MIND THE GAP

Everyone just wants the awfulness to end. The tech bubble and the crash, the billions in write-offs, the outrage over stock options, Enron and its off-balance-sheet accounting shenanigans, and on, and on. When embattled Nortel Networks Corp. released its annual financial results in January, you could almost hear a collective sigh of relief. The company lost only $3.6 billion (U.S.) last year, down from $27.3 billion (U.S.) in 2001. Phew.

No one beyond Bay Street and Wall Street took much notice of a number that was going in the opposite direction. As Nortel's chief financial officer, Doug Beatty, disclosed in a conference call in January, the company's pension plan deficit had jumped to $1.8 billion (U.S.) from $1 billion (U.S.) the year before. Back in 2000, there was no deficit at all, but rather a surplus of a half-billion.

Like other large companies, Nortel had seen its pension investments battered by two years of heavy stock market losses. But you won't find the full pension gap on Nortel's balance sheet, and only a fraction of it has shown up on its income statements. The rest is buried in the notes to the annual report. Not to worry, said Beatty. "Nortel Networks has always met and will continue to meet the funding requirements." Nortel anted up $150 million (U.S.) for its pension plans in 2002, half of it required by law and half of it voluntary. It expects to do the same this year. Unlike the spectacular asset writedowns at Nortel and other companies in recent years, those expenses involve real money, not just bookkeeping entries.

Even if Nortel keeps topping up the pension fund at $150 million a year, it will take more than a decade to pay off the deficit. That's a lot of money that won't be available for other uses, such as capital investment or dividends. And what if stock markets get worse? What if Nortel's business continues to shrink? Don't even ask about the sunny assumptions for future investment returns in Nortel's pension estimates. Someone still thinks the market is partying like it's 1999.

But Nortel has done absolutely nothing wrong. It has followed the pension accounting rules-rules that the bloodhound Toronto forensic accountant Al Rosen describes as a "makeup kit" for putting the best face on a growing pension crisis. The scary thing is, Nortel isn't an exception in this corporate debacle. It's the rule.

"Any person who thinks that accounting has been tightened in the aftermath of 'Enron and the clones' is not looking at the hard data," wrote Rosen and his analyst son Mark in a report drolly titled "Pension Cookery," prepared for Toronto's Caldwell Securities Ltd. last year. The same sentiment was sounded in an article co-authored by Christine Wiedman, an associate professor of accounting at the Richard Ivey School of Business in London, Ont. It noted that at the end of 2001, the 100 largest defined-benefit corporate pension plans in Canada had a total shortfall of $1.8 billion. Yet they had aggregate pension assets of $6.7 billion on their balance sheets. Annual reports for 2002 are now being published, and the picture isn't getting any prettier, by Wiedman's estimate: In fact, the pension gap is metastasizing into a $20-billion Grand Canyon. "Balance sheets really don't reflect the reality at all," says Wiedman. "The losses are accumulating in a tank."

Even though the accounting rules allow companies to spread the hit over many years, rising pension costs are already taking big chunks out of earnings, particularly for old-economy companies with large numbers of retirees. For the Big Three auto manufacturers-General Motors, Ford and DaimlerChrysler-pensions are now a bigger cost item than steel in the average price of a car. Such costs are only expected to rise across the economy, thanks to an aging workforce, a shaky stock market and the delayed impact of pension losses to date. "Nobody really has a handle on these numbers because it's so bizarre," says Caldwell Securities chairman Thomas Caldwell, referring to the auto industry. "You always assume that they're off by a billion or two."

How did we get into this mess? Pension plans at most large corporations are defined benefit plans-retirees get paid a specified amount each month based on their salary and years of service. In the 1990s, those plans were moneymaking machines. Stock and bond markets racked up double-digit gains, and pension plan assets soared. There was more than enough to pay benefits to current retirees and bolster reserves for the future. Many companies took "contribution holidays"-they didn't put money in their plans for several years.

Those investment gains also inflated company profits. According to Martin Roberge, a quantitative strategist with National Bank Financial in Montreal, pension income accounted for about $275 million of BCE Inc.'s profits of $523 million in 2001, and $54 million of Telus Corp.'s profit of $454 million. Pension gains like that should have been red flags for investors, says Roberge, because they are "non-cash earnings boosters," and not a reflection of a company's real business.

But no one wanted the party to end. Still, at the giant Ontario Teachers' Pension Plan, which now has $69.5 billion in assets under management, the plan's investment officers were concerned. Soaring share prices had pushed the equity component of Teachers' portfolio to 75%-very risky, given that pension managers usually like a more even split between stocks and bonds. So long as the good times rolled, both the cash-strapped Ontario government and teachers' unions, which split contributions, felt they could let it ride and use surpluses to limit contributions and boost benefits. But surpluses aren't a "chequing account balance," says Teachers' senior vice-president Leo de Bever. "What a boom giveth, the next bust can take away."

Now the process is reversing itself. The Toronto Stock Exhange's S&P/TSX 60 Index includes 47 companies with defined benefit pension plans. In 2000, when the TSX peaked, just 14 of them had plan deficits. After the TSX fell by almost 14% in 2001, 34 of them had deficits. The chart (above) shows the pension balances at the 20 largest plans.

The TSX Composite Index declined by another 14% last year, and the erosion accelerated. Among the first companies to file annual reports were the Big Five banks. The Royal Bank now has a pension deficit of $843 million, compared with a surplus of $5 million in 2001. The Bank of Nova Scotia's surplus shrank to $473 million from $820 million. Meanwhile, Bombardier's shortfall leapt to $1.6 billion from $398 million. Morneau Sobeco Inc., a Toronto-based pension consulting firm, says the median return for Canadian pension fund managers in 2002 was -5.1%, the worst result since 1974. In January, the federal Office of the Superintendent of Financial Institutions (OSFI) acknowledged that it had put 50 corporate pension plans on a confidential watch list, in part because of heavy stock market losses.

Some smaller plans already are in trouble. In February, members of a farm co-operative pension plan launched a class action lawsuit against the plan and its investment manager. The Participating Co-operatives of Ontario Trusteed Pension Plan had disclosed that it had just $64 million in assets. Liabilities, assuming the business continues: $120 million. Ouch. Unless a settlement can be reached, the plan faces a wind-up by provincial regulators, who would likely reduce benefits by up to half.

No one is forecasting that any major corporate plan will hit the wall soon. Nor that retirees should get used to the taste of cat food. All the major plans have "solvency cushions" that ensure there's enough for years of payments. Still, OSFI said those cushions have shrunk, and "an increasing number of problems are expected to emerge."

What's inescapable is that companies will have to pony up increasing amounts of cash. Inco Ltd. is fairly typical of companies that have "mature" pension plans-a workforce that is stable or declining in size, and a population of retirees that is growing. Inco's pension-plan deficit totalled $524 million (U.S.) at the end of 2001. The company had to inject $67 million (U.S.) into its pension plans last year, and that will rise to about $140 million (U.S.) annually for at least the next couple of years.

Why the big gap between pension reality and the numbers on balance sheets and income statements? Just why are companies allowed to delay the pension hit so long? These are questions for an actuary.

The industry joke is that actuaries are the guys who didn't have enough personality to get into accounting. Actuaries are mathematical specialists who work for insurers and consulting firms, computing benefit payouts. So your biggest professional problem, as an actuary, is when people live too long.

Jack Nicholson is an actuary in his Oscar-nominated performance in About Schmidt. But the profession's Hollywood moment may just mean it's being turned into a metaphor for late-middle-age anomie. Schmidt, a desiccated soul, keeps a copy of U.S. GAAP for Life Insurance on a bookshelf in his study-right next to a picture of his daughter. After his wife dies, Schmidt reminds himself that "there is a 73% chance I will die within nine years, provided that I do not remarry."

Traditionally, economics has been known as the dismal science. Suggest that the label might fit the acturial profession better, and Paul Purcell, 38, the head of Toronto-based Mercer Human Resource Consulting's retirement practice, gets his back up. "It's not that dismal!"

Sitting in a featureless meeting room in Mercer's offices in Toronto's BCE Place, Purcell and Irshaad Ahmad, a principal with a division of Mercer that specializes in pension investments, try to explain some pension basics in down-to-earth terms. They are wearing identical dark blue suits and blue shirts.

Accountants concentrate on the state of a company over the last year or quarter. Actuaries try to forecast what will happen years, even decades, ahead. Pension actuaries estimate how much a company pension plan will have to pay out in benefits each year in the future. Then they work backward and calculate how much the company has to set aside now to cover those benefits. To do that, they have to make long-term assumptions about all kinds of variables: interest rates, bond yields, stock market returns, inflation, when employees are expected to retire, and many more.

Pension plans must file a detailed actuarial report to regulators at least every three years. Plans that are in trouble may be required to file annually. But those actuarial estimates are also the ones relegated to the notes in company financial statements, which tend not to be read by anyone but analysts. If there is a shortfall, a company doesn't have to cover it right away. Pension funding rules allow the company to do that over five to 15 years. It takes that long for the value of assets to be adjusted on the company balance sheet, and for the expenses to flow through its income statement.

You also have to look at the notes to get at perhaps the most contentious issue in pension accounting: the assumed long-term rate of return a company uses to estimate the growth in its plan assets. During the bull market of the 1990s, many companies boosted their return assumptions, and there wasn't much controversy about it. "No one cared when companies were assuming 8% and earning 15%," says Purcell.

As is the case with RRSPs, an extra percentage point or two in return can make a huge difference over time. Say you expect to pay out $100 million in benefits 25 years from now. If you assume an 8% annual return, you must set aside $14.6 million. Boost that to 10% and you have to set aside just $9.2 million.

This is where the fun of pension accounting begins, because company management alone sets the assumed rate of return, (though auditors and regulators do review the assumptions). Consider the 2001 rates at 12 of the companies on the S&P/TSX 60 that have defined benefit plans (see chart at left on previous page). In the group overall, rates range from 7.25% for the Royal Bank's pension plan to 10% at Imperial Oil.

Considering the sharp decreases in pension plan assets that actually occurred in 2001 and 2002, those return assumptions look wildly off the mark. Of course, the assumptions aren't supposed to necessarily hold true for any one given year. And these Canadian companies are being conservative, at least relatively: The median assumption of 8% among those 47 companies for 2001 was 1.25 percentage points lower than among comparable U.S. companies.

Still, highly optimistic return assumptions, plus the "asset smoothing" techniques that pension rules allow, make the accounting at many companies look fishy to investors. "It's more than skepticism," says Mark Campbell, an actuary and a principal with the consulting firm Towers Perrin Inc. in Calgary. "It's outright cynicism now."

Even during the '90s bull market, actuaries could see trouble brewing. In 1998, North American stock markets plunged by more than 20% within weeks due to the Russian debt crisis and the collapse of Long-Term Capital Management, the huge U.S. hedge fund company. Both Towers Perrin and Mercer warned that a prolonged bear market would hit defined benefit plans hard. "It's funny, in hindsight, because it was a turning point-in the wrong direction," says Purcell. Stocks shot back up again. "The types of things we were thinking, the types of articles we were writing, that we never published, we just dusted them off two years later," he says.

It took the stock market collapse of 2001 and a blistering attack on pension accounting and return assumptions by renowned Omaha investor Warren Buffett to reignite the issue. In November, 2001, Buffett noted that General Electric Co. included a $1.74-billion (U.S.) pension credit as part of its earnings in 2000, almost three times its appliance division's profit of $684 million. Yet Buffett, who sits on the boards of directors of 19 companies, said he had "never heard a serious discussion of this subject" at a board meeting.

A few are evidently taking up the subject, albeit slowly. Last year, Bank of Montreal and Bank of Nova Scotia lowered their expected rates of return to 7.5% from 8.2% and 8%, respectively.

There's another wrinkle. So far, we've focused on pension assets, rather than liabilities. Actuaries reduce their forecast of future payments into one current value-the liability-using a so-called discount rate. The rate is based on the yield of high-grade corporate bonds-about 6.5%, lately. If plans have to lower both their rate-of-return assumptions and their discount rate, they'll be hit with a double whammy.

How do we get out of this mess? A strong stock market rebound would certainly help. But with North American markets down about 40% from their peaks, even a strong rebound this year of, say, 10% wouldn't help much. The graph of Mercer's Pension Health Index (at right on previous page) indicates why. It shows the ratio of assets to liabilities in a typical corporate pension plan, with the assets being an investment portfolio of 55% stocks, 42.5% bonds and 2.5% cash. Rising stock prices would obviously boost only about half of the portfolio.

Shifting assets into bonds likely wouldn't help either. First, companies would lock in their recent stock market losses. "You'd be bailing out at the worst possible time," says Ahmad. Unlike stocks, bond markets have climbed over the past two years; pension plans with high bond weightings have benefited accordingly. But bond prices go up when interest rates go down. Interest rates are near 40-year lows, so there's nowhere to go but up. As rates rise, bond prices will decline.

Some companies are looking at investment alternatives. Ahmad says some of his clients are considering hedge funds, income trusts, real estate and stakes in private companies. Used in small amounts, those instruments can help spread risk and increase potential returns. However, there is always the risk of getting caught in a bubble. "Private equity investing was big in the '80s-and, of course, people got burned," says Ahmad.

Managers of mature plans also have less room to manoeuvre than they did a generation ago. When pension assets plummeted in the bear market of 1973-1974, there wasn't an immediate worry because many companies had young and growing work forces. Now, mature plans can't take chances with stocks or other investments that fluctuate in value, because the plans are being forced to reckon with what is, after all, their real purpose-to pay benefits to pensioners every month.