Mellon: Pension Reporting Changes to Lead to Earnings Volatility

November 10, 2003 (PLANSPONSOR.com) - By requiring companies with defined benefit pension plans to expense their plan gains and losses, potential accounting changes are likely to have profound changes on corporate finances, according to a new position paper.

According to the document from Mellon Human Resources and Investor Solutions, the push to get rid of pension “smoothing”  (See  Accounting Rules Smooth Over Pension’s Potholes  ) will make many plan sponsors’ earnings more volatile and will effect key financial ratios used by analysts and lenders.

As a consequence, Mellon contended:

  • More volatile earnings reports could be seen by analysts as an indicator the company isn’t worth as much, or as a sign that management can’t effectively manage business risks.
  • On the other hand, the decreased certainty regarding reporting earnings might actually increase DB companies’ values with the greater transparency, new income breakdowns, heightened disclosure and removal of smoothing.
  • Less predictable balance sheet ratios might cause some lenders to close their doors to the company or only lend on less favorable terms.

One possible response to a pension reporting-induced earnings volatility could be a shift to invest plan assets in securities with cash flows matching the cash flows of the obligations – possibly meaning a large-scale movement out of equities into fixed income, Mellon said (Mellon pointed out that some accounting reform proponents have charged that existing laws dangerously encouraged plan to get too heavily into equities in the first place.).

Finally, Mellon warned that increased earnings volatility arising from changed pension accounting regulations could prompt some companies to cut back or cut out their defined benefit programs. Mellon pointed out that the FRS17 in the UK helped prompt more than 40% of UK firms with DB plans to shutter them to new members in recent years (See  UK Pension Regulations Weigh on DB Plans  ).

However, Mellon warned plan sponsors that it is not possible to “model” the potential impact of a shuttered DB plan on factors such as workforce management and corporate productivity. “Thus, when consideration is given to starting or terminating a plan, the employer needs to consider intangible as well as tangible factors,” Mellon wrote.

The Financial Accounting Standards Board (FASB) is scheduled to discuss pension disclosure requirements at a Tuesday meeting (see  FASB Throws Down Pension Reporting Gauntlet ).

A  full copy of the report is at  http://www.mellon.com/hris/pdf/fyi_11_04_03.pdf .

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