollars to replenish pension funds in 2003 and beyond, according to CSFB and UBS Warburg.

Ford Motor Co. said in November that it would put $500 million into its pension fund in both 2003 and 2004. SBC Communications Inc. said it would pay $1 billion to $2 billion into its pension and post-retirement health benefit funds in 2003, thereby reducing earnings by 20 cents to 40 cents a share. On Dec. 5, Verizon said its earnings per share in 2003 would decline by between 27 cents and 33 cents because of lower pension income.

Other companies could face the same dilemma as Georgia-Pacific Corp., the world's second-largest paper and building products manufacturer, which said in November that pension fund losses would require a charge to shareholder equity as high as $600 million in the fourth quarter of 2002.

The charge would have placed the company in violation of a $2.4 billion loan agreement until a group of lenders, including Bank of America Corp., agreed to a waiver. Georgia Pacific was required to pay the lenders an undisclosed fee to receive the waiver.

In October, Standard & Poor's lowered the long-term debt rating of both General Motors Corp. and Ford to BBB, two levels above junk, from BBB+, citing pension fund liabilities.

Another complication: As companies spend more to replenish pension funds in the next two years, that money will not be available for spending on such improvements as new buildings and manufacturing equipment. A study by Goldman Sachs Group Inc. estimates companies will need to channel an extra $80 billion a year to adequately fund pension accounts.

Economic output

Bobby Inman, director of the U.S. National Security Agency from 1977 to 1981 and a board member of four companies, says the pension liabilities could trim national economic output.

"What it's taking is the money that could otherwise be used for growth," said Inman, who chairs SBC's compensation and pension committee. "There clearly will be an impact."

The pension fund time bomb is coming as a shock to many investors because accounting rules have allowed the liabilities to remain virtually incomprehensible in the footnotes of financial statements, says Howard Schilit, an accountant and president of the Center for Financial Research & Analysis.

"There should be better disclosure," Schilit said. "Even our clients, who are sophisticated investors, don't completely understand."

General Electric Co. reported pension fund gains of $2.1 billion for 2001, or 11 percent of the company's pretax profit of $19.7 billion. Difficult to find in GE's annual report was that the company hadn't gained $2.1 billion from its pension investments that year; it lost $2.9 billion.

GE spokesman David Frail says the company reported the pension gain according to FASB rules. "It's not hard to spot the loss," said Frail. "It's on page 72, in footnote six."

General Motors said in October that the value of its U.S. pension funds had fallen by 10 percent, or $6.7 billion, in the first nine months of 2002. That's the same percentage the company told shareholders on March 12 that it had expected to gain in all of 2002.

GM said its pension funds were valued at $73.7 billion on Dec. 31, 2001--more than triple the $21 billion current market value of GM stock.

Pension fund losses should not disrupt payments to retirees even if a pension fund runs out of money because the Pension Benefit Guaranty Corp. (PBGC), a federal agency funded by mandatory insurance payments from companies, pays retirees when a company fails. The agency pays annual pension benefits of as much as $42,954 per person, says spokesman Jeffrey Speicher.

"We are the insurers of last resort," Speicher said. "If a pension plan is underfunded and has to terminate, we step in and pay the benefit." The agency had reserves of $7.7 billion as of Sept. 30, 2001.

Benefiting executives

Some retirees who remain shareholders in their companies say corporations are using pension funds to benefit executives at the expense of investors. At annual meetings in 2002, shareholders of International Business Machines Corp., GE and Verizon introduced proposals that would stop companies from including pension gains as part of the earnings companies use to determine executive bonuses.

All of the proposals were opposed by the companies and were defeated in shareholder votes. "The retirees' pension fund has become a profit center for the company," said Joe Ristuccia, 71, who retired as a Verizon district plant superintendent in 1989 after 33 years of service.

Ristuccia co-sponsored the proposal at Verizon, which garnered 43 percent of shareholder votes. "It's outrageous," he said. "I was betrayed by my company."

Ivan Seidenberg, Verizon's chief executive, was paid a $2.4 million cash bonus for 2001. Company spokesman Varettoni says pension income is one of many factors used in determining bonuses.

Most companies have been reporting an estimated gain of 9.5 percent in pension fund investments during the stock market slide that began in 2000, UBS Warburg says. For a company as large as IBM, that meant reporting a gain of $1.3 billion from pension fund investments in 2001, after expenses.

An investor reading IBM's annual report filed in March would look at the balance sheet and the management discussion that follows without seeing any mention of actual pension fund returns. The discussion does refer to recent stock-market losses. "Although actual returns in 2001 were less than expected returns in the U.S. pension plan, the cumulative excess of actual returns over expected returns was $5.3 billion since 1986," the report says.

The reader would have to go 35 pages deeper into the report to find a footnote containing dozens of raw numbers related to pension investments and obligations. The footnote says that for 2000 and 2001, while IBM recorded assumed pension returns of $12.2 billion, the funds actually lost $2.8 billion--a disparity of $15 billion.

"If you've got assumptions that make a difference of billions of dollars in your bottom line, it seems to me that's the kind of thing people want to know about," said Simon Lorne, former general counsel at the U.S. Securities and Exchange Commission.

Lorne, now a partner at law firm Munger Tolles & Olson in Los Angeles, says that when it comes to pension performance, financial statements talk about the trees and ignore the forest. "These numbers ought to be clearly shown in companies' financial reports," he said.

IBM spokeswoman Carol Malkovich defends the company's reporting practices. "This accounting treatment is not unique to IBM," she said. "It's FASB accounting followed by thousands of companies and fully disclosed in our annual report."

On Dec. 4, IBM said it had paid $3 billion into its U.S. pension fund to cover all of its underfunding. Chief Financial Officer John Joyce declined to say how the payment would affect fourth-quarter earnings.

Smooth Out volatility

FASB's decision that companies should use an estimate for pension fund investment gains every year was intended to smooth out potential stock market volatility in earnings computations, says Tim Lucas, project manager of the FASB team that wrote the rule known as Financial Accounting Standard No. 87, or FAS 87.

What the rule's authors didn't anticipate was the stock-market boom of the late 1990s and the equally large decline that began in March 2000.

In the late 1990s, as companies reported pension fund earnings of about 9.5 percent, those investments had actually made two or three times that amount, company filings show. As a result, many companies made small or no contributions to pension funds during those years, says SBC director Inman.

"They earned so much money that corporations didn't have to put in anything annually to cover pension costs," he said. "It was a free ride."

As pension investments began losing money in 2000, most companies still had a cushion in their pension funds, annual reports show. Even as the losses mounted in 2001, most companies weren't concerned about pension deficits, Inman says.

In December 2001, billionaire investor Warren Buffett started to caution companies that pension losses had the potential to cause huge disparities if companies didn't address the issue. He began suggesting in public statements that companies should lower annual pension income estimates to 6.5 percent, as he did with his Berkshire Hathaway Inc.

Buffett's cautions went largely unheeded in 2002, as most companies kept pension gain estimates at about 9.5 percent, SEC filings show.

Some companies have already lowered their estimated rates. In July, Marsh & McLennan Cos., an insurance and money management firm, lowered its assumed rates of return to 9.25 percent from 10 percent; in November, Georgia-Pacific said it would tower its expected rate to 8.5 percent in 2003 from 9.5 percent.

Those rates are still far too high, says Joshua Dietch, a consultant at Cerulli Associates, a Boston-based financial research and consulting firm. "Companies got caught with their pants down using high assumptions," he said.

Corporate Focus and Wall Street West will return next week.

Pension Problems

Underfunded Industries


Automobiles      27%
Oil & Gas        18%
Pharmaceuticals  10%
Airlines          8%
Auto Components   7%
Other (<4.3%)    30%

Note: Table made from pie chart

Largest Decline in Percent Funded

                                   Funded

Company                     2002E     2001      Change

Moodys Corp.                 139%     193%       (54%)
Bank of New York              177      223        (46)
Sherwin-Williams Co.          220      264        (44)
FPL Group Inc.                149      188        (39)
Meadwestvaco Corp.            149      187        (38)
Mellon Financial Corp.        137      175        (38)
Cincinnati Financial Corp.    105      139        (34)
McGraw Hill Cos.              122      155        (33)
National City Corp.           116      148        (33)
Automatic Data Proc.           90      123        (33)

Largest Dollar in Funded Status

$ Over (Under) Funded (in millions)

Company                     2002E      2001      Change

General Motors Corp.      ($29,426)  ($12,671)  ($16,757)
Int'l. Business Machines  (13,265)      686     (13,951)
Ford Motor Co.            (14,273)    (2,460)   (11,813)
Verizon Communications      2,698     12,167     (9,469)
General Electric Co.        5,562     14,583     (9,021)
Boeing Co.                 (6,846)     1,117     (7,963)
Lucent Technologies Inc.   (1,466)     5,689     (7,155)
880 Communications           998       7,655     (6,657)
Lockheed Martin Corp.      (4,409)      587      (4,996)
Du Pont (El) De Nemours    (5,176)     (846)     (4,330)

Source: Credit Susse First Boston

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