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Eagan, Minn. — Let's say you have a bunch of money in a retirement nest egg. Which of the following is more important to your financial health?
A) How much you think your investments will earn, or B) how much they actually earn?
Should be obvious, right?
If you're an individual, what matters is how much your money actually grows.
But for a business with a pension fund to pay retirees, it's different. Management's prediction of the pension fund's growth is what counts when it comes to calculating the company's profits.
Here's why: corporate pension funds can be huge--billions and billions of dollars. They can produce enormous gains or losses from year to year. Include those swings in the company's profit reports to investors and you could distort the actual health of the ongoing business. To smooth things out, the accounting rules say companies should calculate their profits based on estimates of long-term pension fund growth, regardless of the actual short-term results.
Seems reasonable, but here's what some of the experts have to say:
"It's generally accepted that pension accounting for defined benefit plans is broken."
"Pension accounting rules are some of the most complex and convoluted and potentially distorted accounting rules."
"The accounting clearly is counting a lot of chickens well before they're hatched."
What gets much of the heat from critics is that management's pension predictions can have a big impact on profits.
Wayne Guay, an accounting professor at the University of Pennsylvania's Wharton School says raising the estimated growth of pension assets can, in turn, boost profits. That opens the door to management manipulating the bottom line.
"They can pump up earnings or pump down earnings by changing the expected return on plan assets," says Guay.
One study found pumping up--$18 billion worth. UBS Investment Research analyst David Bianco says that's the amount of profit generated by aggressive pension assumptions at firms in the Standard & Poor's 500 last year. It amounts to about $36 million per firm.
Other research suggests companies ratchet up their pension estimates in years when the CEO cashes in stock options.
Actuary Jeremy Gold says a small pension fund won't affect the bottom line much, but "sometimes you have pension plans that are bigger than the net worth of the company," says Gold. "In those cases a one percent change in interest, in simple terms ... can represent my bonus coming in instead of my bonus not."
Experts have also raised another concern--that many companies help the bottom line by underestimating how much health costs will rise.
The Securities and Exchange Commission says it targeted Northwest and the other five companies because they appeared to have aggressive accounting assumptions; in other words, they might be overly optimistic. The SEC wants to know what the companies had in mind when they picked their numbers.
Terry Tranter, a senior lecturer in accounting at the University of Minnesota's Carlson School of Management says Northwest's pension and health cost assumptions do seem aggressive. But that doesn't mean there's something wrong with them.
"It really depends on whether the company can actually achieve those particular rates," says Tranter. "There's no such thing as a good number or a bad number there. It's whether or not it's a number that can be achieved consistently."
In a conference call last month, Northwest CEO Doug Steenland defended the company's accounting assumptions.
"We think they're prudent and responsible, and we think they're clearly in line with established and appropriate practices and completely consistent with historic results," Steenland said.
Northwest expects a 9.5 percent long-term rate of return on its pension assets. That's higher than the typical rate found in surveys. But Northwest officials say their actual returns have been better than 11 percent. They declined to comment on health cost assumptions.
Actuary Jeremy Gold doubts the SEC will find much to complain about. But he says the inquiry may convince other firms to back away from aggressive assumptions.