Saturday, May 06, 2006

Senescence soaks the private sector too

FASB has begun the process of instituting an accounting rule change that will bring the true cost of company benefit plans (pensions, post-retirment healthcare plans, etc) from the labyrinthal footnotes to the easily observable balance sheet:

The FASB today issued a proposal that would improve financial reporting by requiring employers to recognize the overfunded or underfunded positions of defined benefit postretirement plans, including pension plans ("plans"), in their balance sheets. The proposal would also require that employers measure plan assets and obligations as of the date of their financial statements. The proposed changes would increase the transparency and completeness of financial statements for shareholders, creditors, employees, retirees, donors, and other users.
Currently, companies report a number in the balance sheet that paints a misleadingly rosy picture of the firm's financial health with regards to its employee post-retirement healtcare and pension obligations. The net funded status of the plans is recorded in the footnotes, but the number reported in the balance sheet is increased by an accounting for "unrecognized actuarial losses and prior service costs". This adjustment is not substantative--it is purely a paper change. These unrecognized losses and service costs stem from large obligation increases (medical care and medicinal cost increases, longer life expectancies, etc) that are very real.

Rather than record these obligation increases as they become known, GAAP rules allow companies to amortize these losses over many years. But the funded status (the number reported in the notes but not on the balance sheet) is computed using the present value of future obligations and then comparing it to the present value of plan assets. That is, it already treats an employee twenty years from retirement as a lesser expense than an employee five years from retirement, even though the former is going to ultimately be more costly. There is no logical reason these companies should be able to defer costs even further out. Because obligations have tremendously outgrown predicted cost trends (most of the post-retirement cost is attributable to health care costs) while assets have remained steady or underperformed (especially earlier this decade), we have an accounting deferral of costs that are quite real in the present.

The balance sheet (from which most of the important financial ratios are calculated) gives an impression tantamount to one declaring that Social Security is a valuable financial asset for the federal government because in 2005 it took in more revenue than it paid in outlays. If you found out your wife had cancer in December and that half your net worth of $500,000 was going to go for treatment next year, would you conduct yourself as if you had $500,000 or $250,000 in savings? If you found out a week later that total treatment costs would actually come to $400,000, would you alter your financial plans again or pretend that you still had $250,000 to play with?

Below are DJIA companies, with the net funded status of each company's post-retirement/pension obligations (in millions), how it is recorded on the balance sheet (in millions), and how much total liabilities will increase by with the FASB proposal, respectively (all '05 except GM, ATT, and Delta, which are from '04):

Honeywell: (1,515), 2,057: 16.98%
GE: (1,700), 11,060: 2.3%
Kellogg's: (764.7), 583.3: 16.26%
3M: (1,990), 2,427: 42.42%
GM*: (65,075), 6,706: 15.55%
ATT*: (1,606), 1,125: 10.59%
Boeing: (9,675), 6,629: 33.27%
IBM: (8,863), 14,933: 32.75%
Delta*: (7,133), (3,183): 14.74%
Alcoa: (5,495), (2,266): 17.03%
Pfizer: (5,283), (619): 8.98%
Coke: (1,172), (461): 5.44%
P&G: (3,433), (1,388) : 4.64%
J&J: (3,746), (682): 14.94%
Disney: (2,452), (371): 7.72%

For some of these companies, the increase now recorded is several times more than the last fiscal's net income (Boeing's change is six times NI, Alcoa's and IBM's are both three times). The forward-looking assumptions used to present value future costs also raise an eyebrow (basically the same for all public-traded companies):
The assumed healthcare cost trend rate is assumed to decrease to 8.50% for 2006, then decline gradually to 5% by 2013 and remain level thereafter.
Healthcare cost year-over-year growth has decreased since 2002, but the baby-boomers who are set to receive all of these benefits haven't yet hit seventy, when healthcare costs really start to skyrocket (p8). When the number of septuagenarians jumps in a decade, will 5% really be accurate (keep in mind that the difference between a long-term trend of 10% and of 5% is the difference between doubling every 7 versus every 14 years)?

The FASB proposal will not physically change anything but what shows up on paper (although this will include an unfavorable change in the debt/equity ratio that banks use to determine interest rates for lessees/debtors). Theoretically, the market should have already priced this stuff in. But big industry and unions are strongly opposed to it. It's no longer an obscure footnote--it's out in the open for the public to dwell on. Most Americans are cognizant of the fact that Social Security and Medicare are in trouble, but how many realize that the programs are underfunded (in present value terms) by an estimated $74 trillion? That is, to meet the obligations as they stand, we need each resident to cough up $246,700 today--the longer we wait, the more that will be required per capita.

What are companies doing to reign this in? The same thing President Bush tried unsuccessfully to do in 2004--replacing defined benefit plans with defined contribution plans. Microsoft and Walmart, for example, do not have material defined benefit plans at all. Newer companies are wisely avoiding this crippling burden altogether. As in politics, it is easier for management (especially of publicly-traded firms that face execrable short-term pressure) to offer things now and figure out how to pay for them later. Defined contribution plans, on the other hand, force companies to come up with the money right away and owe nothing more than what has thus far been contributed.

The developed world is ill-prepared for the effects of an aging population. We know the freight train is coming but we're not doing anything to avoid being hit, even as pessimistic forecasts about costs are revealed to have been overly optimistic. The Social Security reform debate is dead. The profligate prescription drug benefit plan that is so bemusing and ineffective that the government is having to take out paid advertisements just to get people to sign up (only government would take out ads instructing people on how to plunder it) has added another $8 trillion or so to the long-term cost of Medicare. On the bright side, at least it is helping lots of companies like Boeing:
"The Medicare Prescription Drug, Improvement and Modernization Act of 2003 reduced our APBO [accumulated postretirement benefit obligation] by $439 [million]..."
... and IBM:
"In connection with the Medicared Prescription Drug Improvement and Modernization Act of 2003, the company is expected to receive a federal subsidy of approximately $400 million to subsidize the prescription drug coverage provided by the US nonpension postretirement benefit plan..."
I'm worried about my ability to raise a family when all of these obligations catch up with us.


1 comment:

adog said...

Another reason not to invest in US manufacturing.