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[Mr. Ed]

Billions in earnings don't exist
Pension-fund 'time bomb' is detonating on companies' profits

By DAVID EVANS
BLOOMBERG NEWS

NEW YORK -- According to its annual report released in March 2002, Verizon Communications Inc., the nation's largest local phone company, had a strong year in 2001. In the opening pages of the report, the company announced an annual profit of $389 million.

Only those investors who dug into the small print at the back of the document learned that Verizon's reported earnings included $2.7 billion in gains from its pension fund investments -- profit that didn't really exist.

The company pension fund actually lost $3.1 billion in 2001, a footnote on page 58 of the 68-page report revealed.

In reporting gains it hadn't made, Verizon didn't violate any rules. Like other U.S. companies, Verizon was following accounting practices as written in 1985 by the Financial Accounting Standards Board, which sets U.S. accounting standards.

The board rules say that in preparing income statements, companies should include estimated gains -- not actual gains or losses -- from pension fund investments.

Legal or not, the practice has incensed some investors.

"There's a serious illness pervading a portion of the financial market," says Kathleen Connell, California controller and a board member of the state's two largest pension funds: the California State Teachers' Retirement System and the California Public Employees' Retirement System.

She says accounting rules are allowing companies to artificially increase stock prices.

"Phantom pension earnings are portrayed as income," she says. "It's a ticking time bomb."

As the stock market plunged during the past three years, the pension funds of companies in the Standard & Poor's 500 Index lost more than $200 billion in value, according to studies by actuaries and several investment banks, including Credit Suisse First Boston and UBS Warburg LLC.

Because of the standards board's accounting rules, many of those losses weren't reported on balance sheets.

If pension liabilities had been counted in financial statements, aggregate earnings for the S&P 500 would have been 69 percent lower than the companies reported for 2001, or $68.7 billion rather than $219 billion, the Credit Suisse study found.

"We're starting to see billions of dollars of shareholder equity vaporized because of pension underfunding," says Marc Siegel, a senior analyst at the Center for Financial Research & Analysis, an accounting research firm in Rockville, Md. "It's much more pervasive than anything Enron was doing."

Weyerhaeuser Co., the world's biggest lumber company, relied on reported pension earnings for 66 percent of its net income in 2001: $234 million out of $354 million. The Federal Way-based company used an 11 percent assumed rate of return in 2001 -- one of the highest of any company in the S&P 500, according to Credit Suisse and UBS Warburg.

Its pension fund actually lost 9.5 percent on its investments. The estimated pension fund investment income before expenses was $437 million, while the pension fund lost $412 million.

Weyerhaeuser achieved an 18 percent actual rate of return over the 17 years through 2001 by taking on slightly more risk than other pension funds, said Richard Taggart, the company's vice president of finance. That included $47 million invested in LJM2 LP, the now-bankrupt special-purpose entity formed in 1999 by Andrew Fastow, Enron Corp.'s former chief financial officer.

In November, Weyerhaeuser said it would reduce shareholder equity by $90 million in the fourth quarter because of lower investment returns on its pension funds. Weyerhaeuser dropped its expected rate of return to 10.5 percent in 2002, and company officials say another decline seems likely in 2003.

Over the past three years, most companies have allowed their pension fund losses to grow -- out of the sight of balance sheets and investors -- without addressing the problem, said David Bianco, who headed research into the issue for UBS Warburg.

Now, the liabilities have become too big to ignore. Many of the largest companies will be spending hundreds of millions -- and in some cases, billions -- of dollars to replenish pension funds in 2003 and beyond, according to Credit Suisse and UBS Warburg.

Ford Motor Co., the world's second-largest automaker, said in November that it would put $500 million into its pension fund in both 2003 and 2004.

SBC Communications Inc., the second-largest U.S. local phone company, said in November it would pay $1 billion to $2 billion into its pension and postretirement health benefit funds in 2003, thereby reducing earnings by 20 cents to 40 cents a share.

On Dec. 5, Verizon said its earnings per share in 2003 would decline by between 27 cents and 33 cents because of lower pension income.

Many companies' reported profit will be reduced, say Credit Suisse and UBS Warburg.

The pension-fund time bomb is coming as a shock to many investors because accounting rules have allowed the liabilities to remain virtually incomprehensible in the footnotes of financial statements, said Howard Schilit, an accountant and president of the Center for Financial Research & Analysis.

"There should be better disclosure," Schilit said. "Even our clients, who are sophisticated investors, don't completely understand."

Still, pension fund losses should not disrupt payments to retirees even if a pension fund runs out of money because the Pension Benefit Guaranty Corp., a federal agency funded by mandatory insurance payments from companies, pays retirees when a company fails. The agency pays annual pension benefits of as much as $42,954 per person, spokesman Jeffrey Speicher said.

"We are the insurers of last resort," Speicher said. "If a pension plan is underfunded and has to terminate, we step in and pay the benefit." The agency had reserves of $7.7 billion as of Sept. 30, 2001.

The accounting standards board's decision that companies should use an estimate for pension-fund investment gains every year was intended to smooth out potential stock-market volatility in earnings computations, said Tim Lucas, project manager of the board team that wrote the rule known as Financial Accounting Standard No. 87, or FAS 87.

Lucas says that when the board decided on the standard in 1985, it reasoned that stock-market trends had historically shown a gain during any 10-year period. So, regardless of market performance in a given year, an estimated gain over time was a safe and logical bet.

"We thought the investor was not going to be a whole lot better served by having the bottom line move around wildly each year," Lucas said. The plan worked without problems in its first decade.

What the rule's authors didn't anticipate was the stock-market boom of the late 1990s and the equally large decline that began in March 2000.

In the late 1990s, as companies reported pension fund earnings of about 9.5 percent, those investments had actually made two or three times that amount, company filings show. As a result, many companies made small or no contributions to pension funds during those years, said SBC director Bobby Inman.

"They earned so much money that corporations didn't have to put in anything annually to cover pension costs," he said. "It was a free ride."

"Generally, people don't think this is an issue," UBS Warburg's Bianco said. "They think it's a bunch of balance sheet hocus-pocus. They don't know how to deal with it."

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