A multi-billion loss in corporate equity with the stroke of a pen?

November 5, 2006

Major earthquakes, category 5 hurricanes and terrorist attacks strike in an unpredictable manner. A fortune teller who could predict when the next of any of these events will occur would be hailed as the next Nostradamus. Yet, at a Sept. 13, 2006, Professional Liability Underwriting Society (PLUS) Directors and Officers (D&O) Symposium in San Francisco, two prognosticators forecasted a potential loss in equity to the Standard and Poor’s (S&P) 500 companies within the next year or so by as much as $500 billion, when accounting for defined benefit and health care costs.

To put that number in perspective, the most current estimate of the total damage done by Hurricane Katrina in 2005 is roughly $125 billion, according to a Sept. 9, 2006, report by Risk Management Solutions. The coming corporate loss in equity is predicted to be four times as great.

Cary Meiners, second vice president of Travelers, and Jack Zwingli, CEO of Audit Integrity, were able to predict the coming equity loss because the Pension Protection Act of 2006 mandates that underfunded corporate defined benefit pension plans (DBPPs) — the kind where the cost of the plan is determined by the retiring employee’s promised level of retirement payments — be fully funded by the end of 2008. It sounds simple, but to bring defined benefit plans into compliance involves both heavy math and bitter medicine for many companies. More than 30,000 companies and 35 million workers may be affected.

The pair estimated that some S&P 500 companies may be forced to increase their contributions to DBPPs by 60 percent. It is estimated that Ford Motor Co.’s DBPPs are underfunded to the tune of $41 billion. Roughly 20 S&P 500 companies may take an equity hit of 25 percent or more; the average equity hit for the S&P 500 is predicted to be 6 or 7 percent.

As Alan Gra Jr., CEO of FedEx put it, “The medicine may kill the patient.”

Under the new law, plans that are less than 80 percent fully funded by the target date are disallowed from granting any benefit increases. So, the Act not only affects existing pension indebtedness, but it also affects also some companies’ future ability to enhance pension benefits.

The Financial Accounting Standards Board (FASB) had been considering reforms to the ways that contingent pension obligations are reported in corporate financial statements even before the Pension Protection Act was signed into law. In Sept. 2006, FASB issued a new Statement of Financial Accounting Standards No. 158, which amended the prior rules under which DBPP obligations were reported, partly in response to the Act’s passage. Under the new rules, DBPP payment responsibilities will no longer be relegated to the fine print in footnotes, but must be moved up the balance sheet page to be shown among a corporation’s debts. With the stroke of a pen, DBPP responsibilities will become real debts that offset real assets, thus reducing a company’s net equity.

Once defined benefit pension indebtedness has taken its prominent new location on the balance sheet, the next phase of the FASB’s reforms will come into play: better defining the discount factors that are used to show the present value of anticipated future DBPP payments. Furthermore, it is not just the discount rate but the full set of assumptions that companies make — expected rate of return, expected compensation increase and newly expanded assumptions — that are now having a substantial impact on the balance sheet pension liability. As Meiners pointed out, the assumptions made about the “fair value” of pension investments now must incorporate hedge funds and derivatives, which add to D&O exposure because those investments are difficult to value.

The immediate impacts of those changes, according to the PLUS D&O West Symposium speakers, will likely be decreased capital expenditures and cash flow, and increased costs to borrow money, as companies move funds away from production and into pension funding.

“The net of all of that is a company will be required to make many assumptions about both the value of the pension asset and the amount of the pension liability, and any mistakes or misrepresentation related to those assumptions opens up D&O exposure,” Meiners said. He also indicated that there is potential for companies to terminate or freeze DBPPs, or switch to a cash balance plan, which has already begun.

Can these new accounting rules impact the insurance industry as well? As to insurers’ own DBPPs, clearly so, but there is also a potential for new types of claims against insurer’s policyholders. Boards of directors and their outside accounting firms might be expected to face increased scrutiny from securities regulators and the plaintiffs’ bar if corporate earnings forecasts aren’t sufficiently “hedged” to reflect the new accounting for the company’s DBPP obligations. There already are discussions underway as to the implications of improper DBPP disclosures under section 404 of the Sarbanes-Oxley Act.

There is another shoe to drop in this continuing story. DBPPs aren’t the only type of benefit plans that are currently underfunded in many companies. Employee health plans may prove to require an even larger correction to become fully funded. That is an issue for another day, but one that is already simmering on the back burner while the DBPP shortfall is being fixed.

The Pension Protection Act of 2006 and FASB 158 have many other provisions that apply to specific industries. For a full copy of both documents, e-mail Louis.Castoria@ WilsonElser.com.

Louie Castoria is assistant managing partner of the San Francisco Office of Wilson, Elser, Moskowitz, Edelman & Dicker LLP and heads its professional liability defense practice. He defends members of the financial professions, and his practice also includes insurance coverage litigation.

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