Disclaimer: The views expressed here are mine and may change without notice. Past performance is not indicative of future results. All investments carry risk, including financial loss. This analysis is for educational purposes only and does not constitute investment advice or recommendations of any kind. Conduct your own research and seek professional advice before investing. Please see important disclaimers here and here.
Defined Benefit plans are things of the past for most
people. But, not for investors. Roughly 20 companies in Dow 30 and more than
300 companies in S&P 500 indices still have such plans. Thus, these
companies need to record pension expenses in financial statements. A company’s
management uses various assumptions in calculating pension expense. What is the
impact of these assumptions on the company's profits? Can these assumptions tell
something about management? Let's look here.
While there are various assumptions in pension accounting, the one assumption that has the most
impact is the expected return on the pension
plan’s assets. Why? Because this item reduces
the pension expense. Think about it: which company doesn’t want to reduce its
expenses. With pension accounting, management can do so by changing this assumption!
What is a fair return assumption that management should use? Let’s first take a look at assumptions for some of the companies in Dow sorted by low to high return assumptions.
Source: company filings, few assumptions are for 2020
The management of the above companies expects to generate returns in the range of 0% to 8.31% by investing in assets such as stocks and bonds. The lower end of the spectrum looks conservative but what are the chances of achieving returns at the higher end? Currently, the S&P 500 index is yielding around 6%, long-term bonds are under 1.5%, and the US Corporate bonds are under 2.5%. With those yields, it is amusing some corporations still think 8% is a realistic return assumption.
In addition, investors can also gauge management’s behavior. Given that pension plans usually have longer lives than the CEO’s tenure, a high investment return assumption may point to management’s motivation to prop up short-term profits. Investors should keep in mind that if management reduces a high return assumption that will cause their company’s profits to go down (remember, higher return reduces expenses). Additional thought: if management is willing to assume unreasonable returns, what else they must be doing in financial statements!
Using a high rate of investment return in pension accounting seems irresponsible as it is likely going to delay the bad news of lower profits. Investors should keep in mind that the return estimate is an assumption the company can tweak to change the pension expense. Hence, look out for this item while analyzing the financial statements of a company, and making a view about the company’s management.
