Private Pensions: Publicly Available Reports Provide Useful but Limited Information on Plans' Financial Condition
Released: 2004-03-31T00:00:00

Letter

Background

Once the most prevalent type of pension plan, defined benefit plans no longer predominate, but they still constitute a significant part of the nation’s retirement landscape. They usually base retirement income on salary and years of service (for example, a benefit of 1.5 percent of an employee’s highest annual salary multiplied by the number of years of service) and are one of two pension types. The other type of pension, called a defined contribution plan, bases benefits on contributions to, and investment returns on, individual investment accounts. Among workers covered by pensions in 1998, about 56 percent were covered only by defined contribution plans (including 401(k) plans), compared with about 14 percent who were covered only by defined benefit plans, and about 30 percent who were covered by both types of plans.

Under a defined benefit plan, the employer is responsible for funding the benefit, investing and managing plan assets, and bearing the investment risk. To fund their defined benefit pension plans, companies set up dedicated trust funds from which they cannot remove assets without incurring significant tax penalties. To promote the security of participants’ benefits, the Employee Retirement Income Security Act of 1974 (ERISA), among other requirements, sets minimum pension funding standards. These funding standards establish the minimum amounts that defined benefit plan sponsors must contribute in each year to help ensure that their plans have sufficient assets to pay benefits when due. If plan asset values fall below the minimum funding targets, employers may have to make additional contributions.

The financial stability of defined benefit pension plans is of interest not only to workers whose retirement incomes depend on the plan, but also to the cognizant federal agencies and to investors in the companies that sponsor the plans. Federal policy encourages employers to establish and maintain pension plans for their employees by providing preferential tax treatment under the Internal Revenue Code for plans that meet applicable requirements. ERISA established a federally chartered organization, the Pension Benefit Guaranty Corporation (PBGC), to insure private sector defined benefit pension plans, subject to certain limits, in the event that a plan sponsor cannot meet its pension obligations. As part of its role as an insurer, PBGC monitors the financial solvency of those plans and plan sponsors that may present a risk of loss to plan participants and the PBGC. We recently designated PBGC’s single-employer insurance program as high-risk because of its current financial weaknesses, as well as the serious, long-term risks to the program’s future viability. Investors’ interest in pension plans is prompted by the fact that a company’s pension plans represent a claim on its current and future resources—and therefore potentially on its ability to pay dividends or invest in production and business growth. Thus, all three groups—regulators, participants, and investors—need information about these plans.

To meet the information needs of the federal agencies that administer federal pension laws, ERISA and the Internal Revenue Code require the filing of an annual report, which includes financial and actuarial information about each plan. The PBGC, the Department of Labor, and the Internal Revenue Service (IRS) jointly develop the Form 5500, Annual Return/Report of Employee Benefit Plan, to be used by plan administrators to meet their annual reporting obligations under ERISA and the Internal Revenue Code. Plan administrators of private sector pension and welfare plans are generally required to file a Form 5500 each year. The filing includes a short document for identification purposes and general information, plus a series of separate statements and schedules (attachments) that are filed as they pertain to each type of benefit plan. This form and its statements and schedules are used to collect detailed plan information about assets, liabilities, insurance, and financial transactions, plus financial statements audited by an independent qualified public accountant, and for defined benefit plans, an actuarial statement. More than 1 million of the forms are filed annually, of which approximately 32,000 represent defined benefit pension plans insured by PBGC. The information on the form is made available to plan participants upon request and serves as the basis for a summary annual report provided to plan participants and their beneficiaries.

One part of the Form 5500 filing, called Schedule B, includes information about a defined benefit pension plan’s assets, liabilities, actuarial assumptions, and employer contributions. The various measures of plan assets and liabilities are required by ERISA and the Internal Revenue Code to determine whether plans are funded according to the statutory requirements. Specifically, under Schedule B, IRS requires, among other things, the disclosure of assets and liabilities and an expected rate of return, which is called the valuation liability interest rate. IRS reviews this information to ensure compliance with the minimum funding requirements for pension plans. In addition, according to PBGC officials, PBGC may use Schedule B information to help them identify plans that may be in financial distress and thus represent a risk to the insurance program and plan participants. Some plan sponsors also use information in the Schedule B to calculate certain insurance premiums they pay to PBGC.

In addition to the annual reporting requirement, PBGC has authority to require plans to provide the agency with detailed financial information. Specifically, if a company’s pension plans reach a certain level of underfunding in aggregate, ERISA requires the company to provide information to PBGC in what is called a 4010 filing. The 4010 filing includes proprietary information about the plan sponsor, its total pension assets, and its total benefit obligations were the company to terminate its pension plans immediately. However, under current law, PBGC is not permitted to disclose this information to the public.

The Securities Exchange Act of 1934 requires publicly traded corporations to annually file a 10-K report, which is often referred to as the corporate financial statement, with shareholders and the Securities and Exchange Commission (SEC). The SEC uses 10-K reports to ensure that companies are meeting disclosure requirements so that investors can make informed investment decisions. The 10-K report describes the business, finances, and management of a corporation. For companies whose defined benefit pension plans are material to their financial statements, accounting standards require a footnote to the financial statements that details the cost, cash flows, assets, and liabilities associated with these plans. Footnote disclosures provide more detailed information about data presented in the company’s financial statements. Standards for reporting this information are set by the Financial Accounting Standards Board.

Actuaries estimate the present value of pension liabilities using economic and demographic assumptions. These assumptions are needed to estimate the amount of money required now and in the future to meet a pension plan’s future benefit obligation. Economic assumptions include rates of inflation, returns on investments, and salary growth rates. Demographic assumptions include changes in the workforce from retirement, death, and other service terminations. Most actuarial assumptions for measuring pension plan funding are not specifically prescribed by law or subject to advance approval from the IRS or any other government agency. However, ERISA requires the plan actuary to select assumptions that are individually reasonable and represent the actuary’s “best estimate of anticipated experience under the plan.”

Form 5500 Reports and Corporate Financial Statements Differ in Key Respects

The pension plan financial information reported in Form 5500 Schedule B serves a different purpose from the pension information disclosed in corporate financial statements. The information in each source is subject to different reporting requirements; therefore, measurements of pension funding are unlikely to be the same in the two reports. Government regulators and others use Form 5500 information for many purposes, including to determine whether plans are meeting minimum funding requirements and required contributions for each defined benefit plan that a company sponsors, while financial analysts and investors use pension information in corporate financial statements to determine how the company’s plans in aggregate affect its overall financial position, performance, and cash flows. Because of their different purposes and reporting requirements, these two sources use different measures and assumptions to generate information. For example, in providing information about the values of their pension assets and the present value of their future pension obligations, the Form 5500 and the corporate financial statements often base their valuations at different points in time and use different methods of calculation. Both of these reports also include an assumption about rates of return on the investment of pension assets. However, these rates may differ, and this assumption serves a different purpose in each report. As a result of such differences, information in the two reports is generally not similar, and because the two sources of information use similar terminology—for example, both refer to asset values and investment returns—the results can appear contradictory.

Form 5500 Reports and Corporate Financial Statements Serve Different Purposes

One objective of the Form 5500 is to provide financial and other information about the operations of an individual employee benefit plan. For defined benefit pension plans, the Form 5500 Schedule B provides measures of plan assets and liabilities; actuarial information, such as economic assumptions and demographic assumptions about plan participants; and information about how much the plan sponsor is contributing to meet ERISA funding requirements. If a company sponsors more than one plan, it must file a Form 5500 for each plan. While analysts and investors may use this information, it is primarily used by federal regulators to measure plan funding and ensure compliance with applicable laws and regulations.

The pension information in a company’s financial statement, by contrast, primarily serves a different purpose. The financial statement is intended to provide financial and other information about a company’s consolidated operational performance as measured primarily by earnings. In this context, pension information is mostly provided in a footnote to give financial statement users information about the status of an employer’s pension plans and the plans’ effect on the employer’s financial position and profitability. For example, certain details about the company’s annual cost of providing pension benefits are presented in the pension footnote disclosure because this cost, or expense, affects the company’s profitability. The users of corporate financial statements are primarily financial analysts and investors who are trying to assess the company’s financial condition, profitability, and cash flows, and whose concern is not so much the financial condition of individual pension plans but the effect that the company’s pension obligations may have on its future cash flows and profitability.

Measures of Pension Assets and Liabilities Differ in Form 5500 Reports and Corporate Financial Statements

Even where the Form 5500 and corporate financial statements provide similar types of information, such as pension assets and liabilities, their values usually differ. Among the key reasons for this are different dates of measurement, different definitions of reporting entity, different methodologies for determining costs of benefits, and different methods of measuring assets and liabilities. Table 1 summarizes some of the differences.

These differences in asset and liability measurements can result in significantly divergent results for the Form 5500 and the corporate financial statements. As an example, table 2 shows the different asset and liability values presented in a plan’s Form 5500 filing and in the plan sponsor’s corporate financial statements for a Fortune 500 company in 1999-2001 and the resulting effects on the reported pension funding ratios (pension assets divided by pension liabilities).

One reason for the significant differences in measures of assets and liabilities between the Form 5500 and corporate financial statement filings in table 2 is that the company sponsors more than one pension plan. When companies sponsor multiple pension plans, the details of specific plans are generally aggregated in corporate financial statements to show their net effect on the plan sponsor and are not intended to provide details about the funding of each plan. Thus, the pension information of a sponsor with both underfunded and overfunded plans may show little or no funding deficiencies, although the consequences to participants in the underfunded plans could be quite severe in the event of plan termination.

Form 5500 Reports and Corporate Financial Statements Use Expected Rates of Return Differently

One of the most confusing aspects of these two information sources is their difference with regard to the expected rate of return on pension assets. The expected rate of return is the anticipated long-term average investment return on pension assets. The Form 5500 Schedule B and the corporate financial statements both use an expected rate of return in calculating financial information about pension plans. In this regard, the expected rate of return is one of many assumptions, such as inflation and mortality rates, that affect a key pension reporting measure. In theory, the expected rates of return reported in each source should be similar because the assumption is derived from similar, or even the very same, assets. However, between these two sources there are differences in the rate’s purpose, selection, and method of application that may, in fact, contribute to differences between the assumed rates of return used in the two sources. Key differences in expected rates of return between the reports are shown in table 3.

In Form 5500 Schedule B, the expected rate of return is used to calculate pension funding—that is, the measurements of pension assets and liabilities, which determine whether, and in fact, what amount the company needs to contribute to its pension plan to meet the statutory minimum funding requirements. The expected rate of return is usually derived from the pension plan’s investment experience and assumptions about long-term rates of return on the different classes of assets held by the plan. Actuaries calculate a present value of plan liabilities using the expected rate of return, which is called the valuation liability interest rate on the Form 5500 Schedule B. If plan liabilities exceed assets, the resulting difference is used, in part, to determine the amount the company may have to contribute to the pension plan for that year. The amount of contributions required under the minimum funding rules of the Internal Revenue Code is generally the amount needed to fund benefits earned during that year plus that year’s portion of other liabilities that are amortized over a period of years. Amendments to ERISA in 1987 and 1994 made significant changes to the funding rules, including the establishment of a deficit reduction contribution requirement if plan funding is inadequate. The 1987 amendments to ERISA established the current liability measure, which is based on a mandated interest rate rather than a rate selected at the discretion of the plan actuary.

For financial statements, the expected rate of return is used to calculate the annual expected investment return on pension assets, which factors into the measurement of pension expense. Pension expense represents the company’s cost of benefits for the year and generally includes (1) service cost—benefits earned by plan participants for a period of service; (2) interest cost—increases in the benefit obligation because of the passage of time; (3) expected returns on pension assets, which offset some or all of the net benefit costs; (4) amortization of prior service cost resulting from plan amendments; and (5) amortization of gains or losses, if any, that may result from changes in assumptions or actual experience that differs from assumptions. To calculate a dollar amount for the expected return, the expected rate of return is multiplied by the value of pension assets. This expected return is used instead of the actual return on pension assets in the calculation of pension expense, which has the effect of smoothing out the volatility of investment returns from year to year. Furthermore, if the expected return on plan assets is high enough, a company may report a negative pension expense—or pension income.

Form 5500 reports and, until recently, corporate financial statements have not provided specific information about how expected rates of return are selected. Actuaries told us that they estimate rates of return on the basis of several economic forecasting measures and also take into account how asset allocations may change in the future based on the demographics of plan participants. In contrast, financial analysts and actuaries told us that many companies select their expected rates of return on the basis of their pension asset returns in past years. However, in December 2002 a Securities and Exchange Commission staff member publicly stated that the SEC would likely review expected rates of return higher than 9 percent if the rate was not clearly justified in the company’s financial statement. The SEC determined the 9 percent rate on the basis of studies on the historical returns on large-company domestic stocks and corporate bonds between 1926 and the first three quarters of 2002. According to actuaries and financial analysts we spoke with, this statement by the SEC has been a primary factor in the selection of lower rates of return in 2002.

Figure 1 shows the average expected rates of return reported for 1993 to 2002 by the companies and their pension plans in our sample.

Both Reports Provide Complementary Pension Information but Do Not Fully Satisfy Users

Both the Form 5500 Schedule B and corporate financial statements have limitations in the extent to which their required information meets certain needs of regulators, plan participants, and some investors. The Form 5500 takes considerable time for companies to prepare and for federal agencies to process, so it is not available to pension plan participants and others on a timely basis. The required asset and liability measures in the Form 5500 Schedule B are used by regulators to monitor compliance with statutory funding requirements. However, these funding measures are not intended to indicate whether plans have sufficient assets to cover all benefit obligations in the event of plan termination. In addition to using the Form 5500, regulators can also use corporate financial statements to try to determine whether a plan sponsor will be able to meet its obligations to its pension plans. However, some investors have concerns about whether corporate financial statements accurately reflect the effect of pensions on plan sponsors. According to financial analysts we spoke with, the pension information in corporate financial statements is also limited because it has not, until recently, included key disclosures, and the methodology used to calculate pension expense does not reflect the potential impact of actual investment returns on a company’s future cash flows and profitability. However, others argue that the current accounting for pension expense is appropriate for reflecting the long-term nature of pension obligations and their effect on the plan sponsor.

Form 5500 Information Is Untimely but Statutory Reporting Requirements Limit Opportunities to Improve Timeliness

Information in the Form 5500 is plan-specific and identifies the value of assets a plan must have to comply with ERISA funding requirements. However, this information is at least 1 to 2 years old by the time it is fully available, making it an unreliable tool for determining a plan’s current financial condition. The value of plan assets can significantly change over this period of time, and the value of plan liabilities may also change because of changes in interest rates, plan amendments, layoffs, early retirements, and other factors. For plans that experience a rapid deterioration in their financial condition, the funding measures required in Form 5500 may not reveal the true extent of a plan’s financial distress to plan participants and the cognizant federal agencies.

The Form 5500 Schedule B information is not timely for three main reasons. First, the plan’s assets and liabilities can be measured at the beginning of the plan fiscal year instead of the end of the year, resulting in information that is over a year old when the Form 5500 is filed. In 2001, of the 61 companies in our sample with both Form 5500 and corporate financial statement data, at least 48 used the beginning of the plan sponsor’s fiscal year for the plan’s measurement date. Second, ERISA allows plan sponsors 210 days, plus a 2½ month extension, from the end of the plan fiscal year to file their Form 5500. According to PBGC officials and actuaries we spoke with, most plans file at the extension deadline, almost 10 months after the end of the fiscal year, and almost 2 years from the measurement date if it is the beginning of the fiscal year. Third, according to Department of Labor officials, it has taken an average of 6½ months to process Form 5500 filings, though actuaries and PBGC officials told us that recently, some processing has been completed within 1 to 2 months of receiving the forms. Even with this improvement in processing time, most large companies’ 2003 pension data in Form 5500 will be based on valuations as of January 1, 2003, and will not be available to the public until January 2005.

There are several difficulties in making the filing of Form 5500 reports more timely. According to actuaries we spoke with, collecting and preparing the necessary information is time-consuming and resource- intensive for plan sponsors. Large companies’ human resource data are often not well organized for this purpose, according to two pension experts we spoke with. Common problems include merging information from different databases, dealing with retiree data that may not be computerized, and identifying vested participants who have left the company. The data collection and analysis becomes much more complicated when companies go through mergers, acquisitions, or divestitures. According to one senior pension actuary we spoke with, data preparation efforts can consume as much as 75 percent of the time involved in preparing the Form 5500 filing. Other issues include scheduling the work of auditors and actuaries who must review and work with the information once it has been assembled.

Once the forms are completed and submitted to the Department of Labor, speeding up the processing also has complications. While the process is significantly faster now than it used to be, it depends on paper rather than electronic filing and is slowed because the Form 5500 is also used for defined contribution and welfare benefit plans. Only about 32,000 of the more than 1 million Form 5500 filings pertain to PBGC-insured defined benefit plans, and the filings for defined benefit plans are not readily identifiable in order to receive priority when the Department of Labor processes these forms. Additionally, if errors in the Form 5500 filing are identified, the filing is returned to the plan sponsor with a 30-day deadline for making corrections and refiling. If errors are not properly corrected in the first response, the administrator is notified and given an additional 30 days to correct the amended filing.

ERISA Does Not Require Reporting of Plan Termination Funding in Form 5500

A second limitation in Form 5500 is that it is not required to furnish information about the ability of a plan to meet its obligations to participants if it were to be terminated. Compliance with ERISA funding rules, as reported in Form 5500, is often based on the plan’s current liability, which is the sum of all liabilities to employees and their beneficiaries under the plan. In theory, keeping a pension plan funded up to its current liability will ensure that the plan has assets to meet its benefit obligations to plan participants as long as the plan sponsor remains in business. However, if a plan is suddenly terminated because of its sponsor’s financial distress, the plan liabilities are likely to increase and plan assets are less likely to cover the cost of all benefit obligations. Therefore, Form 5500 information often does not accurately indicate the ability of the plan to meet its benefit obligations to plan participants in the event that the plan sponsor goes bankrupt. A different measure, called the termination liability, comes closer to expressing the pension plan’s cost of discharging the promised benefits to participants in a distress termination. The termination liability, which is usually higher than current liability, reflects the cost to a company of paying an insurer to assume its pension obligations were the plan to be terminated. PBGC has found no simple relationship between measures of current and termination liability, and therefore a fixed set of factors cannot be applied to the plan’s current liability funding level (or its components) to estimate termination liability. For plans whose vested benefits are underfunded by at least $50 million, PBGC receives a termination liability measure in a separate filing called a Section 4010 filing (named after the ERISA section that requires companies to submit such reports). However, this information is available only to PBGC and by law may not be publicly disclosed.

The differences in the two types of liability measures are substantial enough that a plan can appear in reasonable condition under the current liability measure that serves as the basis for the minimum funding standard, but not have sufficient resources to settle plan termination liabilities. For example, Bethlehem Steel’s pension plan was 97 percent funded on a current liability basis in its 1999 Form 5500 filing. However, when the plan was terminated, in December 2002, it was funded at only 45 percent on a termination liability basis. Plan terminations often result from a plan’s sponsor entering bankruptcy, which, according to PBGC officials, cannot usually be predicted more than a few months in advance. Some of the reasons that a plan can have a reasonable ratio of assets to liabilities under the current liability measure but a less than adequate ratio under the termination liability include Different retirement ages. When companies shut down, many long-time employees retire and begin collecting pension benefits at an earlier age.

Different discount rates. Termination liability discount rates have usually been lower than for current liability in recent years, making the present value of termination liability larger.

Different plan provisions. Terminations may coincide with factory shutdowns, which often trigger provisions that increase retirement benefits.

Corporate Financial Statement Information Can Supplement Form 5500 Data

While the information about pensions in corporate financial statements does not serve the same purpose as the information in Form 5500, it can also be useful to the PBGC. This information is useful in two primary ways: Its overall measures of the company’s financial condition provide indications about the company’s ability to meet its pension obligations. According to PBGC officials, most large plans that were terminated by PBGC were sponsored by companies whose debt was rated below investment grade for a number of years prior to plan termination. Though plan asset-to-liability ratios are not dependent on the health of the plan sponsor, participants in underfunded pension plans at financially distressed companies face the risk that the plan sponsor will lack the cash resources to meet the ERISA funding requirements. In contrast, a company in a strong financial position is much more likely to be able to make up funding shortfalls.

It provides the timeliest public data about pension plans, which may be useful if the company sponsors only one pension plan. Within 60 to 90 days from the end of their fiscal years, publicly traded companies must file their financial statements, which provide data based on measurements on the last day of a company’s fiscal year.

Pension Accounting Disclosures and Methods Have Been Subjects of Debate

Some primary users of corporate financial statements have expressed concerns about the extent to which these reports show how pension plans affect a company’s profitability, cash flow, and financial position. This information is particularly important for companies with large pension plans because the greater the value of a company’s pension assets relative to the company’s market value, the more sensitive its cash flows and profits will be to changes in pension asset values. According to analysis by Standard and Poor’s (S&P), a leading corporate debt rating agency, defined benefit pension plans significantly affect the earnings of about half of the companies in the S&P 500 index. As conveyed to us by financial analysts, investors’ concerns about financial reporting on pensions have been twofold: First, financial statements have heretofore lacked adequate disclosures about how pension plans affect the sponsoring companies’ cash flow and overall risk. Second, some investors believe that current standards for measuring pension expense do not adequately recognize the financial condition of pension plans and distort measures of company earnings. However, others argue that these standards provide a more appropriate accounting of a company’s annual pension costs over the long term.

Disclosure concerns, to date, have been of two main types: First, according to financial analysts we spoke with, it has been difficult to reasonably estimate a pension plan’s claims on a company’s cash resources in the coming year and near future. Contributions are determined primarily by ERISA funding requirements, but the plan funding status reported in the Form 5500 is not current enough to be used by financial analysts and investors. Large required contributions to pension plans can reduce the cash available to companies to apply to shareholder dividends or invest in their business so that profits may continue to grow. For industries in which investors are concerned primarily with a company’s cash flow, estimates of such future contributions would be critically important, but have been unavailable to date.

Second, to date it has been difficult to accurately evaluate the risk that pension investments pose to the plan sponsor. The allocation of pension assets can pose additional risk to the company’s cash flow and profitability, especially for companies with very large pension plans. Investments in more volatile assets, such as equities, are likely to create a wider range of potential cash contributions for the company in the future, as companies may need to make contributions to meet statutory funding requirements following negative returns on pension assets.

In addition to raising these disclosure concerns, some financial analysts and investors have also expressed opposition to current accounting standards for measuring pension expense, while others support these standards. Pension expense is included in the calculation of corporate earnings, which investors use to track a company’s performance, in comparison both with other firms and with a company’s own past performance. In order to reduce the potential volatile effect of pension plans on their sponsors’ earnings, the accounting standards call for three main smoothing mechanisms to calculate pension expense: (1) expected return is used instead of actual return on pension assets, (2) the expected return may be based on an average value of pension assets rather than their current fair value, and (3) differences between actual experience and assumptions are recognized systematically and gradually over many years rather than immediately when they arise. Therefore, when the expected return on pension assets significantly differs from the actual return, this difference does not immediately affect a company’s reported pension cost or earnings.

As actual experience differs from assumptions on such things as expected rates of return, inflation rates, and plan participant mortality rates, the differences are added to or subtracted from an account for unrecognized gains or losses. When unrecognized gains or losses exceed 10 percent of either the market-related value of pension assets or the projected benefit obligation, whichever is greater, the company must factor a fraction of the excess unrecognized gain or loss (difference between the total gain or loss and the 10 percent threshold) into its calculation of pension expense. For example, a company may experience 3 years of unusually high gains on its pension assets, and at the end of year 3, the cumulative difference between expected and actual returns on pension assets surpasses the minimum threshold for recognition of the difference. The company must record part of its unrecognized cumulative gain in its calculation of pension expense, thereby decreasing the pension expense for the year.

Although actual and expected rates of return may differ sharply in any given year, or even over 2 to 3 years, the variance between them should decrease over the longer term, provided that expected rates of return are reasonably accurate. Table 4 shows the results of our comparison of expected and actual rates of return for 52 companies from our sample of Fortune 500 companies that had data available over the 9 years from 1994 through 2002. During this period the average expected rate of return used in the financial statements was 9.29 percent, while the average actual rate of return was 7.56 percent and ranged from a low of –8.85 percent to a high of 22.36 percent in any given year.

In comparison with the results of our analysis, a study by one investment bank revealed an average actual return on pension assets of greater than 12 percent between 1985 and 1998. Therefore, average actual rates of return will vary according to the time period being measured. For example, for the companies in our sample, the average actual return on pension assets was 15.25 percent from 1997 through 1999 and –3.59 percent from 2000 through 2002.

Opponents of current methods of accounting for pension expense argue that the smoothing mechanisms lack transparency because reported pension expense (1) does not reflect the current financial condition of pension plans and (2) distorts measures of corporate earnings. Under the current methodology for calculating pension expense, the cumulative net effect of pension asset gains or losses may not be reflected in reported pension expense for a few years, if at all. While alternating years of gains and losses may keep reported pension expense relatively smooth from year to year, consecutive years of gains or losses can eventually result in significant changes in reported pension expense. Many companies that reported pension income in 2001 and 2002, while their pension assets were in fact decreasing in value, benefited from the use of the market-related value of pension assets (the average asset values over not more than the previous 5 years) rather than the lower actual value of these assets. For example, of the 97 companies in our sample, 26 reported net pension income in 2002, but only one of these companies saw an increase in the value of its pension assets. Conversely, it is likely that many of these companies will report net pension expenses in the next few years, even if their pension asset values rise, because their market-related values of pension assets will reflect, in part, the decline in the stock market between 2000 and 2002.

In contrast, employer contributions, which are only indirectly related to pension expense, may better reflect the current financial condition of pension plans. Employer contributions to pension plans are determined by a complex set of factors, including the tax deductibility of contributions, minimum funding requirements, the employer’s expected cash flows, and PBGC premiums. In 2002, when most large companies saw declines in their pension asset values, many were required to make contributions to their pension plans to meet the statutory funding requirements. The 93 Fortune 500 companies in our sample with available financial statement data reported aggregate contributions to pension plans of $10.1 billion in 2002, while their aggregate pension expense totaled $622.6 million. Financial analysts pay close attention to companies’ cash contributions to pension plans because large contributions to plans represent resources that companies will not have available to use for other purposes, such as expanding their businesses.

Investors have also been concerned about the extent to which defined benefit pensions contribute to a company’s total profits. According to one investment bank study, 150 of the 356 Fortune 500 companies with defined benefit plans reported net pension income (negative expense) in their financial statements in 2001. However, the value of pension assets for 313 of these companies actually declined in 2001. To try to address these apparent inconsistencies in the financial reporting on pensions, many financial analysts and investors try to strip out the effects of pensions to determine a “true” measure of a company’s earnings that reflects its performance from ongoing operations. For example, Standard and Poor’s issued a proposal in 2002 to standardize measures of corporate earnings that excludes several items from the earnings calculation, including investment returns on pension assets.

Proponents of current pension accounting standards argue that the smoothing mechanisms are beneficial because (1) pension obligations are long-term liabilities that do not have to be funded all at once and (2) sponsoring pension plans and investing plan assets are not the primary business activities of plan sponsors. Pension obligations are normally paid out over a long period of time; therefore, pension assets have a similar time period to meet those obligations. The smoothing mechanisms allow plan sponsors to gradually and systematically attribute portions of the long-term cost of pension plans to each year. Without smoothing mechanisms, companies would potentially face year-to-year fluctuations in their reported pension expense that some investors may also consider misleading given that unexpected losses on pension assets in one time period may be offset by unexpected gains in another.

The Financial Accounting Standards Board adopted the smoothing mechanisms in part to reduce the volatility of reported earnings caused by investment returns on pension assets. Because investing pension plan assets is not the primary business activity of plan sponsors, FASB determined that earnings volatility caused by immediately recognizing all changes in the value of plan assets and liabilities as they occur would be misleading to investors. Furthermore, such volatility could make comparisons of earnings more difficult when looking at different firms, some of which may not sponsor defined benefit plans.

Changes to Pension Accounting and Regulatory Reporting Have Been Implemented or Proposed

Both in this country and abroad, changes have been proposed—and in a few cases, implemented—to make information about defined benefit plans more transparent or complete. These changes relate to information associated with both Form 5500 and corporate financial statements. The administration has proposed augmenting current Form 5500 information by making available certain data that currently are not made public, such as measurements of termination liabilities. The Financial Accounting Standards Board has recently amended one of its accounting standards to require, among other things, that companies provide more information about the composition and market risk of their pension plan assets and their anticipated contributions to plans in the upcoming year. Outside the United States, proposals are being discussed that would move toward eliminating or reducing the use of smoothing mechanisms in calculating pension expense.

The Administration Has Proposed Making Additional Information Available Relating to Pension Risk

In July 2003 the Department of the Treasury announced “The Administration Proposal to Improve the Accuracy and Transparency of Pension Information.” The proposal presented four areas of change, and one of them would broaden the public’s access to pension information currently available only to PBGC. The proposal would expand the public’s access to pension information in two main ways: Reporting termination liability. Under the proposal, information about a plan’s termination liability would be included in ERISA-required summary annual reports to workers and retirees. The annual reports, which are based on data from the Form 5500 reports, now report the plan’s financial condition based on the plan’s current liability. Termination liability information is reported to PBGC by companies whose plans are collectively underfunded by more than $50 million.

Public disclosure of underfunding of at least $50 million. Section 4010 of ERISA requires companies with more than $50 million in aggregate plan underfunding to file annual financial and actuarial information with the PBGC. This information is reported separately from Form 5500 information and must generally be filed no later than 105 days after the end of the company’s fiscal year. PBGC uses this information to monitor plans that may be at greater risk of failure, but under current law, PBGC cannot make the information public. According to the administration, the information is more timely and better in quality than publicly available data. Under the proposal, the market value of assets, termination liability, and termination funding ratios contained in these reports would all be publicly disclosed.

Since the announcement of the administration’s proposal, no further action has been taken by either the administration or Congress to implement these proposals.

FASB Has Changed U.S. Pension Disclosure Standards; Other Changes Being Considered Abroad

In regard to corporate financial statements, one change designed to address users’ concerns about pension-related information has recently been enacted. In December 2003 FASB issued a revision to its accounting standard on pension disclosures. The revised standard incorporates all of the disclosures required by the prior standard and requires more informative pension disclosures. FASB added the new disclosures because users of financial statements, such as financial analysts, requested additional information that would assist them to evaluate, among other things, the composition and market risk of the pension plan’s investment portfolio and the expected long-term rate of return used to determine net pension costs. As a result, some of the new disclosure requirements include listing the percentage of pension assets invested in major asset classes such as equity securities, debt securities, real estate, and other assets. Companies must also provide a narrative description of the basis used to determine the overall expected rate of return on assets assumption. The FASB believed that this new information would allow users to better understand a company’s exposure to investment risk from its pension plans and the expected rate of return assumption. Another required disclosure is the employer’s estimated contribution to pension plans in the following year. However, the revised standard does not change the general approach used in the financial statements of aggregating this information across all pension plans.

Outside the United States, other standard-setting boards have been addressing issues related to the use of smoothing techniques designed to smooth out the volatility of reported pension expense. One of these boards is the International Accounting Standards Board (IASB), an independent accounting standard–setting organization. Many countries require publicly traded companies to prepare their financial statements in accordance with IASB’s financial reporting standards. IASB’s current pension accounting standard is very similar to the current standard promulgated by FASB, in that both allow a smoothing mechanism to reduce the volatility of pension expense. However, IASB is considering a revision to its current standard to allow companies to calculate pension expense using actual investment returns instead of expected returns, on a voluntary basis. According to the IASB manager in charge of the project, the exposure draft will be issued in 2004, and a final standard is expected in March 2005. Separately from the IASB action, the United Kingdom’s Accounting Standards Board has already issued its own accounting standard that would require companies to report the differences between actual and expected returns on pension assets in their financial statements. Full adoption of this standard has been delayed out of concern that the changes made by firms to comply with the Accounting Standards Board standard might need to be modified again in subsequent years to meet a potentially different IASB standard.

Concluding Observations

Form 5500 reports and corporate financial statements both provide key pension financial data, but they serve different purposes and, as a result, provide significantly different information. To date, neither report in isolation provides sufficient information for certain users to fully determine the current financial condition of an individual pension plan or how pension obligations could affect the financial health of the plan sponsor. While particular concerns have been raised about differences between expected and actual pension asset rates of return reported on corporate financial statements, expected rates of return do not have a significant effect on the actual financial condition of plans.

Continued concerns about the financial condition of plans and how this information is disclosed have been highlighted by the administration’s proposal to provide information about funding in the event of plan termination to plan participants and regulators. We have previously reported that an essential element of pension disclosure should include requiring plans to calculate liabilities on a termination basis and disclosing this information to all participants annually. Likewise, we recommended that Congress consider requiring that all participants receive information about plan investments and the minimum benefit amount that PBGC guarantees should their plan be terminated. While such new requirements could help improve the transparency of pension plans’ financial condition, there are other challenges to be addressed as well. For example, plan participants and regulators continue to need more timely information. However, there appear to be few opportunities to improve the timeliness of Form 5500 information under the current statutory reporting requirements. One challenge to improving the timeliness of this information on pensions will be to find a solution that does not impose undue burdens on plan sponsors. Resolving this challenge will prove crucial to providing policy makers, plan participants, and investors with more timely and transparent information on the financial condition of defined benefit plans.

Agency Comments

We provided a draft of this report the Department of the Treasury, the Department of Labor, the Pension Benefit Guaranty Corporation, the Securities and Exchange Commission, and the Financial Accounting Standards Board. We received technical comments from each agency that we incorporated as appropriate.

We are sending copies of this report to the Secretary of Labor, the Secretary of the Treasury, the Executive Director of the Pension Benefit Guaranty Corporation, the Chairman of the Securities and Exchange Commission, the Chairman of the Financial Accounting Standards Board, appropriate congressional committees, and other interested parties. We will also make copies available to others on request. In addition, the report will be available at no charge on GAO’s Web site at http://www.gao.gov.

If you have any questions concerning this report please contact me at (202) 512-7215 or George Scott at (202) 512-5932. Other contacts and acknowledgments are listed in appendix III.

Appendix I: Scope and Methodology

To explain the two sources of pension financial information, we interviewed federal agency officials from the Pension Benefit Guaranty Corporation (PBGC) and the Department of Labor (DOL). These federal agencies use Form 5500 information in performing their oversight and monitoring responsibilities. In addition, we reviewed the Form 5500 instructions, form, and schedules to understand the information they provide. For the financial statements, we reviewed relevant accounting standards from the Financial Accounting Standards Board, which sets standards for financial statements, and spoke with board officials. We also reviewed many financial statements of large domestic companies.

Our work also included analyses of a sample of corporate financial statements of Fortune 500 companies and the corresponding Form 5500 filings for those companies with available data. We chose to sample from the universe of publicly owned Fortune 500 companies with defined benefit plans because (1) the pension plans sponsored by these firms represent a large percentage of the total private defined benefit pension plan participants, assets, and liabilities in the United States; (2) these firms tend to have the largest defined benefit plans, and if these plans fail they would create the largest burdens for PBGC and possibly the government; and (3) most of these firms are publicly traded, so their corporate financial statements are publicly available.

We drew a systematic random sample of 100 of the 2003 Fortune 500 companies with defined benefit plans, after excluding government- sponsored entities. The sampling process accounted for the companies’ revenues in 2002 and the distribution of expected rates of return on pension assets. This distribution was available in a Compustat database for approximately 290 of the 329 companies in the population. From the initial sample of 100 companies, 3 companies were removed because one is not publicly traded, another is European and filed its financial statements in euros, and the third changed its end-of-fiscal-year date in 2001, which made it more difficult to compare with other firms. For the 97 remaining companies, we obtained as much as 10 years of pension data from these companies’ corporate financial statements using the Securities and Exchange Commission’s Electronic Data Gathering, Analysis, and Retrieval System (EDGAR), depending on data availability. Data were available from 1993 through 2002 for 68 companies. However, others did not have 10 years of data available because, for example, they were formed, or only began to publicly trade their stock, at some time between 1993 and 2002. Nine companies in our sample reported more than one expected rate of return for their pension plans and a weighted average could not be determined accurately. Most of these companies sponsor pension plans for employees outside the United States and provide separate assumptions for domestic and international plans. These companies did not report the weighted average expected rate of return that was used to calculate their expected return on pension assets.

We also obtained the corresponding Form 5500 filings for the companies in our sample from PBGC for plan years 1993 through 2001. To identify these filings, we matched the sample of 97 Fortune 500 companies to their pension plans on the basis of their employer identification number (EIN). An EIN, known as a federal tax identification number, is a nine-digit number that the IRS assigns to organizations. We developed a list of EINs reported on the companies’ financial statements and provided this list to the PBGC. PBGC matched the EINs to their Form 5500 database and provided information to us. However, in several cases, PBGC did not find matches to our list of EINs, either for all 10 years or for just some of the years. Based on the number of companies with data available in any of the 10 years, we decided on a threshold of 7 years’ worth of data in order to achieve a sample size that would allow us to compare data over most of the 10-year period. In other words, to be included in this analysis, a company must have at least 7 years of Form 5500 data. One hundred and fifty plans had at least 7 years of Form 5500 data. The years in which data were missing were spread sporadically among the 10-year period covered in this analysis.

Before deciding to use the Form 5500 data, we investigated its reliability. Prior to plan year 1999, the Internal Revenue Service was responsible for keypunching Form 5500 information into a database, and DOL officials explained that some of the data contained errors. DOL officials explained that since plan year 1999, Form 5500 data have been recorded with optical scanning devices and have been subject to edit and validity tests. In 1999, some Form 5500 filings were not captured because many plan administrators did not send forms on the correct paper and the scanner could not capture some information. However, DOL officials explained that this problem has not occurred since. We obtained the Form 5500 data from PBGC’s Corporate Policy and Research Department. PBGC officials explained that as errors surface in their use of the Form 5500 data, corrections are made to PBGC’s database. In the past hard copies of original Form 5500 filings were obtained for making corrections. Today PBGC can view electronic images of the actual plan filings. As PBGC receives the data on Form 5500 Schedule B, it screens the data for errors, particularly in the asset and liability fields. Information we received from pension actuaries corroborates the data we used from Form 5500 filings and the data on expected rates of return, as presented in figure 1, show consistency from year to year. Taking all these factors into consideration, we feel that the data we used were sufficiently reliable for the purpose of differentiating between expected rates of return reported in Form 5500 filings and corporate financial statements.

In obtaining financial information for the sample companies, we had to account for companies that had merged with another company during the 10-year period under review. In the event of a merger between a company with a defined benefit pension plan and a company without a defined benefit plan, we selected the company with the defined benefit plan. In the case of a merger between two companies that both had defined benefit plans prior to the merger, we selected the company indicated by the EDGAR database as the predecessor company.

While our sample is designed to represent our population for calendar year 2002, it is not representative of any population in prior years. The makeup of the Fortune 500 changes from year to year, and our method of tracking the same companies across several years precludes us from making specific statements about any larger population prior to 2002. Thus, while we believe that the trends identified in our sample could be indicative of trends in the population of large firms with defined benefit plans and that this supposition is supported by other studies, we do not claim these trends are representative of past populations of Fortune 500 companies.

To explain the usefulness and limitations of the information from the two information sources, we interviewed expert users of pension information in Form 5500 reports and corporate financial statements, including federal officials from DOL, PBGC, and SEC; pension actuaries; corporate debt rating agency officials; financial analysts; and Financial Accounting Standards Board officials. Some experts explained the uses of information available in the Form 5500 reports and limitations of these reports. Other experts described and shared documentation about how they analyze financial statements to understand the impact of pension plans on the plan sponsors’ financial statements. Some experts explained the need for additional pension information in companies’ financial statements. As part of our review of pension information in corporate financial statements, we used several research reports published by different investment banks. We reviewed the methods used in these studies and found them to be sufficiently reliable for the purpose of corroborating our own data analysis and illustrating trends in pension accounting.

To explain the recent and proposed changes to the current information sources, we interviewed officials from the International Accounting Standards Board and the Financial Accounting Standards Board. These boards set standards for financial statements for international companies and United States companies, respectively. We also reviewed the recently revised accounting standards issued by the Financial Accounting Standards Board. We also reviewed congressional testimony regarding the administration’s proposal for more transparency of pension data.

We conducted our work between January 2003 and January 2004 in accordance with generally accepted government auditing standards.

Appendix II: Expected and Actual Returns in Financial Statements

This appendix shows two things: (1) how a company may experience an actual loss on its pension assets while reporting income from its pension plans in the same year and (2) how a change in the expected rate of return affects other items in the financial statement. The information is based on numbers taken from the corporate financial statement of a real company from its 2002 fiscal year.

Company X’s pension assets lost $512 million in value during its fiscal year, yet Company X still reported pension income of $90 million. This apparent inconsistency is possible because the expected return on assets is used in place of actual returns to calculate net periodic pension cost.

The second column of table 5 shows the effect of changing the expected long-term rate of return on pension assets from 9.8 percent to 8.5 percent. The figures affected by this change are in bold text. All of the changes caused by the change in the expected rate of return are related to measurements of Company X’s pension expense and measures of overall profitability. The change has no impact at all on measures of pension assets and liabilities.

An explanation of the pension elements in table 5 follows in table 6.

A company’s total operating costs include its labor costs, which include the net periodic pension cost. Therefore the net periodic pension cost is factored into the calculation of total operating costs, which affects operating profit, consolidated profit before taxes, the calculation of tax to be paid, and net profit (Items Y—CC in table 5).

Changing the expected rate of return on plan assets from 9.8 percent to 8.5 percent has the following effects: In the components of net periodic cost of defined benefit plans, the expected return on plan assets (Item S) falls from $783 million to $679 million. This increases the total periodic pension cost by $114 million, which is enough to turn Company X’s periodic pension income of $90 million into a cost of $14 million.

The increase in net periodic pension cost of $114 million increases the companies total operating costs (Item Y) and decreases the operating profit (Item Z) and consolidated profit before taxes (Item AA) by the same amount. Because taxable income is reduced, Company X pays less in corporate income tax (Item BB). Last, net profits (Item CC) decline from $802 million to $720 million, which for Company X’s shareholders of approximately 344 million shares of common stock would have meant a drop of about 24 cents in earnings per share (Item DD).

Appendix III: GAO Contacts and Staff Acknowledgments

Contacts

Staff Acknowledgments

In addition to those named above, Joseph Applebaum, Kenneth Bombara, Richard Burkard, David Eisenstadt, Elizabeth Fan, Michael Maslowski, Scott McNulty, Stan Stenerson, Roger Thomas, and Shana Wallace made important contributions to this report.