In the article Analyzing Pension Risk I define pension risk and explain why it is important to assess this risk posed by a company's defined benefit pension plan. Here in this article I present one way (but not the only way) that can help you evaluate and assess whether or not a company's pension exhibits a high risk of shortfall.

Analyzing a company's pension risk should be as easy as reading the footnotes to compare what is owed (accumulated benefits due employees) to what is owned (the value of the portfolio). Unfortunately, thanks to complicated accounting and IRS rules, evaluating pension risk is a Gordian knot that is not easily unraveled.

However, there is a way to use information in the footnotes to evaluate pension risk. While it involves some work, this process will make you a more informed investor. The goal of this process is to cut through the accounting mumbo jumbo to estimate pension funding and cash risk.

The Process
In General Electric's (NYSE: GE) 2002 annual report, Footnote 6 contains the pension data we need. Under the "effect on operations" section it is disclosed that GE's pension plan contributed $1.556 billion to pre-tax income (before payments for retiree healthcare and other benefits), or $0.12 per share on an after-tax basis.

However, this amount was arrived at after using the smoothing techniques allowed by generally accepted accounting principles (GAAP). The table in Footnote 6 (shown in Table 1 below) shows that the $1.556 billion was the result of the expected return of $4.08 billion, the real costs and smoothing accounting techniques. It is these real costs that will be used to analyze the real cost of GE's pension plan.


In order to gauge the impact of "core" pension expenses on EPS, you need to examine the real annual costs of a pension plan, namely service and interest costs. The service costs represent the pension benefits earned by the employees during that year, and in GE's case, that number is the net of employee contributions. The interest cost represents the interest that accrued on the unfunded part of the projected benefit obligation. Analyzing the impact of these costs in relative isolation helps analyze the impact of pension liabilities without the smoothing allowed by GAAP.

To determine the "real" annual cost of the pension plan, you need to back out the massaged number (in this case the $1.556 billion) and add back the service and interest cost. The real annual, after-tax, per share cost of the pension plan in 2002 is $0.38.

As shown in Table 2, this calculation increases the cost 16.7% in 2001 and 6.1% in 2002. This represents a total "swing" of $0.50 from the GAAP EPS number. GE is unique because its plan contributed income whereas most plans add expense. Generally, when evaluating pension risk plans adding expense, you would add the periodic pension cost and subtract the service and interest costs to get the net effect on EPS, but in GE's case, you subtract everything:

This adjustment reduces GE's EPS growth rate by 38%. As shown in Table 3, the GAAP EPS growth rate for 2002 was 2.9% versus the 1.8% that results from making the adjustments described above.


What about Periodic Investment Gains?
This process does not factor in the return on plan assets for two main reasons. First, the above process focuses on the actual annual costs in order to gauge their impact on earnings. Second, the return on plan assets does not belong to the company but to the retirees. While an accounting convention may allow a company to net the costs against the returns, the company has no legal right to the returns. Factoring the return on plan assets into the process would distort the analysis.

If you wanted to include the return on plan assets, you would need to look at the disclosure of the Fair Value of Plan Assets. In GE's case, the actual loss on plan assets was $5.25 billion (compared to the $4.1 billion return that was expected). Including the actual loss on plan assets would reduce EPS by another $0.42 (after taxes).

The Bottom Line
This approach analyzes the EPS impact of the hard (or undiluted by accounting practices) cost of defined pension plans on EPS. Focusing on the per share impact of annual service and interest costs provides a clear view of annual costs that is unclouded by the actuarial assumptions and smoothing techniques allowed by GAAP.

Related Articles
  1. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  2. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  3. Retirement

    5 Secrets You Didn’t Know About Traditional IRAs

    A traditional IRA gives you complete control over your contributions, and offers a nice complement to an employer-provided savings plan.
  4. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  5. Retirement

    Are Fees Depleting Your Retirement Savings?  

    Each retirement account will have a fee associated with it. The key is to lower these fees as much as possible to maximize your return.
  6. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  7. Retirement

    Retirement Tips for Doctors

    Learn five tips that can help physicians get back on schedule in terms of making financial preparations they need to retire.
  8. Investing Basics

    Do You Need More Than One Financial Advisor?

    Using more than one financial advisor for money management has its pros and cons.
  9. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  10. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  1. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  2. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  3. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>
  4. Are catch-up contributions included in the 415 limit?

    Unlike regular employee deferrals, catch-up contributions are not included in the 415 limit. While there is an annual limit ... Read Full Answer >>
  5. Can catch-up contributions be matched?

    Depending on the terms of your plan, catch-up contributions you make to 401(k)s or other qualified retirement savings plans ... Read Full Answer >>
  6. Are catch-up contributions included in actual deferral percentage (ADP) testing?

    Though the Internal Revenue Service (IRS) carefully scrutinizes the contributions of highly compensated employees (HCEs) ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center