The GAAP (generally accepted accounting principles) used for U.S. corporate pension earnings is not only detrimental to a plan’s long-term risk management efforts but also increasingly irrelevant, according to a new report.
In Funny Money: The increasing irrelevance of pension earnings, Mercer Consultants and Oliver Wyman explain how the current U.S. pension accounting standards obscure true economics by including a “funny money” component in pension earnings, which presents a fundamental obstacle to chief financial officers in pursuing rational risk management. The report estimates that this earnings component amounts to approximately US$18 billion, or 4% of reported earnings at S&P 500 companies.
According to the report, the current accounting standards dictate that the act of switching a dollar’s worth of pension assets from public or private equities to fixed income will reduce the Expected Return on Assets and lead to an immediate reduction in corporate earnings. Even fully funded plans that seem ripe for de-risking will be forced to deal with a painful upfront earnings reduction as they migrate their pension management strategy to a liability driven investment strategy.
However, proposed amendments to international accounting standards do exist and would deal with the offending component of pension earnings by 2013, and the Securities and Exchange Commission (SEC) has indicated that convergence in U.S. and International GAAP standards may occur sometime around 2015.
“We see a growing number of U.S. corporates announcing an intention to reduce the impact of defined benefit pension volatility on their balance sheets,” says Mick Moloney, senior partner and head of Mercer’s financial strategy group. “We believe evolving accounting standards will hasten the need for others to adopt similar approaches to better manage market perception of their plans, similar to a trend we have seen in Europe.”
On the verge
The report’s authors provide four reasons why the defined benefit world is on the cusp of a transformation, hastening the need to de-risk pension plans:
Accounting standards are set to change. The recently proposed changes to International GAAP look likely to remove the “funny money” component of “pension earnings” from 2013 or thereabouts for European corporate plans. The SEC has indicated that U.S. and International GAAP will converge sometime around 2015, so U.S. plan sponsors should prepare.