Marking to Market: A Preliminary Look at the Impact of Proposed Changes to FASB Accounting Standards on Postretirement Benefit Plans

Sentiment has been rising among financial market participants that pension accounting standards are confusing and lack a solid grounding in economic principles. Accordingly, at its November 10 meeting, the Financial Accounting Standards Board (FASB) voted unanimously to reconsider FASB Statement No. 87, Employers' Accounting for Pensions, and FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions, which generally covers retiree medical and life insurance plans. The FASB seeks to make accounting for postretirement benefits more "conceptually sound" and align U.S. standards more closely with international practice.

The FASB's recommendation was for the project to proceed in two phases. Phase One would focus on the balance sheet, eliminating all smoothing of actuarial gains and losses in the funding position that flows into the other comprehensive income section of shareholders equity. FASB sources said they hope to have this revision in place for firms whose fiscal years end after September 30, 2006, so that the financial statements of most firms with December 31 fiscal year-ends will reflect the new standards in their 2006 annual reports. The FASB plans to release an exposure draft by March 2006, accept comments through June and then possibly hold a roundtable in July.

Phase Two would completely reevaluate postretirement benefit accounting, including the expense calculations reflected on the income statement. This phase is expected to take several years.

To project the impact of Phase One, we examined Watson Wyatt's database of pension and other postretirement plans of Fortune 1000 companies. We used data for fiscal year-end 2004, the most current data available.

To gauge the effect of marking the balance sheet to market for pension plans, we looked at the difference between the funding position and the net asset or liability recognized on the balance sheet as reported in the footnotes, where the funding position was calculated as the projected benefit obligation (PBO) minus the market value of assets¹. However, many sponsors already recognize an amount on their balance sheet that exceeds the net amount recognized figure reported in the pension footnote. Sponsors that have an underfunded accumulated benefit obligation (ABO) must recognize a minimum pension liability. About two-thirds of our sample fell into this category. For these firms, we estimate the impact of Phase One as the difference between PBO-based funding status and ABO-based funding status — or simply the difference between the PBO and ABO.

For other postretirement benefit plans (such as retiree medical and life insurance) we also looked at the difference between the funding position — the accumulated postretirement benefit obligation (APBO) minus the market value of assets (if any, as most of these plans are unfunded) — and the net amount recognized reported in the footnotes.

The difference between the funding position and the net amount recognized is driven primarily by unamortized actuarial losses. These losses are included in the funding position but are fed into the net amount recognized from these plans on the balance sheet, generally over 10 to 15 years. As of 2004, the difference between the net amount recognized and the current funding position is substantial for the firms in our sample, owing mainly to higher plan liabilities pushed up by the sustained decline in long-term interest rates in recent years. Under current rules, these actuarial losses would feed into the balance sheets of pension sponsors for many years to come.

Since the current position of most pension and other postretirement benefit plans is worse than currently recognized on the balance sheet, Phase One of the FASB's proposal would significantly reduce reported shareholder's equity (Table 1). The effect from FAS 87 is notably larger than that from FAS 106. The aggregate decrease from the two types of postretirement benefit plans is about 11 percent, while the median decrease across firms is about 4 percent.

Table 1
Estimated Impact of Phase One of FASB Proposal on Reported Shareholder's Equity of Fortune 1000 Firms ($ billions)

Source: Watson Wyatt Worldwide.

As shown in Figure 1, the proposal's effects on shareholders equity would be highly skewed. While the decline would be minimal for a majority of plan sponsors — and a few would even report an increase — many firms would have to report markedly lower shareholder's equity.

Figure 1
Distribution of Changes in Shareholders Equity From Proposed Changes to FAS 87 and FAS 106

Source: Watson Wyatt Worldwide.

The effects of the proposed accounting changes would fall disproportionately on certain industries (Table 2). The durable manufacturing industry would realize the largest decrease (including both FAS 87 and FAS 106), while decreases would be minimal for the finance industry. Both industries have large concentrations of pension plans. However, manufacturing firms shoulder more retiree health liabilities, while the finance industry's pension plans are almost fully funded, and their balance sheets more accurately reflect their current funding position.

Table 2
Total Change in Reported Shareholders Equity by Industry

Source: Watson Wyatt Worldwide.

The FASB initiative raises a fundamental question: Does the market already understand pension accounting? The dramatic reduction in shareholder's equity reported on some company balance sheets might not drastically lower the share prices or alter the credit terms of sponsoring companies if the market has already priced in the current funded status of pension and other postretirement benefit plans. This data is readily available in the footnotes to financial statements, and both credit and equity analysts have developed explicit methodologies for adjusting both the income statements and balance sheets of sponsoring firms to account for postretirement benefit plans.² However, while these analysts inform the market, investors actually set prices. So the extent to which investors buying and selling securities have factored in postretirement obligations remains a more open question.

While it seems plausible that investors in large industrial firms with prominent postretirement obligations are well aware of the plans' current position, they may be less aware of the complete financial picture for companies whose plans constitute a smaller share of total company obligations and market value. A preliminary strategy for responding to the potential accounting changes is to discuss with analysts and investors the likely impact on reported shareholders equity.