The Canaries Sing But They Sing Not To Thee

Employee Benefits and Retirement Planning Email Newsletter #372

By Alvin D. Lurie

July 12, 2006

"Who would not share FASB's goal of enhancing employers' ability to meet their pension obligations, or not want to see pensioners get their pensions? But isn't there also another consideration that must be weighed, when the means to that end carry the very real potential of destruction of the pension provider and impairment of the plan itself, so that not only are future pensions imperiled, but the jobs on which such pensions depend are lost, as the sponsor goes down the tube?"

Alvin D. Lurie, LISI's grand master of pension philosophy, arch enemy of pension sophistry, and man with a lantern takes on a no less challenging foe than the Financial Accounting Standards Board, affectionately by some called FASB.

Al was prompted to write the following commentary by "roundtables" FASB conducted two weeks ago to hear live comments from, and engage in spirited colloquies with, stakeholders (actuaries, accountants, rating agencies, the SEC, US Chamber of Commerce, etc.) in the proposed rule changes FASB published in March.

Al confronts very specifically the issues and arguments that FASB has proposed, the opposing views, as highlighted during those roundtables, and presents his own critique of all this. The time of decision is now drawing near, since it is now apparent that FASB is hell-bent to finalize its proposals in September, which is frankly surprising. It may be tempting to say, "I don't have time to read philosophy - I'm not even involved in defined benefit plans - this has nothing to do with me!" But Al's warnings are anything but theoretical - and you and all of your clients will be severely impacted - if even only some of his predictions come true. Listen carefully to these canaries!


The title of this piece, The Canaries Sing But They Sing Not To Thee is meant to invoke the image of the canary in the mine, in its first three words, and of notes falling on deaf ears, in its final six words. Is elucidation necessary? The subject is pensions. The mine is the deepening descent of defined benefit plans as they continually plunge in popularity, with a corresponding decline in numbers; while the canaries are the signs of danger in the mine. Thee are all those who can play a role in digging pensions out of this hole, but do not heed the warnings. Poetic license? Maybe a little, but more truth than poetry. The scenario is the stuff of nightmares.


Overnight, most of the defined benefit plans in the country still standing become massively under-funded. Congress convenes a special emergency session requiring that the under-funding be rectified forthwith by the contribution of sufficient sums to achieve full and immediate funding. Simultaneously, the FASB adopts a new accounting standard for all companies, public or private, large or small, requiring the prompt restatement of financial statements to reflect 100 percent of the liability for under-funding on the balance sheet by adjustments to appropriate accounts, with consequent massive charges to shareholder equity, wiping out all such equity for many of our largest companies, resulting in an immediate sell-off on the stock markets that erases 500 points from the Dow in three hours after the markets open in New York, prompting the exchanges to halt trading for an indefinite period. The following day a report appears on the AP wires that the PBGC is requesting Congress to enact a 200 percent premium surcharge across-theboard for all companies on its rolls, payable within 30 days, to stave off imminent insolvency of the agency; and later that day thousands of plan sponsors call a special meeting of directors to consider whether to immediately terminate or freeze their DB plans, or to file for bankruptcy. Okay, that's only a nightmare scenario. It couldn't really happen at least not in the exaggerated state that seems all too real in a frightening dream. But the very events that I have just described are not such a far cry from things that have been occurring in the recent past or could easily occur in the immediate future.


Evidence of the swelling disenchantment with traditional defined benefit plans is readily at hand. The statistics tell the result, if not the reason. A recent survey by Watson Wyatt Worldwide reveals that where 89 of the 100 largest companies offered DB pension plans in 1985, only 50 provided such plans to new hires in 2002, and that number was down to 42 in 2004, and 37 in 2005.

In a separate study of the 627 Fortune 1000 companies sponsoring DB plans, Wyatt found that 113 had frozen or terminated plans, or announced that they were, as of April 2006, compared with 71 in all of 2004. An additional 49 sponsors closed their plans to new hires by that time this year, up from 25 in 2004.

A study by the Center for Retirement Research at Boston College adds that in the years 2004-2005 17 even large, financially healthy companies names like Coca-Cola, IBM and Verizon froze their plans for all employees, so no further benefits will accrue for future periods of service.

Obviously, many other companies, with unfamiliar names -- some with healthy balance sheets, many more less so were doing the same thing. The $23 billion PBGC deficit in 2005, compared with a $10 billion surplus in just four years before that, tells its own story. A sharp increase in the PBGC premium was instituted just this year when Congress raised the annual, per participant premium for individual DB plans from $19 to $30, to ameliorate that imbalance between the dollars flowing out of and into that insurer of failing DB plans.

Did my reference to bankruptcy, as the alternative to plan termination in the above scenario, seem a bit much? United Airlines has done just that, dumping its plan on the Pension Benefit Guaranty Corporation, Delta either has or is about to, and Northwest Airlines is also expected to, as I write this. That is not to suggest that only the airlines can take flight into the bankruptcy court. One doesn't need wings for that flight, and many other companies have filed, or are considering, similar flight plans. Oh yes, I also mentioned massive hits to shareholder equity. We will get to that shortly.

The "perfect storm" of the early post-millenium years low interest rates, sinking stock prices are generally given credit (if that is the right term) for having started the rash of DB plan terminations, although its beginnings could be detected 20 years before. But the contemporaneous declines in interest rates and stock prices certainly greatly accelerated the demise of many plans. As companies dropped or froze traditional DB plans, new plan formations since the 1980s have been dominated by the wave of 401(k) formations. Somewhat offsetting the loss of traditional DB plans was the surprising surge of cash balance plan conversions a modified form of DB plan -- among S& P listed companies in the past decade. But even this has now been virtually halted by recent developments that are once again giving pause to plan sponsors (more of this in a moment).


By my count there are presently three circumstances, any one of which has the clear and present potential to destroy what's left of the defined benefit pension scheme: (1) the pending pension reform legislation that the conference committee in Congress on H.R. 2830 has been attempting to craft for nearly five months at this writing; (2) the revised rules of accounting for pension liabilities proposed by the powerful Financial Accounting Standards Board in an exposure draft released March 31st;; and (3) the decision of the 7th circuit court of appeals in the IBM cash balance litigation that could be announced any time now. I would add to this list an unlikely fourth candidate that, while not directly affecting qualified pension plans, could have an unexpected consequence, the present and proposed regulations under Code section 409A governing nonqualified deferred compensation arrangements. The first two on my list will greatly increase the costs and consequences (not just the visible, objective costs) of maintaining a defined benefit plan, to the point of prompting additional termination or freezing of plans by numerous sponsors already disenchanted with and leery of the financial risks of carrying such plans, and driving countless companies towards financial difficulties and, as we have seen, even into bankruptcy as a result of the immediate cash effects and balance sheet impact of the emerging rules from Congress and the accounting standards agency. The IBM appeals court decision, if it sustains the trial court's holding that the company's cash balance and pension equity plans were violative of the age discrimination prohibitions of federal law an eventuality that I do not see as likely to happen would surely accelerate the dropping of such plans that 70 percent of the S& P 500 companies had gravitated towards in the past decade as a way of escaping the unforgiving and unpredictable liabilities of their previous traditional defined benefit plans. It would also certainly prompt many other companies that had considered adopting cash balance plans to abandon that course; because when employers have no certain ways to insulate themselves from the worrisome exposure to which they can presently be subjected under such hybrid plan designs, such plans will largely drop out of sight, and drag what's left of the defined benefit scheme down with them. The impact of the 409A regulations on defined benefit plans is less obvious, inasmuch as the statute explicitly excludes them from its coverage. But the impact is nonetheless discernible, since resort to nonqualified compensation arrangements has often been a satisfactory way to compensate executives and other highly compensated employees without enriching the benefits of rank-and-file employees under a qualified plan; so companies have been content to maintain an affordable defined benefit plan or other types of qualified plans for employees across-the-board as long as the complementary NQDC approach was also available to satisfy the requirements of executives they sought to recruit hence, the great popularity of excess benefit plans and SERPs.


Of the four potential troublemakers for DB plans, I would place the proposed new pension accounting rules "exposed" by the FASB (Exposure Draft 189) at the top of my list. I would not have been inclined to do that until very recently, specifically June 27th, when I listened to a webcast of two public roundtable meetings conducted by FASB for the purpose of discussing with stakeholders the proposals in Draft 189. These proposals had seemed to me so radical and controversial, with such potentially enormous effects on the economy, and moreover were to become final in September, barely six months after their publication after providing all of two months for written public comments and to be effective for 2006 calendar years and subsequent fiscal years, that I assumed they would be met with such howls of protest as to be placed on a much slower track, if not entirely derailed. How surprised I was to hear the FASB board members and staff calmly and matter-of-factly state their obvious determination to go forward with their plans on exactly that timetable, as if they were proposing nothing more momentous than a requirement that henceforth balance sheets should be printed in at least 12 point type, and footnotes captioned in some prescribed manner. How even more surprising it was to hear the invited participants from the public representatives of the reporting employers' community, and major accounting and actuarial firms (no law firms curiously or is that "no curious law firms"?), the American Academy of Actuaries, the U.S. Chamber of Commerce, banks, brokerage houses, the rating agencies, Financial Executives International discuss the proposals equally calmly and matter-of-factly, even dispassionately. Not all of them agreed with the FASB, of course, or with each other; but I heard no barn-burning rhetoric, and only relatively slight demurrers even to the fast-track timing. It was almost as T.S. Eliot had put it in The Love Song of J. Alfred Prufrock,

"In the room the women come and go
Talking of Michelangelo."

If Eliot or Prufrock was to be their model, I would have been more prepared to find them mirrored in this couplet:

"I should have been a pair of ragged claws
Scuttling across the floors of silent seas.

The divisions among the participants at the FASB roundtables were largely between the actuaries and employers on one side, and the credit rating agencies and investors on the other, the former urging restraint and conservatism, the latter full -, indeed, I would say, over -, exposure, as one might expect, given what they each saw as best serving their respective, disparate uses of the financial statements.

Less to be expected was how some of the FASB persons present entered the discussion from time to time, not as moderator but almost as combatant, to assert certain institutional positions long held by the agency and reaffirmed in the exposure draft, when on occasion an opposite point of view, articulated principally by the actuaries, seemed to gain traction in the discussion. The chief issues that attracted the most interest were FASB's proposals regarding the recognition of unfunded benefit liabilities and the measurement of such liabilities. Obviously these are very different aspects of the liability. In this context recognition is concerned with elevating the unfunded pension or other (e.g., retiree health) benefit liability from footnote to balance sheet, while measurement is a question of what matrix is appropriate for determining the amount of such liability for this purpose.

The choice of matrix has come down to two principal contenders, in accounting parlance the projected benefit obligation basis (PBO) and the accumulated benefit obligation basis (ABO). The principal difference between the two is that PBO takes into the calculation whereas ABO does not the effect of likely future pay raises extending out until the normal retirement date, even though not promised, agreed to or in any sense owed, let alone contractually or otherwise fixed at the balance sheet valuation date. FASB has opted for PBO in its exposure draft, and points to its own consistent position on this for almost 20 years going back to its seminal FAS 87 ("Employers'Accounting for Pensions"), although, it must be noted, not for the current purpose of bringing that figure into the balance sheet.


The PBO-vs.-ABO issue evoked the most extended discussion. But even there the arguments of those disputing the FASB position lacked passion. The main argument between parties revolved around the threshold question of what is a liability for balance sheet purposes. The purists (I do not mean that as a pejorative) argued it must be definite and fixed, that is, not contingent on whether the employer retains discretion as to whether, how much and when the pay raise will be made. FASB says that if the pay is likely and expected to be raised, that is tantamount to a liability for this purpose. The opposition rejoinded, inter alia, that the day of the automatic cost-of-living raise is rapidly disappearing from the compensation scheme. There is no obviously correct choice, or even one that is correct for all purposes, as one might expect of an issue that has proved contentious among knowledgeable experts. There are good arguments on both sides of the divide. Each can claim strengths for its position and cite the other's weaknesses, as in any legitimate debate. Avoiding year-over-year volatility is something ABO adherents can claim, but excluding very material components that are reasonably predictable is misleading, the PBO-ers would claim. One must be concerned about projected wage increases to forecast funding and likely benefit payouts, say they; but a balance sheet deals with liabilities, not cash flow projections, comes the riposte from the other side. It turns out that rating agencies are keenly interested in the projection of future compensation (to which pension benefits are usually geared) hence their strong support for the PBO approach. On the other hand, actuaries albeit in the very profession most attuned to future events and the measurement of them uniformly oppose the introduction into the benefit obligation concept of future pay raises that may never occur. The difference between inclusion and exclusion can be enormous, as we shall soon see. FASB itself recognizes that the issue has wide repercussions, and may require a different solution when applied to the broader issue of pension accounting for financial statements generally, which it proposes to address, but only after first settling upon what might prove to be only an interim decision for balance sheet purposes. For that reason it has decided to break up its current study of employers' accounting for defined benefit and other postretirement plans into two phases, the first phase to deal only with balance sheet questions this year, and then to give possibly another two years of deliberation in Phase 2 to the broader matter, during the course of which it is prepared to look again at the choice of PBO and reverse itself if it so determines. In a most interesting interjection, the chief accountant for the SEC, who attended the roundtables as an "official observer", warned, with just a trace of menace befitting his high station, that the SEC would take a very dim view were FASB to do any less. (One can almost see the moment portrayed in a Gilbert and Sullivan operetta; but in a long day of technical dialogue there were few such moments.) That underscores an issue that ran through and parallel to the discussions during the roundtables, and figured also in the comments of many of the papers that were submitted to FASB in response to its exposure draft, namely, the timing of putting into effect the FASB positions decided upon in Phase 1, more particularly the PBO decision, inasmuch as it would have to be reconsidered, possibly leading ultimately to adoption of ABO, or any of several other possible approaches, in Phase 2.


A reasonable compromise suggested by one of the participants was, for purposes of balance sheet recognition in Phase 1, to adopt ABO, as the more conservative of the two main choices, and defer further consideration of PBO for decision as part of the global resolution of all accounting matters under Phase 2. In other words, a Solomnic decision, one might call it: go along with the FASB position on immediate timing of balance sheet recognition of the liability, but postpone adoption of the FASB decision on measurement of the liability. That works very well because whether to recognize a liability is not dependent on how the liability is to be measured. I find it surprising that the Board has not itself opted for that course. They have not made a particularly muscular case for selecting PBO in Phase 1.Their principal justification is that is the choice made by FASB almost 20 years ago when the Board last addressed pension accounting issues in FAS 87. But the very rationale offered by the Board for the current project is "to address the concern that existing standards on employers' accounting for defined benefit postretirement plans fail to produce representationally faithful and understandable financial statements ....Insufficient guidance in existing standards may cause incomplete reporting of the employer's financial condition and results of operations....This proposed Statement is the first step in a comprehensive project to remedy that situation." Why then allow the dead hand of the past to continue to control this current reassessment? The Board acknowledges that the issue of PBO is complex, and that new issues and new pension designs have emerged in the past two decades. It particularly mentions cash balance plans, which it says will require "analysis and research", which it promises to devote to the PBO matter as part of the Phase 2 work. (Parenthetically, one can fairly ask why that analysis has not already occurred, since hybrid plans of the cash balance type have been on the scene for 20 years, emerging almost contemporaneously with FAS 87 itself.) Clearly the issue is contentious, and has deeply divided professionals, as is apparent from the comment letters that have poured into the FASB office in response to its exposure draft, and from the extended discussions during the roundtables last month. The FASB assured participants in those roundtables that it will reconsider its present decision and is prepared to reverse itself, repeating on several occasions that it is not committed to PBO and has not predetermined its choice.


If it were mine to call, I would certainly defer fixing on PBO at this time, for the very reason that it will have to be reconsidered before this project is finished and very possibly re-decided; and at a time when that outcome is so uncertain, it can only be needlessly disruptive to have imposed on the business community for a brief period a significant accounting change that may well be abandoned, with ensuing further disruptions. More important are the immediate and greatly undesirable consequences on pension planning that one can reasonably predict will occur from the imposition of the PBO standard, namely, another strong push towards the freezing of DB plans inasmuch as that would eliminate the ABO/PBO dichotomy by foreclosing the issue of future wage increases as an element of pension liability. It is no answer that this may be undone when the Board reconsiders the issue. The harm will have been done by then. The Board should think long and hard before triggering this eventuality while the issue remains unresolved.


If strenuous debate was lacking on the PBO issue, discussion of the proposal to elevate the unfunded pension and other postretirement benefit obligations to liability status on the balance sheet proper, as part of the Phase 1 project, was almost muted, as if its opponents were resigned to that outcome and stated their views for the record rather than for persuasion. That restraint among the roundtable participants was not to be expected. Some of the written comments had even proposed collapsing the entire Phase 1 into Phase 2. Accounts in the lay press of the FASB proposals have just focused on the moving of the unfunded obligation from the footnotes to the balance sheet proper, as the only newsworthy aspect of the proposed changes, and paid scant attention to the PBO matter (doubtless because its arcane and nuanced elements, as regards its appropriateness as a balance sheet measuring tool, made it difficult for the nonprofessional reader to grasp, lacking the requisite grounding in the intertwined accounting, actuarial and legal underpinnings of the issue). Under the FASB proposal, the balance sheet change would come into effect in one gulp, as of the end of this year, producing a shock effect such as is highlighted by the discussion that follows regarding the effect of the FASB proposals on shareholder equity (to which I had hinted in my nightmare scenario). But before doing so I could suggest another approach, i.e., to phase in the balance sheet changes over a reasonable period of years, so as to cause less immediate effect on shareholder equity a smoothing effect, in the term du jour. I did not hear that suggested during the roundtables; and it may be that there are practical or technical obstacles of which I am unaware. But there it is, for what it's worth.


I identified above the newly proposed pension accounting rules as now topping my list of the greatest threats to DB pension plans. I could have added: and threats to plan sponsors themselves. As such, they are why we need those canaries in the mine. A fairly recent article in the Wall Street Journal, under the following headline, captures the point quite tellingly: For GM, Pension-Accounting Shift Could Dwarf Gain on GMAC Deal - W.S.J. 4/5/06, p. C3. As all who read the financial pages know, GM is reeling from a string of blockbuster losses most recently and spectacularly, last year's $10.6 billion loss. So, much relief in the GM headquarters and in dealerships around the world greeted the sale earlier this year of a majority stake in the company's crown jewel and only current profitable unit, GMAC, that yielded the parent a hefty $10 billion cash infusion in the current year, with another $4 billion to follow in the out years. But ironically, the FASB exposure draft hit the street almost simultaneously with the GMAC announcement, and with it came the realization at least among financial types that the company's liabilities for under-funded pension and welfare plans a staggering $68 billion figure -- if recorded as liabilities on the balance sheet at the end of this year, as proposed to be required by FASB, would not only erase the benefits of the GMAC sale, but actually turn a multibillion dollar stockholder equity into a negative $43 billion equity deficiency, according to the Wall Street Journal piece. The potential cascading consequences of that for the once-giant from Detroit are not hard to imagine: declining credit rating, slumping stock value, possible loan covenant defaults, increased borrowing costs, an already dicey financial condition, and the prospect of inability to honor future obligations as they mature (invoking the specter of the b word). Barring forces that I cannot possibly forecast like a government bailout such as accompanied the meltdown of a previous major U.S. automaker those consequences would seem a not unlikely scenario to follow from the FASB's high-minded goal of enhancing the "employer's ability to carry out the obligations of its plans" by making the true state of the company's funding, or insufficient funding, of pensions and other post-employment benefits transparent to its benefits plan participants, stockholders and other interested observers (a nonsequitur, it would seem). But even if, as it has been claimed, the FASB proposals in the main do not increase the actual long-term costs of a plan, but merely treat the deferred funding of those costs as items to be charged against shareholder equity directly on the balance sheet, the above noted risks to the plan sponsor would still be present. Besides, it is problematic whether recording unfunded pension benefit obligations as balance sheet liabilities overcomes the problem identified in the FASB press release accompanying its exposure draft, that "current incomplete accounting makes it difficult to assess an employer's financial position." Difficult for whom? Financial analysts are not stymied by footnotes. No one has to draw them a picture of how the balance sweet would look if the content of the footnotes were translated into a balance sheet item. But labeling it as a "liability" on the balance sheet can have quite a different impact on the pension participant or retired health benefit recipient, or the shareholder whose equity has suddenly taken a trip south, or even the supposedly sophisticated company banker whose sophistication doesn't extend to PBOs. None of these can really be expected to understand that this newly surfacing "liability" is an obligation to pay benefits for perhaps hundreds of thousands of participants at a future time, out of a pool of assets that will rise and fall with the vagaries of the stock market and will be regularly enhanced by contributions geared to continuously changing actuarial assumptions as to wage increments, interest rates, deaths, retirements, quits and possibly other factors pertinent to a particular business from time to time. Is it a stretch to suggest that posting this liability, which has been monitored all along by the employer's actuaries and accountants, who, following standards of practice of their respective disciplines, had not before viewed it as a liability, will actually befuddle plan participants and other uninitiated users of the balance sheet more than if it were not there?


Who would not share FASB's goal of enhancing employers' ability to meet their pension obligations, or not want to see pensioners get their pensions? But isn't there also another consideration that must be weighed, when the means to that end carry the very real potential of destruction of the pension provider and impairment of the plan itself, so that not only are future pensions imperiled, but the jobs on which such pensions depend are lost, as the sponsor goes down the tube? Who is the winner here? The Milliman actuarial firm, in its recently released annual survey of 100 large plans, states that the pre-tax charge to shareholder equity would have increased by $222 billion last year, on account of pension plans alone, plus an additional $106 billion for health and other post-employment benefits, if the FASB proposals, presently scheduled to be in force initially in this CY 2006, had been in effect in 2005. Watson Wyatt Worldwide adds, no more comfortingly, that the Fortune 1000 companies, as a group (hence, 10 times the Milliman sample), would lose 10 percent of shareholder equity recorded at the end of fiscal 2004, although there obviously would be wide variances as among different industry sectors (ranging from 25 percent for durable goods manufacturers down to 2 percent for financial service firms). FASB likes to say that its decisions are not driven by policy considerations. Granted it should not be influenced by such crass matters as politics, or favoritism, or personal preferences. But does that require it to operate in a vacuum? What nature abhors should the FASB embrace?

Senate Minority Leader Harry Reid (D-Nev.), speaking of the efforts of the H.R.2830 conference committee, said something that could apply equally well to the work of FASB at this time:

"The conference agreement should strike a proper balance between improving pension funding and keeping these plans an attractive benefit option for employers. While there is a trend away from defined benefit pension plans and this trend is likely to continue, rules should not be enacted that exacerbate this problem."

Spoken like a true canary, Harry.


Al Lurie
Edited by Steve Leimberg

CITE AS: Steve Leimberg's Employee Benefits and Retirement Planning Newsletter #372 (July 12, 2006) at
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© A.D. Lurie 2006