UPDATE: Since I posted on Wednesday that this does not seem to be a hot topic, of course it was only two days later that a fifth member of the $20 billion club—Federal Express—announced that they are making the change. CFO Alan B. Graf cited greater transparency and the removal of certain costs from segment results as reasons for the change.
The majority of U.S.-listed corporations amortize pension gains and losses through their earnings statements over a period of several years. Some, however, have adopted a mark-to-market approach, which is simpler and more transparent, but results in greater volatility.
Mark-to-market is clearer—but more volatile
Accounting for defined benefit pension plans in the corporate balance sheet is fairly simple: assets and liabilities are each recognized at their estimated current market value. Income statement calculations, however, are generally far more complex: unexpected gains and losses in the pension plan are generally not recognized immediately in the income statement, but rather are spread over a period of several years.
This approach reduces the volatility of the pensions plan’s year-to-year impact on corporate earnings, but it does so at a price: the smoothing approach is complex and opaque and the numbers it produces don’t necessarily mean a great deal.
Some corporations have chosen to take a different approach, marking their gains and losses to market in the year they occur. Of the 20 U.S.-listed corporations with the largest worldwide pension liabilities (we refer to these as the $20 billion club), four use a mark-to-market approach: AT&T, UPS, Verizon Communications, and Honeywell.
The impact on the numbers has been significant, as expected
In the chart above, we show the line item “recognized actuarial losses” for these 20 corporations for 2010 through 2014. The corporations are ordered from left to right from the largest pension plan (IBM—with a PBO of $106 billion) to the smallest (Honeywell: $24 billion.) The four mark-to-market corporations are circled.
We see that the results for most corporations followed the same pattern: there was an expense recorded each year, which in most cases peaked in 2013. This reflects the impact of the large losses of 2008 (which are being worked through the income statement over a period of typically 10+ years), and the subsequent unexpected actuarial losses as interest rates continued to fall (offset by investment gains due to strong equity markets in most of these years.)
GM is one exception from this general pattern, a result of entering bankruptcy in 2009 (which led to accumulated actuarial losses being recognized as a one-off at that point and the amortization process being reset to zero.)
The other corporations that show different patterns are the four that mark to market. Gains and losses have been proportionately larger, and considerably more volatile. Most notably, there were big losses in 2011, 2012 and 2014 due to the fall in interest rates in each of those years. 2013 showed substantial gains.
The difference in the pattern of results between these four corporations is a result of different policies regarding the use of corridors: AT&T and Verizon Communications fully mark-to-market, while Honeywell and UPS retain corridors within which gains/losses are not recognized. This is why, for example, there was zero gain/loss recognized by UPS in 2013.
Analysts do not appear to be confused
The numbers themselves have worked out largely as we would have expected them to. But one significant area of uncertainty when these corporations first moved to mark-to-market was how analysts would react: the underlying economic reality is the same whether a corporation marks to market or not, but the reported numbers are different. Would analysts be able to interpret the two types of reporting accurately? Would one approach or the other be preferred?
On these questions, the experience of the past five years seems to have been that, by and large, marking to market has not caused confusion or hurt share prices. We believe that, in practice, the better analysts re-cast smoothed results to mark-to-market anyway. It is not proving difficult for them to look at corporations on a like-to-like basis.
It helps, of course, that these are large corporations with large pension plans: any competent analyst will spend a little time understanding the dynamics of the pension plan and the nature of its impact on the corporation’s finances when the impact is material.
Other things we have learned from the past five years: first, that changes to accounting standards can be a long time coming. When balance sheet accounting moved to mark-to-market in 2006, earnings statements were expected to follow. However, even though the international standard has now adopted mark-to-market, momentum for change in the U.S. appears to have slowed. Second, the adoption around 2010 of mark-to-market by a first wave of corporations appears to have been a one-off, with no major second wave following.
So I’m not going to argue that pension expense marking-to-market is a hot topic for most corporations at this time. Nonetheless, five years of hard data seems worth documenting.