There have been years of improvements to accounting rules for pension plans. So why are more than $1.3 billion in pension liabilities missing from BCE Inc.’s financial statements?
Investors should scrutinize the details of any public company’s pension plan. The impacts on share valuation have always been significant—ever since we first looked at the issue over 15 years ago.
As times have changed, so have the importance and impact of various issues related to company pension plans. Two big factors investors need to pay attention to are changing accounting rules and fluctuating interest rates.
Significant risks to valuation continue to exist, and the impacts can be quite material as evidenced by the BCE example.
This is an improvement
The accounting rules regarding pension plans used to be much worse, allowing companies to use a broad range of smoothing mechanisms. As a result, economic impacts on pension plans were not being reflected in corporate financial statements.
For instance, companies were able to report net pension assets on their balance sheets even when their pension plans were in serious deficit.This led to situations where analysts and investors weren’t including off-balance sheet liabilities in share-price valuation.
Canadian pension plan sponsors are preparing for sustained pension turmoil by making changes to plan design and investment strategies, according to results from a Towers Watson survey. The poll reveals 65% of DB sponsor respondents believe Canada is in the midst of a pension funding crisis that will be long-lasting and likely to worsen over the next 12 months — up from 56% who felt the same in 2011. Among DC/CAP sponsor respondents, 70% are bracing for an increase in plan-related litigation in the coming years.
Also, more than half (54%, up from 50% in 2011) of DB respondents indicate they’re planning or considering investment strategy changes. Of these sponsors, 49% say their long-term goal in changing investment strategy is specifically to de-risk, regardless of whether it means lower returns, while 41% say they’re equally seeking higher returns and lower risk.
Further, most DB plan sponsors are moving their target asset mix away from equities and into fixed income, with the average plan expecting to shift from a 50% allocation to domestic and international equities in 2012 to 46% in 2015. Assets allocated to fixed income are expected to rise from 40% in 2012 to 45% in 2015.
In similar fashion, some companies actually used to report pension profits on their income statements, even when their pension plans were in deficit.
Instead of recognizing the pension plan as an expense (like any other employee-related expense), some companies would recognize gains that reduced expenses and actually increased overall income. This is because companies would flatten out the impact of changes in their pension plan’s funded position over an extended time period.
For instance, when the actual results of investing the assets of the plan fell short of expectations, the negative impact of the real results were not reflected in reported income.
Instead, companies were allowed to use very optimistic estimates of what they thought they might earn in the future as a way to boost reported profits in the current period.
Likewise, when companies used to reduce the discount rate on their pension obligation (as a reaction to declining interest rates), the impact was not immediately reflected in the company’s balance sheet. Instead, the negative impact of increasing obligations or declining assets could be smoothed over time.
This required serious accounting adjustments when it came to valuing stocks.
Thankfully, circumstances have improved, and accounting rules now produce a more reasonable economic picture. The billion-dollar pension deficits of companies such as Bombardier, Manulife and Imperial Oil are better-reflected on the balance sheet, giving a more accurate reflection of their total obligations and fiscal leverage.
However, there are still some loopholes in current accounting rules. For instance, multi-employer pension plans remain off balance sheets for companies.
Multi-employer plans cover employees in an industry where there are multiple employers, or companies with employees that belong to the plan.The plans are extensions of the benefits provided by industry labour unions. Under the accounting rules, companies can report these plans in a way that hides the liabilities from investors.
By nature, these plans tend to be in perpetual deficit, and companies that are responsible for funding those deficits aren’t reporting the associated obligations on their balance sheets.
In the Canadian grocery industry, for instance, the largest plan is the Canadian Commercial Workers Industry Pension Plan for members of the United Food and Commercial Workers (UFCW).
Major contributors to the plan, such as Loblaw Companies and Metro Inc., do not report their shares of the plan’s deficit on their balance sheets.Worse, they don’t quantify the size of the deficit in their financial statement notes, making it difficult for investors to know the plans and associated debt obligations even exist.
There are other shortfalls to the current accounting rules, which also have significant impact on valuation. Take discount rates as an example. When tallying up the obligations of their pension plans, companies estimate what they will need to pay out to current employees for services they’ve already provided.
The rules then require the amount to be discounted back to a current value today. The choice of discount rate can impact the calculation by billions of dollars (see “Bad discounts”).
In its 2011 annual report, BCE discounted its future obligations at 5.1%. By contrast, close peer Telus Corp. used a rate of 4.6% (the lower the discount rate, the greater the resulting liabilities to the firm).
The accounting rules require companies to use a discount rate that equates to the current yield on high-quality corporate debt. And therein lies the wiggle room for management in applying the accounting rules.
What constitutes high-quality corporate debt? Interestingly, BCE itself recently issued 7-year debt at a new low of 3.4%.
If BCE had used the same rate as Telus in determining its pension obligations, then its reported liabilities would have increased another $1.3 billion. The difference when it reached the balance sheet would theoretically have had an impact on leverage, P/E multiples, and per share value.
But there are also more tangible and immediate concerns at play for investors. BCE’s most recent figures put its pension deficit at $2.8 billion. Adding in the $1.3 billion in phantom obligations would push total pension liabilities over the $4 billion threshold.
In 2011, the company contributed approximately $1.5 billion in cash to its plans, including a voluntary top-up of $1.1 billion. In 2010, total infusions of $1.3 billion included a voluntary contribution of $750 million.
But the large contributions only helped BCE’s pension plans tread water in 2011, since lower interest rates led to a significant increase in obligations at year-end.
Moving forward, the company’s capacity to make voluntary contributions will be stretched, especially given its recent acquisitions. BCE is shelling out roughly $4.0 billion to acquire Astral Media Inc. and part ownership in Maple Leafs Sports & Entertainment.
Adding in the burden of playing catch-up to peers in valuing its obligations, and the potential that rates will drop even further in 2012, BCE could be strapped for cash moving forward. It will again need to contend with a ballooning pension deficit dragging on its balance sheet and share price.
At the very least, dividend increases could be stalled for the foreseeable future to conserve cash. And the four increases in the quarterly payout over the past 24 months have been a draw to investors in BCE.
Advisors only have to look at the bottom line, and the lack of comparability between companies, to know accounting rules can create too much uncertainty.
And finding $1.3 billion in liabilities hiding in the accounting vapour reinforces the need to check financial statement assumptions, especially when it could end up impacting something as important as dividends.
Dr. Al Rosen , FCA, FCMA, FCPA, CFE, CIP and CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.