The front page article in the October 16 Wall Street Journal, “Pension Funds Flee Stocks in Search of Less-Risky Bets,” was a real eye-catcher.
I can understand the motivation to reduce risk in view of the fact that Funds generally have taken on far more risk (or blame) than good judgment dictates. The eye-catching part of the headline, however, is the disparity between risk reduction and the increased Return on Assets (ROA) assumptions that many Funds are declaring. If they have found a low-risk, high-return alternative, I’m certain the rest of us would be eager to know about it!
The reasons this doesn’t make sense are twofold. Pension Plans are reducing risk and, by implication, reducing their potential rate of return. Secondly, expected returns on investments are approaching a historic low. By what logic are companies using return assumptions as high as 10%?
Investment in a 30-year bond, assuming no default, yields 4%. Stocks, a far riskier asset class, bring expected returns to no more than 7%. It is not reasonable to expect long-term return on assets to exceed a rate somewhere between 4% and 7%. Based on quantifiable facts, corporate Pension Plans should be reducing the long-term expected ROA to reflect market conditions. Instead, many corporations have elected to maintain or raise their return assumptions to outrageous levels. Why?
The answer is obvious. Higher return assumptions reduce current pension expenses, raising earnings (see Table I). This accounting manipulation is easily performed. Rate of Return assumptions are discretionary, and the pension actuarial firms that bless the chosen rate are agents of the corporation.
Table II represents some (but not all) of the companies that, ignoring market conditions, have ROA far in excess of market averages. Some have even had the audacity to raise their ROA in 2010. None of the companies listed has a portfolio asset allocation that would be considered high risk/high return; most have equity exposure less than 70% of total assets and realistically should expect a long-term return lower than 7%.
[The Audit Integrity Accounting and Governance Risk (AGR®) rating is a forensic measure of the transparency and reliability of a corporation’s financial reporting and governance practices. The focus of AGR analysis is on identifying the measures most highly associated with fraud, and quantifying those risks for interested stakeholders in relation to company stock price, securities litigation, and major restatement probabilities.]
What does this mean to the investor? An unrealistic return assumption could be masking operating problems, or could be indicative of accounting games.
Raising the appearance of profitability in the short term only increases damages down the road when pension expenses increase. I strongly suggest that stakeholders carefully assess their holdings to ensure that they are not basing their expectations on improper representation of the companies they own.
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