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What’s Wrong with This Picture?

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Pension Contrib v Cost 2014 dec 100

Correct Response: All of the Above.

Explanatory Notes —

  • What’s wrong? Nothing at all. As will be discussed in greater detail below, the main question mark concerns the pension cost (orange squares for the lower trendline) for the most recent 4 years, for which several of the companies switched to a different accounting method that produces materially different results. Yeah, but so what? Cost is cost, no matter what accounting method is used. After all, the costs include foreign pension plans, for which costs can vary widely from the trends for domestic pension plans, and nonqualified deferred compensation plans, for which costs actually equal contributions (blue circles for the higher trendline). So why get bent out of shape over the accounting method used by one small subset of employers to report the amounts that actually flow through to the profit/loss statement just like every other company’s costs likewise flow through to profits and losses?
  • All of the major studies will carry their own versions of the same misleading image. And yes, even though it’s correct that cost is cost, whatever the accounting method, it is misleading to aggregate the results that arise from different accounting methods that can produce such widely divergent results. As misleading as if we were to aggregate the volatile defined benefit pension plan costs of one company with the stable 401(k) defined contribution plan costs of another without recognizing the differences between the two types of retirement savings. So this response is also correct: although a small subset of employers now rely on an accounting method that determines pension cost that is very materially different from the costs determined by the majority of employers, don’t expect any of the major pension studies to even notice the change. As the leader of one of those studies once openly bragged, they don’t actually study the actual data; they merely push the buttons to aggregate it, as if throwing everything into the pot to manufacture spam.
  • All of the major analysts, business press, policymakers and other observers will rely on similarly misleading aggregations. If the “experts” who produce the studies of pension costs aren’t going to notice anything wrong or misleading, can we expect any analysts, business press, policymakers or anyone else to pick up on the issue? More than likely, the change has probably even escaped the notice of the SEC — which oversees the publication of the financial reports that carry the pension cost numbers — and of FASB — who actually prefers the accounting methodology now being used by the small subset of renegades.
  • Nobody cares. Sad, but as a leading partner of one of the largest pension consulting firms once advised of even worse outright blunders being perpetuated by established pension studies, nobody does care. Known blunders and misleading studies about pensions continue to be published, nobody bothers to question or correct obvious errors, and readers of those studies continue to rely on new editions of those studies even when updates are based on the same errors. It’s wrong, but it’s true: nobody does care.

OK, but if that first chart does actually show pension cost for the companies it represents, then where’s the problem. Well, as alluded to, a very small subset of those companies now use a different accounting methodology for their pension costs than is used by most companies. The traditional methodology has used a defer-ignore-spread methodology for gains and losses (for example, investment results or remeasurement of obligations due to changes in discount rates): (i) results from one year are recognized no earlier than the following year; (ii) cumulative gains and losses within a corridor of 10% of the greater of the pension obligation or pension assets are completely ignored; and (iii) any cumulative gains or losses outside the corridor are spread over the average future service of active employees. In contrast, a small subset of employers has recently elected to recognize gains and losses in full, no corridor and no spreading, immediately during the year in which the gains or losses are experienced. The result: for that subset, pension costs are materially more volatile than the pension costs being reported by the companies who continue to use the traditional methodology. Let’s see that by looking at the same chart, excluding the small subset who use immediate recognition of gains and losses —

Pension Contrib v Cost 2014 dec 100-4

The subset of companies that have chosen immediate recognition of pension gains and losses have been using that new methodology for the most recent 4 years shown on the two charts displayed in this post. As seen in this second chart, under the traditional accounting methodology the trend for aggregate pension costs has tended to lag the trend for pension contributions by one year, but otherwise has been about as stable. When the small subset is included, as is the case for the graph shown at the top of this post, the pension cost for the most recent 4 years becomes much more volatile. There will still be some correlation between the cost and the contribution: when the volatile costs go sharply up, expect the contribution and the costs under the traditional accounting method to gradually turn upward, and likewise when the volatile costs go sharply down. As does make sense, given the essence of the defer-ignore-smooth technique. But the route for getting to the same result varies very very significantly.

And I’ve called the first chart “misleading.” That’s because since the “experts” who will be publishing their own versions never actually look at the actual data that gets blended into their reports, few if any of them will realize what is going on. So as they have done the past 3 years since the new accounting method came into the picture, completely false statements will be made about why aggregate pension costs increased during 2014, and equally erroneous predictions will be advanced for future costs.

The correct appraisal of aggregate 2014 pension costs: for companies that continue to use the traditional defer-ignore-spread technique, aggregate pension cost declined in 2014; but given the decrease in discount rates, resulting in significant increases in pension obligations, the immediate actuarial losses for the pension plans of the small subset of employers who use immediate recognition were huge enough to more than offset the lower pension costs of the majority, so that the aggregate of all companies merged together give the false impression that for the typical company, pension costs increased.

And the correct forecast? Well, for the companies using the traditional defer-ignore-spread technique, look for pension costs to increase . . . but remember, that will be an increase from the lower cost levels to which those companies had dropped, not an increase from the higher overall-aggregate cost level that includes the small subset of immediate-recognition companies. And here’s the real punch line being missed by those studies who don’t yet get it: for that small yet very influential subset, the correct prediction is a very huge shrug. Where will interest rates be at the end of 2015? We think maybe slightly higher, giving us some actuarial gains that might reduce pension costs; but we really don’t know, especially with Europe just recently moving to its own qualitative easing program and so much risk still keeping banks tight with their lending. And where will the equity and other markets be at the end of 2015? Producers of pension studies have never been better predicting short-term future market results than they’ve been at their pension predictions, so the real answer there is another shrug. Yet as long as we can’t reliably predict those future economic conditions, we can’t predict either the direction or the degree of the pension cost for the coming year for that subset of immediate-recognition companies. And since their numbers can so significantly affect the result for the entire pension universe, the real answer for any prediction of 2015 aggregate pension cost is: nobody knows.

More on this as I come back to edit this post with further commentary, analysis and conclusions, as well as to update it for additional data as I continue to collect newly published financial statements.

(As I’ve previously disclaimed, posts such as this represent efforts of my favorite pastime. My formal work does not involve any of this, and none of it represents any position or comment that should in any way be attributed to my employer. Likewise, as always, it represents general personal impressions and should not be treated or used as formal professional advice.)

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Written by macheide

22 February 2015 at 9:27 am

Posted in άctuary

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