Pension Accounting Rules Lead to Stock Overvaluation

This was the finding of two Federal Reserve Board staff members, attributing the overvaluation to the use of accounting rules that make it difficult for investors to distinguish pension gains from the earnings generated by companies’ core operations.   Specifically, the Fed staff pointed to FAS 87 and the ” smoothing” provisions in the accounting rule, which allows companies to take certain assets and obligations off balance sheets and amortize them as income or expenses over time, according to a Wall Street Journal report (See    Smooth Move).

Supporting their conclusions, the Fed staff said companies in the S&P 500 index with defined-benefit plans on average had “an unjustifiably high valuation of the underlying net pension assets.” The study’s authors wrote “the evidence for this overpricing is particularly strong for 2001, when underlying pension-asset values had been decimated by a steep stock-market decline, while the accrual of pension earnings was still quite high.”

In fact, as 2001 drew to a close, the aggregate value of net pension assets among companies in the S&P 500 had plunged to a $2 billion deficit. However, these companies reported pension earnings totaling $20.4 billion. “At this point in time, naively valuing pension earnings, rather than taking account of pension net-asset positions, could lead to nontrivial valuation errors,” the study said.

‘Re-examined and revised’

However, the study’s authors did not say the present system needed to be overhauled.   Rather, Julia Coronado and Steven Sharpe of the Fed’s division of research and statistics, recommend that the current system of pension accounting “be re-examined and revised.”

This conclusion supports FASB’s stance and concerns surrounding FAS 87, recently voting to add pension accounting to its formal review agenda (See    FASB Agrees To Look At Pension Accounting).  The move came inresponse to a plethora of complaints about current pension accounting standards, and will focus specifically on how to enhance companies’ disclosure of their pension finances (See  Pension Accounting on FASB Radar Screen ).  

However, it should be noted whenthe FASB passed those rules during the mid-1980s, the board drew praise from many companies for reducing volatility in corporate-income statements.   Yet now investors are complaining that reducing volatility comes at the expenses of a clouded reality (See  Finance Pros Say Pension Rules Need Change ). These complaints alleged the smoothing mechanisms require companies to calculate their pension earnings, in part, based on subjective estimates of future returns and discount rates, among other things. Thus, corporate managers easily can manipulate such estimates to goose future quarters’ earnings.

The Fed study found investors are basing their charges on the tendency to apply the same price-to-earnings multiples to pension earnings that they do to earnings from core operations. In part, that is because fuzzy disclosures make it hard for investors to carve out pension earnings from corporate-income statements. However, pension plans should be valued on these earnings multiples, instead investors should base pension valuation on their net asset values.