Pensions in the Regulatory Environment
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1 Pensions in the Regulatory Environment NARUC Staff Subcommittee Meeting on Accounting and Finance David G. Pitts, FSA, MAAA Independent Actuarial Services September,
2 Survey of Per Capita Costs 2
3 Survey of Per Capita Costs Lack of transparency makes it difficult to assess whether company is appropriately managing compensation costs Per-capita retirement costs Sector Average Per Capita Retirement Costs Cost Relative to regulated utility Regulated Utility $15, % Non-regulated Utility $12,000 80% General Business $4,000 27% 3
4 Pension Cost Cashflows PNM Expected Pension Payments ($Millions) Source: AG 4-1(A) Cost Actuarial Measures PBO = present value using assumed discount rate Funding liability = present value using statutory rates Market Value Liability = present value using risk-free rates Consistent with risk-transfer pricing, 15 20% higher than PBO 4
5 Rating Agency Perspective Moody s standard adjustments Pensions are debt-like due to contractual nature Primary financial statements adjusted to include pension debt Income statement adjusted to remove accounting noise (artificial smoothing) Borrow-to-fund strategies companies that borrow to fund their pension obligations are exchanging one form of debt for another, which will typically be a credit neutral event. - Moody s Special Comment, March 28,
6 The Magic of Pension Accounting If you bring up the topic of pension accounting, most people will roll their eyes, some will run the other way as fast as they can, and a few people will even fall fast asleep right on the spot. The problem: The accounting in FAS No. 87, Employers Accounting for Pensions, is convoluted, complicated, misleading, and for many it just doesn t make any sense. David Zion, CFA, CPA Bill Carcache, CPA CSFB, September
7 FASB Perspective FASB Board (FAS87): Pensions are an exchange between employer and employee Obligation earned when services are rendered Regulatory Implication: Pension deficits = intergenerational inequity Note that deficits include both trust shortfall and prepaid pension assets 7
8 Key Features of FAS87 Delayed recognition of certain events changes are not recognized as they occur but are recognized systematically and gradually over subsequent periods. Net cost Aggregates three items that might otherwise be reported separately: compensation cost, interest cost, investment activity Offsetting assets and liabilities 8
9 FAS87 30 years later Delayed recognition doesn t work (1) The main purpose of this paper is to utilize recent developments in panel data techniques to evaluate whether the smoothing of pension expenses is neutral in its long term effect on reported earnings...results suggest that the current smoothing mechanism tends to induce significant biases in the recognized pension expenses. For a majority of the sample firms, the tendency is to overstate the sponsoring firms earnings in the long run. Regulatory implication: cost of service artificially low, legacy pension costs transferred to future generations, persistence of prepaid pension assets (and company profits) 9 (1) Xiaowen Jiang, Smoothing of pension expense: a panel analysis, Review of Quantitative Finance and Accounting, 2011
10 FAS87 30 years later Exposure Draft comment letter excerpt: The corridor was established as guard rails to keep a company on the gradual path to reach its destination of matching postretirement benefit costs with the ultimate cash it would expend to provide those benefits. The idea was to keep from jerking the wheel from side to side as a company encountered potholes in its path. Instead companies have been careening down the road, with their vehicle jammed against the guard rail, never returning to the center line. SFAS No. 87 and SFAS No. 106 were meant to smooth expenses to represent a normalized cost over several reporting periods. Instead the reported amortizations are a significant component of expense, unrepresentative of current changes in the liability, that can continue for years. - Paul Hubling, Manager Special Projects ArcelorMittal USA 10
11 FAS87 30 years later Net Cost under review Pension Exposure Draft issued January 2016 Service Cost = operational cost, all other FAS87 features to be recorded elsewhere Service Cost only element subject to capitalization Comments from utility companies generally opposed to change 11
12 FAS87 30 years later Offsetting assets and liabilities Will remain under ED Consistent with rating agency treatment Ignores underlying riskiness of investment strategy, and pension leverage Holistic balance sheet would be better 12
13 The Magic of Pension Accounting Add the enormously complicated rules from Section 412 of the tax code that determine when a company has to contribute to its pension plan (if you think that pension accounting is tough, try reading Section 412); mix in a pension obligation with unknown future cash flows; and you have a recipe for confusion. David Zion, CFA, CPA Bill Carcache, CPA CSFB, September
14 Cash vs. Expense PNM FAS87 vs Cash ($Millions) Source: 10-k FAS87 Expense Cash Contribution FAS87 income in early years created prepaid pension assets FAS87 cost in later years nowhere near sufficient Smoothing and deferral mechanisms inadequate for shocks Cash contributions well in excess of FAS87 14
15 Deficits and Prepaids PNM Funded Status at 12/31 ($Millions) Source: 10-k FVA (ratepayer) FVA (shareholder) PBO Inadequate FAS87 rates led to near tripling of prepaid pension assets Represents a company claim on ratepayers, similar to credit card debt Violates regulatory principal of intergenerational equity Will remain for many, many years under current accounting policies 15
16 What is a prepaid pension asset Company testimony A prepaid pension asset represents the difference between: (1) the cumulative cash amounts contributed to the pension fund, and (2) the cumulative actuarially determined net periodic pension cost calculated in accordance with FAS 87. Translation A prepaid pension asset is an obligation owed to the Company, often times interest bearing at above market rates In addition to deficits owed to plan trust 16
17 Why should I care Prepaid pension assets: Have grown exponentially since 2007 Will persist for decades under current accounting and funding regimes Locked in source of risk-free profits for company Represents growing intergenerational inequity Pervasive and hotly contested Recent wins in Colorado electric and gas jurisdictions (PSCo) 17
18 Underlying economics Company can earn spread on prepaid pension asset Can borrow at cost-of-debt, with tax deductible interest charges And earn an after-tax return of WACC for the shareholder investment Ratepayers are captive borrowers Forced to borrow at rates > 10% Penalty rates compared to credit worthiness 18
19 How did we get here Rise in overall pension debt Asset/liability mismanagement Increased longevity? Regulatory inertia Complicated, lack of transparency Arcane accounting and funding standards Agency problem Hotly contested Profit center for company 19
20 Colorado Ruling Prepaid Pension Asset: Legacy and New Legacy Prepaid Equals Prepaid Pension Asset as of 12/31/ year amortization (post-tax) Cost of debt vs. WACC Interest charge to be renegotiated in 2017 New Prepaid is non-interest bearing 20
21 Colorado Ruling Before: $156 M After: 51 M Savings: $105 M 21
22 David G. Pitts, FSA David Pitts has provided actuarial consulting services to Fortune 500 companies for more than 25 years, assisting the Human Resource and Finance functions in the design, pricing, risk management, communication and administration of pension and other compensation programs. In 2010, David launched Independent Actuarial Services, focusing primarily on the actuarial needs of the legal community. In this role, David has served as a consultant and expert witness representing utility ratepayers in both Colorado and New Mexico, and has served as a forensic economist in civil matters ranging from wrongful termination to personal injury claims. David received his BS in Mathematics from Tufts University, and is a Fellow in the Society of Actuaries. David is a regular speaker at actuarial conferences, and currently serves on the Pension Finance Task Force a sponsored committee whose primary mission is to strengthen retirement systems, by incorporating the teachings of financial economics into traditional retirement actuarial practice. David also serves as the retirement expert for the SOA curriculum committee on enterprise risk management
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