A critical perspective on pension accounting, pension research and pension terminations

Critical

Perspectives

on

Accounting

3,61-85

(1992)

A CRITICAL PERSPECTIVE ON PENSION ACCOUNTING, PENSION RESEARCH AND PENSION TERMINATIONS REITER*

SARA ANN

AND THQMAS OMER~

* School of Management, State University of New York at Binghamton f University of Illinois at Urbana-Champaign

an

The purpose of this study is to examine the implications of pension accounting principle changes in the 1980s for conflicts involving ownership of pension surpluses and distribution of wealth between shareholders and employees. Pension accounting measurement and disclosure issues are related to pension terminations in the mid 1980s which involved corporate recapture of billions of dollars of pension surpluses. In addition, assumptions underlying pension research are examined and biases in method and interpretation, which affect the use of research results in public policy contexts, are discussed. Finally, a empirical analysis is conducted to test the conclusion from pension termination research that employees’ interests were not affected by pension terminations since recaptured assets represented excess funds previously stored in pension plans by sponsors. Results do not support this contention and indicate that terminations of defined benefit pension plans with recapture of pension surpluses represented some degree of expropriation of employees’ wealth.

Introduction This study offers a critical research related to defined . xv) notes that there significance of accounting following definition of the I, . ~. accounting practice

is a means for resolving social conflict, a device for the terms of exchange between social constituencies, and an mechanism for arbitrating, evaluating, and adjudicating social

appraising institutional choices”

While

(Tinker,

many

perspective on accounting practice and accounting benefit pension plans’ in the 1980s. Tinker (11985, has been a systematic understatement of the in both a societal and economic sense. The true role of accounting is offered:

1985,

accountants

p. 81).

view

their

role

as objective

tracers

of historical

cost,

it is particularly evident in the area of pension accounting that accounting choices play a major role in distributional decisions, particularly the distribution of wealth between shareholders #and employees. During the 1980s there have been major changes in pension accounting rules and in tax laws and regulations relating to pensions (particularly in the area of terminations), and there tias been an epidemic of pension terminations. Pension accounting changes may have played a rdle’in tax and administrative law changes anId in the termination occurrences. ’ Addre’ss ,Bihghaniton, Received

for

correspondence: Binghamton, New

8 February

1991;

Professor Sara York 13902-6000,

revised

5 May

1991;

Ann Reiter, USA. accepted

School

28 July

of

Management,

SUNY

1997.

61 1045-2354/92/010061

+25$03.00/O

0

1992

Academic

Press

Limited

at

62

S. A. Reiter

and T. Omer

Before the early 198Os, termination of defined benefit pension plans with reversion of the surplus to the sponsor was uncommon’. From 1983 through 1986, the years of heavy termination activity, over 1300 overfunded pension plans were terminated with total asset recaptures of more than 16 billion dollars (DH + S Review, 27 March 1989). There was considerable concern that employees’ retirement benefits were decreased by the terminations. When no successor plans are offered, employees’ claims are limited to benefits earned to date. In a majority of cases, terminated pension plans were replaced by some form of successor plan3. Replacement defined contribution plans may have generous contribution formulas but do not provide the same type of retirement protection as the terminated defined benefit plans. Even with defined benefit successor plans, future benefit increases meant to be funded with the recaptured pension assets may not materialize; and for participants whose claims are settled with annuities purchased from insurance companies, a new problem is emerging as failures of insurance companies, such as Executive Life, put their retirement income in jeopardy (Castro, 1991). Some members of Congress were concerned with the use of tax-deferred pension plans as corporate financing tools (Stone, 1987). The withdrawal of funds that had accumulated tax-free in pension trusts, presumably as a government incentive to private sector pension saving, sparked considerable policy debate resulting in the imposition of a 10% excise tax on, recaptures of pension assets after 15 December 1985 and a 15% #excise tax on’ reca&.rres after 21 October 1988. The 1990 Revenue Reconciliation ‘Act increased the excise tax on reversions to 20% and provided for a 50% tax if ‘the employer does not establish a replacement plan meeting certain criteria or increase benefits for participants in the terminated plan (Tax&Business Adviser, November/December 1990). While ,the,‘interests of employees appear to be protected at last, after the number of terminations has reduced to -a trickle, a new threat to employee interests looms on the pension horizon. The IRS does not allow tax deductibility for contributions to overfunded pension plans and, in 1988, the IRS amended its full funding regulations so that many plans are considered overfunded (Alderson, 1990’). Sponsors often do not make contributions when no tax deduction is allowed. Therefore, tax policy is forcing many firms to reduce pensi’on funding and draw down their pension surplus. The result may be an er;os,ionI, of the extent to which employers make adequate ,,provision for future pension costs. The;,pen$Qn termination craze and changes in administrative and tax law mayI, be,related, ,,in part, ito accounting practices. Accounting stanbards for define! be,nefrt: pension plans take positions on controversial issues related to valuatr,onand :prdperty rights, such as the nature of,the pension contract and owi-&shrp ‘offsur@l,us assets, that have consequences in th,e social arena (Tinker, &,985ir’ ,&counting disclosures present pension obligations on a term~natron’ ~basis~ ignoring going concern concepts ‘and ,employees’ claims to future pension’ benefits. Pension expense understates future ‘expected cash flows$or $ehsEon obligations and therefore overstates current ,net income. Untiil recent&, :accounting gains could only be recdgnized currently if blans

Pension

accounting

research

and terminations

63

were terminated without equivalent successor pension agreements. The changes in accounting standards in the 1980s and their implications are reviewed in detail in the following section. It is likely that research on pension issues has also played a role in influencing policy of both pension sponsors and regulators. As Arrington and Francis (1989 p. 25) warn, “It is entirely possible that the kind of libertarian [underlying positive theory in accounting]. . is finding its way economics.. into public policy by persuading others that it is based on objective, value-free science.“. While many accounting researchers see their role as neutral seekers after the truth, Tinker (1985, p. 82) asserts that contemporary accountin thought is overwhelmingly influenced by marginalist economic theory. SeveI of the implications of this viewpoint are that shareholders’ interests are ivileged and that market mechanisms are viewed as sufficient to ensure appropriate social choices. Arrington (1990) criticizes accounting researchers’ over-reliance on modernist scientific method: “Modernism is elitist and arrogant; it denies our capacity as human beings to “know” in many ways and to make our knowledge serve our values. Even worse, the modernist offers his own research results as if they were independent of his own values” (Arrington, 1990, p. 8).

A critical review of research on pensions points out hidden assumptions which impact on the conclusions drawn by researchers. Finally, empirical evidence is presented on the neutrality of the predominant explanation for pension terminations, the withdrawal of financial slack. Accounting researchers have concluded that pension assets recaptured by sponsors in ferminations represent recapture of excess funds previously stored in pension plans (Stone, 1987; Thomas, 1989) and, therefore, do not represent expropriation of employees’ wealth. We find that although terminations appear fo represent withdrawal of excess pensidn assets by firms suffering finaqcial stress, the funds do not appear to represent “excess” funds previously stdred in the pension plan by sponsors. Therefore, it seems likely that sdme degree of expropriation of wealth from employees has taken place.

Accounting

for Pensions in the 1980s

Pension accounting changes in the 1980s include two changes in pension liability footnote disclosures, a major change in the computation of pension expense, introduction of the possibility of balance sheet recognition of net pension liabilities and a change in accounting for pension terminations. Three principal results of these accounting changes have been: (I) moving away from the use of actuarial principles and measures used by actuaries for funding purposes; (2) showing lower net liabilities (and even surpluses) and lower pensior;l expense figures; and (3) breaking links between accounting r&cognition of gains and expenses and realization of cash inflows and outflows.

64

S. A. Reiter

and T. Omer

SFAS No. 36 SFAS No. 36 (FASB, 1980) went into effect for most firms in 1980 and dealt with footnote disclosures for defined benefit pension plans. The principal innovation was presentation of the components of a snapshot picture of the funded status of the firm’s pension plans. Total benefits owed to employees, vested benefits and net assets in the pension trust (at current market value) were disclosed separately; previously, only disclosure of net unfunded vested benefits (if any) was required. SFAS No. 36 pension obligations were calculated on an “as if terminated” basis. Despite initial concerns on the part of pension plan sponsors about showing greater liabilities, the pension liabilities shown under SFAS No. 36 were considerably smaller than before (Lutz, 1982). Two aspects of SFAS No. 36 are particularly likely to have influenced pension policy-measurement of pension liabilities on a termination basis and disclosure of pension surpluses. There is considerable controversy about th’e nature of the pension contract between the firm #and workers and how pension obligations should be measured. Under the explicit contract interpretation, pension promises are viewed as nominal prdmises measured,on an “as if terminated” basis. Since most pension plans cab legally be term’inated at any time, the pension promise is viewed as a short-term obligation which is renewed from period to period if termination is not :chose’n (Bulow, ‘1982): lppolito (1986b) indicates that in virtually all cases of pension,plan termination to date, excess plan assets measured on an explicit contract ‘basis have reverted to the stockholders4. Therefore, in cases ‘of plan termination, there’~is a legal net liability for guaranteed benefits or a rev&?&n ‘of net pension ;ass&S in excess of termination obligations5. Firms also argue that since .they ar;e responsible for pension shortfalls, all gains should Ii’kewise accrue,, to’ the,m and, therefore, the excess pension assets are owned by’ the’ sponsoi(f%eg~n,, 1984j6. The stated objective of accounting principles, however, is not to refj~ect administratively created risk sharing arrangements, but to reflect :expected future cash flows to investors and creditors (FASB, 1978). Despite wide&p&d co’ncern about pension terminations in the 198Os, sponsors terminating plans represent a small part of the total pension picture. The other view of pension contracts, the “implicit contract model,” assumes that pension promises include continuation of the pension plan, expected future benefit increases and adjustments for inflation (Ippolito, 1985). Bodie (1990a) views the implicit contract as a complex contingent claim where if the’sponsor d.oes not do .~ell financialfy, employees do not expect future benefit’inczreases, :whereas if I!the corporation does ‘well and retirees face i’nflation’, futu(e benefit’ increases[@ill be fot-t’hboming. Bodie suggests:that one way to view~this !jmp:licit claim i&as an employee ownership ,share inthe’pension fund surplus.‘Petisionacco~Ynting under SFAS No. 36 provided only explicit’ c,b ntiact or. termjna~f!on measu’res m,of pension obligations-and ‘it should be rrote’d that tern&-&ion o’bligations: are much smaller th’en going concern or ~rnpll~~it’~c~ntra~~~‘ldb/~,~ations (tppo#iito, 1985). While,‘there had been speculation that some firms used unduely conserva-

Pension

accounting

research

and terminations

5

tive actuarial practices to generate large current pension expense and develop “hidden income pools” (Briloff, 1972, p. 2), net pension assets had never been disclosed prior to SFAS No. 36. Disclosure of separate components of pension funded status under SFAS No. 36 represented an extension of the “augmented balance sheet” concept which was promoted after the passage of ERISA (the Employee Income Security Act) in 1974 under which employers became strictly liable for pension promises. Sponsors were encouraged by finance academicians and pension advisers to view pension assets and liabilities as indistinguishable from firm assets and liabilities (Treynor et al., 1976). Highlighting pension surpluses measured on a termination basis made pension surpluses appear real and available. It is not surprising that some corporations were tempted to recapture these funds or that. raiders were enticed.

SFAS No. 87 SFAS No. 87 (FASB, 1985a), which was adopted by most firms in 1986 or 1987, calls for footnote presentation of pension trust assets, termination obligations (accumulated benefit obligations) and larger pension obligations that take future salary increases into account (projected benefit obligations)‘. Firms may be forced to recognize a net pension liability on the balance sheet if there is an underfunded accumulated benefit obligation, Pension expense under SFAS No. 8~7 is calculated on a uniform basis, whereas previously, pension expense was determined by actuaries and generally conformed to pension funding amounts. Under SFAS No. 87, pension accounting has moved further away from the conservatism practiced by actuaries. As explained by Ezra and Ambachtsheer (1985), actuarial calculations build in a margin of safety which serves two purposes-a contingency reserve against future reversals and a store to fund the periodic benefit improvements typical of most plans. Actuarial practice takes an implicit contract view of the pension obligation as compared to the explicitcontract or termination view taken by accounting. From an actuarial point of view, overfunding arises from three sources. Pension asset values fluctuate, depending on market conditions, and may lead plans to seem quite hell fundedsduring periods of high stock market values and low interests rates such as the early 1980s. Stock market values and interest rates are known to change; therefore, actuarial assumptions about future ,asset and obligation growth tend to be conservative to build a cushion against future losses. commonly us,ed actuarial methods overfund benefits early in the service lives of ,employeesin order to smooth the projected benefit contributions over the entire Service~life. If the plan is terminated, only benefits earned to date ‘nee to’ be funded #and windfall profits, safety cushions and amounts contributed for future ibenefits can be recaptured’ by the firing. By using termination measures of pension liabilities, accountants overlook ‘any ~of ‘the sensible features of actuarial conservatism and present an inaccurate picture of how much surplus should be available for removal from pension plans. The projected benefit obligation disclosed under SFAS No. 87

66

S. A. Reiter and T. Omer

and used in determination of the interest component of pensiori expense falls somewhat short of an implicit contract obligation because it does not consider expected future benefit increases (Ambachtsheer, 1987; Bodie, 1990b). The actuarial cost method used under SFAS No. 87 produces a lower normal service cost for most firms resulting in lower reported pension expense than the previously used actuarial methods designed to even out pension contributions over employees’ work lives”. In the sample of firms in this study, there was an average 36% decrease in pension expense for 1986, the first year of general adoption of SFAS No. 87. Therefore, pension expense under SFAS~ No. 87 under-represents expected future cash outflows for ongoing plans and the surpluses highlighted in accounting disclosures continue to reflect a termination viewpoint despite the adherence of accounting in general to the going concern assumption. In addition, there are concerns that the potential appearance of net pension liabilities on the balance sheet may influence the funding and asset allocation policies of pension plan sponsors. Arnott and Lowell (1988) worry, for example, that concerns about lessening short-term volatility in order to insure that liabilities need never be booked, may lead firms to undertake investment strategies that generate less than optimal returns. Another possibility is that firms may reduce pension contributions or change actuarial methods to bring funding into alignment with accounting numbers (Ghicas, 1990).

SFAS No. 88 Accounting for gains from pension terminations under SFAS No. 88 (FASB, 1985b) no longer depends on the nature of the successor plan agreement as in the past when gains from termination of plans with defined benefit successor agreements were amortized over a number of years. SFAS No. 88 allows firms to recognize immediate gains on all terminations of pension plans. Pension accounting policy no longer encourages termination with no replacement or defined contribution replacement. Actually, SFAS No. 88 allows recognition of gains from curtailments of pension plans, settlement with severed employees and even settlement of benefits for certain employees (through purchase ,of annuities) without termination of pension plans or reversion of assets to sponsors. While formerly sponsors had to terminate plans to recognize gains, this is no longer required and a recent study documents a number of cases’of gain recognition without termination and asset recapture (Haw et al., 199i). This gives ,]a different twist to the symmetry of removal of !+urplus pension assets by ,pmployers and removal of accounting ,gains from the “hidden inc,ome ppply’. Before SFAS No. 88, if employers did not wish entirely to breach &&ion agreements with employees (by fiat’ providing succeSsor pIins!, ftj$/ could not show immediate accounting g&ns. Now eniployers can show iinQl$i’ate accounting gains without terminating plans” or remo&n’g pension SurpIIuses.

OBRA

of 19@

The OBRA, (Omnibus definition’ of pension

Budget Reconciliation obligation-the current

Act) of 1988 developed a new liability which is fundamentally

Pension accounting research and terminations

67

identical to the accumulated benefit obligation (the termination liability measure of SFAS No. 87). Contributions that would result in funding in excess of 150% of the current liability are not deductible (Alderson, 1990). Sponsors often do not make contributions when no tax deduction is allowed. Therefore, tax policy is forcing many firms to reduce pension funding and draw down their pension surplus even though the surplus may result from use of common conservative actuarial practices or fluctuations in the value of pension asset investments. It seems possible that accounting measures of pension obligation were influential in influencing the IRS to adopt a similar concept. The result may be an erosion of the extent to which employers make adequate provision for future pension costs. The probable role of accounting standards in the termination movement was three-fold: (1) pension surpluses were highlighted by the presentation of separate components of pension funded status in SFAS No. 36; (2) the magnitude of pension surpluses was arguably greatly overstated by use of termination liability measures; and (3) accounting rules limiting gain recognition for terminations with similar replacement plans may have led to erosion of employee benefits by encouraging use of defined contribution or no replacement plans. While discussion so far has focused on employees’ interests, reversion of surpluses and funding limitations may ultimately affect taxpayers responsible for funding the government pension guarantee agent (the Pension Benefit Guarantee Corporation). Recent events relating t government insurance of saving and loans and banks indicates that man other facets of deregulation in the 1980s have had the effect of transferrin eafth from taxpayers to ‘private sector business interests. A Critique

of Pension Research

Research reports on pension issues-by accounting scholars and othershave also played a considerable role in the pension debates. This section presents a brief overview of the results of research on the nature of the pension contract (explicit versus implicit benefits), pension funding policy, d pension terminations. Several underlying assumptions of these orts are explicated. A debate about the proper underpinnings for ing and economic research is beyond the scope of this study’*. We simply seek to clarify some of the underlying assumptions of researchers in the pension area and demonstrate that the research conclusions strongly reflect a particular political perspective that focuses on the interests of shareholders and promotes the operation of free market forces. The Nature of the Pension Contract Accounting researchers have largely ignored the measurement issues presented by the conflict between explicit and implicit contract views of the pension promise. There is some research evidence from finance and economics that the implicit contract view is representative of pension contracts. The sources of this evidence are cash wage-service profiles (Ippolito, 1985, 1986a, b; Pesando, 1985);, observed behaviour of firms changing benefit levels

68

S. A. Reiter and T. Omer

(Ippolito, 1986b); valuations of pension obligations inherent in stock market prices (Ippolito 1986a, b; Bulow et al., 1987); and associations with bond risk premiums (Reiter, forthcoming). One problem with research in this area is that empirical research cannot supply an answer to the essentially normative question-who should own the pension surplus. What happens is not necessarily desirable from a societal point of view. Second, there is an implicit assumption in looking at market reactions to settle this issue, an assumption which underlies much accounting and economic research. This assumption that market artifacts indicate correct distributional decisions rests on a belief that market forces provide the optimal, socially desirable allocation of resources (Tinker, 1985, p. 110). An example of this kind of thinking is Thomas’ (1989) support of the view of corporate ownership of the entire pension surplus: “Moreover, Landsman (1986) pension assets are capitalized to the workers.“.

documents evidence suggesting that excess in stock prices, and therefore do not belong

We wonder how many workers would be content to let stock market prices determine their property rights. In addition, modernistic methods of accounting research have limited the types of evidence that researchers look at to “objective” measures such as market reactions (Arrington, 1990). Pension professionals are not so limited in outlook and bring different sorts of evidence to bear on the question. For example, Bodie (1990a) writes: “Most of the academic finance literature has assumed that the sponsoring corporation owns the entire surplus. The case for viewing shareholder ownership of the pension surplus as less than complete is that virtually all parties to the pension contract view plan beneficiaries as having some claim to the pension surplus.“.

Ambachtsheer (1987) makes a similar point and cites surveys and interviews with financial executives and observed asset allocation patterns as supporting an implicit contracts view. Accounting researchers should be more critical of the commonly. made assumption that the market “knows” more than the various parties actually involved in issues. Funding Policy Research Myers and Majluf (1984) argue that firms prefer to rely on internal sources of funds to finance investment projects. Therefore, storing excess funds for later use is a strategy that may have value for firms. In the 197Os, a strategy of deliberate corporate overfunding of pension plans to take advantage of tax-free accumulation of pension plan earnings was promoted by several finance researchers (e.g. Tepper & Affleck, 1974; Tepper, 1981; Black, 1980). Research evidence indicates that some firms took advantage of these potential tax benefits to store excess funds in corporate pension plans (Francis’& Reiter,‘l987; Bodie et a/., 1987; Thomas, 1988). The fihancial slack arguments depend implicitly on the corporate financial perspective of pension management which holds that pension assets and liabilities are fir~m assets and liabilities and should be managed in ways that

Pension accounting research and terminations

6

enhance the firm’s interests. This contrasts with the traditional view of pension management that pensions should be managed in the interests of the employees (Bodie et a/., 1987). Bodie (1990a) describes the corporate financial perspective in the following manner: I, . . . the pension fund balance sheet can be consolidated with the balance sheet of the sponsoring corporation. According to this approach, the economic significance of the pension trust is that it provides shareholders with an opportunity for tax arbitrage and the possibility of exploiting PBGC insurance under certain circumstances.“.

This is hardly a neutral position and one could expect that policy-makers might object. In the corporate financial perspective, the interests of shareholders completely override the interests of employees, taxpayers (through government insurance of pension plans) and fund managers who may fin the perspective in conflict with their fiduciary duties (Martin and Ifflander, 1984):Alderson (1990) points out that: Wy design, the provisions sponsors to use the pension its risk-offsetting capabilities.“.

of OBRA sharply curtail the ability fund as a captive finance unit, thereby

of plan limiting

This indicates that the conclusions of researchers and the recommendations of academicians can influence policy, perhaps in unintended ways, and that the entire process of research and publication is not as neutral or value-free as many researchers would like to suppose. Terminations number of researchers have explored the reasons for pension plan termination. Stone (1987) and Thomas (1989) conclude that withdrawals from pension funds are motivated by financial need or by friendly changes in corporate control. Mittelstaedt (1989a) investigates the decision to terminate pension plans, severely cut contributions or maintain a steady level of pension contributions in the early 1980s and concludes that terminations were principally motivated by financial distress and that firms in less severe distress chose to cut contributions. The same corporate financial perspective on defined benefit pension policy discussed previously underlies research into motives for termination. By and large, employees’ interests are dismissed by the researchers. For example, Stone (1987) finds evidence in support of the financial slack explanation for termihations whiCh implies that “managers purposefully overfund pension plans so/that they can be terminated and excess assets

corporate

withdrawn whe&additional hnancing is needed.“. While acknowledging that this type of practi~ce was considered an abuse in recent Congressional hearings, the study concludes that pension surpluses as well as net liabilities should be recogniied~on Icorporate balance”sheets since sponsors appear to view surpluses as available funds. thornas (1989) also finds support for the financial slack hypothesis and dismisses the possibility of wealth transfers from employees to shafeholders by testing, the hypothesis that the primary motivation for

termination

accem

was

desire

Ilower wages

to’oxpropriate

early

in their

pension

tenure

bonds

created

in expectation

when

of greater

workers

future

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S. A. Reiter

and T. Omer

compensation through pension agreements13. As Thomas himself points out, this type of bond is not particularly affected by termination, and not surprisingly, empirical evidence is not consistent with predictions from this straw man theory. Thomas then concludes that there is no expropriation of wealth from employees. This conclusion ignores the possibility that expropriation of wealth from employees might be an effect of the employer treating the pension plan as a corporate funding tool. There is a very strong bias toward individual or shareholder interests in marginalist economic theory (Tinker, 1985), which results in great difficulty in even imagining the validity of the interests of other parties. The financial press argued that some firms used assets recaptured from pension terminations to facilitate or avoid take-overs (Mittelsteadt, 19896), and this issue was of particular concern to policy-makers. These concerns resulted in a 6-month moratorium on pension terminations, which expired on 1 May 1989 to give policy-makers time to reconsider their positions (Tax Notes, 10 April 1989) and House Ways and Means Committee hearings on the utilization of pension plan assets in mergers, acquisitions and leveraged buyout transactions (Tax Notes, 20 February 1989). Ghicas and Tinker (1989) analyse the role of pension terminations in take-over activity from the perspectives of several economic theories, including neoclassical economics (marginalism),, conflict theories and implicit contract theories. They conclude that under certain circumstances a variety of externalities, including macroeconomic effects such as amplificatio,n of levels of mistrust and increases in the levels of business risk and uncertainty, may result from breaches of implicit contracts associated with pension terminations. An association is found between ‘Ithe size of pension surpluses and corporate control changes so that accounting disclosures may be implicated in take-overs. Other researchers frame issues of employee welfare in terms ‘of the type of replacement plans offered after terminations. Mittelstaedt (1989b) investigates whether the likelihood of termination is higher after a ~change iln ownership, whether the benefits of repl’acement plans are comparable to thesbenefits ‘of the ,terminated defined benefit plans, ;and what, factors influence the decision to terminate a pension plan subsequent to an ownership change. Mittelstae.dt finds that :the percentage of terminations is higher for firms with ownership changes (22% versus ,l y “/d~)~~ but’ the rate of continuing;jdefined ‘benefit plans after termination is similar f,or the acquisition and ‘non+cquisition terminator samples. The implicit assumption that employees’ interests are not affected when terminated plans have similar defined benefit successor, plans isquestionable. Funds ,representing safely cushions against future losses and expected future benefit increases are removed from the pension trust in termination and annuities purchased for retirees do not have the protection of government peh$ion insurance. Researchers do concede, however, that employee interests m,ay ,be affected when no successor plans or defined contributilon success,or plens follows a termination. &one (1989) investigates replacement decisions and finds that a pattern of divi/$& elimjnation’ and debt restructuring surrounded the’ termination de&on for many firms with defined contribution kuccessor’ blans: One

Pension accounting research and terminations interesting conclusion of the Stone study is that it can be in the best interest of employees of financially distressed firms to reduce their wage demands by terminating defined benefit pension plans and replacing them with less risky (from the point of view of the employer) defined contribution plans. Schleifer and Summers (1987) suggest that take-overs preceded terminations because the new management could more easily breach implicit contracts with the employees and recapture excess pension assets needed for other purposes. The notion that the interest of all parties are protected by competitive market forces is a basic marginalist assumption (Tinker, 1985, p. 110). As Arrington and Francis (1989) point out, this concept is often translated into a “‘survival of the fittest” type argument that can be used to justify any corporate action. Implicitly, corporate actions reflect the competitive market for resources (survival) and must therefore be optimal solutions from the point of view of all parties given basic marginalist assumptions. While in some cases, employees’ interests might be served by making wage concessions of renegotiating contracts (even implicit ones), this should be an empirical issue, not an automatic assumption. The social context of conflicting interests between all of the parties involve in commerce is quite complex, involving ethical issues and social choices that are simply assumed away by marginalist economic theory. Marginalist economic theory takes an overfy simplistic view of the context of business decisions and the interests of parties involved (Tinker, 1985) and it i important to recognize this bias when using results of research to recommen or justify actions. The problem is not so much that an essentially (conservative) political point of view underlies most pension research, but t researchers seldom acknowledge their biases and indeed may view themselves as neutral and feel that they are providing a value-free, “scientific”” perspective on issues that have important social implications14.

Empirical

Analysis

This study provides evidence on assumptions that have been made underlying the principal explanation for pension terminations-the financial slack hypothesis. Researchers do not acknowledge the possibility of expropriation of employees’ wealth in pension terminations because of an assumption that the sponsors had previously put aside excess assets in pension plans to draw upon in the future. The fact that overfunded pension plans exist is considere evidence that financial slack has been stored in the plans. However, as previously discussed, overfunded pension plans arise from high stock market values and interest rates, projected funding methods which reflect an implicit contract perspective and actuarial conservatism. Determining what degree of overfunding should be considered “excess” is difficult but the IRS defines excess funding as over 150% of termination obligations (Alderson, ISSO), an thi’s concept can be used to provide a benchmark for detecting “excess’” funds. The question of whether excess funds had previously been stored in pension plans is crucial to the issue of whether employees’ interests were affected by terminations with recapture of excess assets.

72

S. A. Reiter and T. Omer

The following research questions are addressed: (I) were firms which later terminated or contracted pension plans overfunded in 1980 on an implicit contracts basis and were firms which later terminated pension plans more fully funded in 1980 than firms which contracted the size of pension contributions or firms which maintained a steady level of pension contributions; and (2) did firms which later terminated plans have a financial profile in the late 1970s indicating likelihood of following a deliberate overfunding strategy to store excess funds in a tax advantaged manner? When analysed together, these two research issues provide evidence on whether pension surpluses of firms which later terminated appear to represent excess funds stored in pension plans against future contingencies. There are limitations to conclusions that can be drawn from such an empirical study. It is not possible to tell in a snapshot view at any particular point in time whether a pension plan is overfunded on a going concern basis15. However, comparison of funded status between groups at a point in time provides valid insights and, given current measurement biases, plans would have to be quite overfunded before funding levels represented “excess” funds. Second, if pension surpluses are present, they may represent storage of excess funds-but if terminating firms have the l,owest funded status in 1980 and the lowest levels of profitability and tax burden with the highest levels of debt in the 197Os, as is found in this analysis, it seems unlikely that reversions represented excess funds previously stored in pension plans.

Sample and Tests Sample Pension policy is difficult to study because there is no machine readable database which reports plan level data, such as the actuarial and funding rates used, and the age structure of plans. Pension footnote disclosures prepared under SFAS No. 36 provide aggregate information on plan assets at market value and plan obligations measured on a termination basis. A data tape supplied by the FASB provides information from pension footnote disclosures. The Blue Book of Pension Funds provides information on actuarial rates, age structure and assets and participants in defined benefit and defined contribution plans by sponsor. We merge the financial statement footnote information with the Blue Book information to provide the basic sample for this study. When financial statement and Blue Book data are combined, an in-depth analysis of funding policy is possible that focuses on the ratio of plan assets to plan liabilities and allows estimation of pension obligations on’ an implicit contract basis. Pension plans of firms in this study have actuarial valuation dates between 1 July 1980 and 30 June 1981. The reasons why 1980 is chosen as a focus for analysis are that 1980 is: (1) before the take-off in stock market values and market interest rates; (2) before terminations of recapture of pension assets became common; (3) several years after the passage of ERISA in 1974 which m’ay have motivated changes in pension policy for many firms; and-(41 the first year for which accounting disclosures of funded status are available.

Pension accounting research and terminations

73

Blue Book information is available for 488 firms on the FASB 36 data tape and COMPUSTAT which are not public utilities or financial firms. Lack of complete COMPUSTAT information for 1980 results in elimination of 67 firms. Thirteen firms are eliminated from the sample because they represent firms in regulated and defence industries which have different motivations for pension funding policy (Thomas & Tung, 1989). The final sample consists of 408 firms. Measuring

Termination

Status

Annual reports for the sample firms from 1984 through 1988 are scanned for termination activity using the NAARS database. Firms with terminations relating to plant closings, sales of divisions and acquisition of new subsidiaries (19) are not included in the termination sample. These causes of termination are felt to be substantially different from the causes of voluntary asset recapture of interest in this study. If terminations did not result in material reversions of excess assets to the sponsoring firms, they were not considered in the termination sample. Of the 408 sample firms, 71 are classified as terminators using these criteria. Subsamplesof firms that maintained a stable pension funding policy and firms that sharply contracted the level of pension contributions during the 1980s are chosen from firms that did not terminate pension plans. Firms are classified as maintainers if the percentage change in pension expense each year from 1980 through 1985 was an increase or a decrease of not more than 10%. Firms are classified as contractors if for any year from 1980 through 1985 they have a decrease iln pension expense larger than 40% accompanied by a decrease in number of employees of 20% or less16. This classification procedure results in the identification of 85 maintainers, 60 contractors and 71 tsrminators. Measuring Funded Status Tha funded status measures relate to the first set of research issues about the 1980 funded status of the groups. Measures of funded status are computed based on three different estimates of pension obligation: (1) as disclosed in anhual reports; (2) standardized to a uniform settlement rate; and (3) estimated on an implicit contract basis. Firms choose the discount rate used in determining the pension liability disclosed in annual report footnotes. To show a low pension liability, firms can choose a high discount rate and vice vetsa. ‘For comparison between firms, pension liabilities are adjusted to a uniform current ann,uity settlement rate (the annual average PBGC rate)17. StandardiZed pension liabilities are calculated on a termination basis and can ‘e’used’td approximate the liability or surplus that would have resulted from termination in I1980. The implicit contract theory holds that the firm forms an implicit contract to continue the ‘pension plan and pay pension promises that reflect inflation. Using account[ng disclosures and actuarial data, estimates of funded status u’nder implicit ,cbntract assumptions are computed using methods developed by Cppofitd (1985, 1986a, b)“.

74

S. A. Reiter and T. Omer

Comparison of funded status between the three groups (terminators, contractors and maintainers) shows: (1) whether firms were overfunded on a termination basis in 1980; (2) whether firms were overfunded on an implicit contracts basis in 1980; and (3) whether terminators and contractors, which withdrew funds from pension plans later in the 198Os, were more completely funded in 1980 than firms that maintained a stable funding policy. Financial Slack Tests The second research issue involves testing whether assets recaptured represented financial slack stored in defined benefit pension plans by firms following a deliberate strategy to overfund defined benefit pension plans taking advantage of certain tax breaks. Pension fund earnings are allowed to accumulate tax free which makes the pension fund an expecially advantageous place to store funds, particularly if they can be withdrawn when tax rates are lower. Several cross-sectional studies of the determinants of pension policy (Francis & Reiter, 1987; Bodie et al., 1987) find strong support for the association of capital availability and profitability with full funding and weak support for a tax-motivated funding strategy. Thomas (1988), focusing exclusively on tax explanations for pension funding policy, finds an association between tax status and pension founding policy. Practically, there are potentially significant costs to overfunding: (1) the excess pension assets may not be freely recaptured by the corporation; (2) recaptures could be taxed at penalty rates; and (3) firms are obliged to follow relatively stable funding policies once chosen and it is possible that a firm might be obliged to continue to make excess contributions during future periods of reduced marginal rates (Thomas, 1988). In addition, since returns on pension plan assets tend to be relatively low, it is possible that firms have superior investment opportunities elsewhere even after taking tax benefits of pension investment into account. Since there are costs and risks associated with a strategy of pension overfunding, only firms with strong tax incentives or considerable profit cushions should be motivated to store excess funds in pension plans. From previous research, we would expect debt ratios, profitability and capital availability to be associated with funding policy (Francis & Reiter; 1987; Bodie ef al., 1987). High levels of profitability and capital availability, particularly in conjunction with high tax rates, form a profile of firms with motives to enter into a deliberate overfunding strategy. Firms with”high debt ratios relative to industry averages are considered more vulnerable to declines in profitability because of binding debt contracts and therefore r-nay be reluctant/to enter into a strategy that lowers net income and commits the firm to a’: ‘hrg’h level of pension funding (Francis & Reiter, 1987). Definitions of the variables used to proxy the factors of profitability, capital availability, debt ratios a,tid tax rates are provided in Table 1. ‘Financial ratios for the 1975 through 1980 period are compared for firms in the terminator, contractor and maintainer groups. From this analysis, we can see if the’$firms~ahat later withdrew funds from pension plans seemed likely candidates to enter into an overfunding strategy in the 1970s.++We also

Pension accounting research and terminations

75

Table 1. Definition of variables Funding

variables

FR SFR EFR Financial Effective Size Debt

ratios tax rate

ratio

Profitability Capital availability

Source of Data CMPST FASB BLUE BOOK

Defined benefit pension plan assets/total accumulated benefits as reported in SFAS No. 36 disclosures (FASB). Defined benefit pension plan assets/total accumulated benefits adjusted to 1980 PBGC annuity settlement rate (FASB). Defined benefit pension plan assets/economic benefits (FASB and BLUE BOOK) (Calculated year by year or as a g-year average from 1975-1980) Worldwide taxes (CMPST No. 16-CMPST No. 50Vpretax book income (CMPST No. 18 + CMPST No. 16 + CMPST No. 49) Total assets (CMPST No. 6) Long-term debt (CMPST No. S)/Total assets (CMPST No. 6) less average debt ratio for major industry code Operating income (CMPST No. 13)/Total assets (CMPST No. 6) (Funds from operations (CMPST No. 1 lO)-Capital expenditures (CMPST No. 30)-(Dividends paid (CMPST No. 19 + CMPST No. 21) + (0.5 x Pension expense (CMPST No. 43))/Net sales (CMPST No. 12) = COMPUSTAT data item = FASB 36 Tape = The Blue Book of Pension Funds, Inc.)

Funds

(Washington,

D.C.;

ERISA

Benefit

compare financial ratios for the 1981 through 1986 period between groups see if termination and contraction are related to financial stress as found previous studies (Thomas, 1989; Mittelstaedt, 1989a; Stone, 1987).

to in

Results Ratios of pension assets to pension obligations representing funded status in 1980 are reported in Table 2. Funded status reported in the annual report footnotes is lower for terminators than for contractors and maintainers. When funded status is determined using a termination discount rate (the standardized funding ratio), contractors and maintainers are significantly better funded than terminators. The average standardized funding ratio for terminators is 1.29: 1 compared to 1.49: 1 for contractors and 1.44: 1 for maintainers. To evaluate employee’s interests, estimates of the funded status taking implicit contracts into account are compared. When pension liabilities are measured on an economic basis, taking all expected future benefit increases into account, all three groups are underfunded in 1980. The terminators are most underfunded, with a ratio of 0.79 : 1. Contractors have a funded ratio of 0.90: 1 and maintainers of 0.84: 1. Contractors and maintainers report larger pension excesses in 1980 than the terminator group. All three groups are overfunded on a termination basis in 1980. This indicates that they would have been able to recapture excess assets if terminations had occurred at that time. Therefore, at least some of the surpluses reverting to firms in the 1980s arose from firm contributions to pension plans in the 1970s rather than to stock market and interest rate rises in the 1980s. However, none of the groups is fully funded on an implicit contract basis in 1980 nor do any of the groups have an average standardized

76

S. A. Reiter Table 2. Analysis

of funded

Terminators

and

t-statistic

Prob*

Approx. t-test prob*

1.119 1.440 0.845

-1.2448 - 1.8376 - 1.3763

0.215 0.068 0.171

0.099 0.087 0.143

2018 0.361 -0.008 0.189 0.001

-0.7530 -1.8713 2.4507 -3.2286 -0.7401

0.453 0.064 0.015 0.001 0.460

0.569 0.027 0.011 0.001 0.582

ratios

ER EFR ratios:

(6-year

Size Effective tax rate Debt ratio Profitability Capital availability

averages7: 69 71 70 70

n = 85

-1975-1980) 1624 0.320 0.044 0.159 -0.003

8: 84 85 85 83

Terminators

and

Mean terminator

Variable Funding

n = 71

ratios:

(g-year

t-statistic

Prob*

Approx. t-test prob*

1.226 1.489 0.905

-2.7137 -2.4167 -2.6192

0.008 0.017 0.009

0.007 0.019 0.014

0.6286 -0.0616 1.3814 - 1.2809 0.0432

0.531 0.952 0.169 0.203 0.966

0.704 0.760 0.085 0.098 0.743

n=60

averages-1975-1980) 7: 69 71 70 70

1624 0.320 0.044 0.159 -0.003

7: 59 60 60 58

Contractors

and

Mean contractor

Variable

1427 0.322 0.015 0.171 -0.004

maintainers Mean maintainer

t-statistic

Prob*

Approx. t-test prob*

1.119 1 A40 0.845

1.6194 0.5492 1.2677

0.107 0.584 0.207

0.156 0.404 0.163

2018 0.361 -0.007 0.189 0.002

-1.1742 - 1.8250 - 1.0737 - 1.9395 -0.7492

0.242 0.070 0.285 0.054 0.455

0.881 0.059 0.267 0.041 0.391

ratios n = 60

FR SFR EFR Financial

Mean contractor

1.047 1.295 0.786

Size Effective tax rate Debt ratio Profitability Capital availability

Funding

contractors

ratios

FR SFR EFR Financial

ratios

maintainers

1.047 1.295 0.786

Financial

and financial

Mean maintainer

n=71

n = 85 1.226 1.468 0.905

ratios

(6-year

Size Effective tax rate Debt ratio Profitability Capital availability l

status

Mean terminator

Variable Funding

and T. Omer

Two-tailed

averages-1975-1980) &I 59 60 60 58

probability-approximate

1427 0.322 0.015 0.171 -0.003

8: 84 85 85 83 t-test

probability

from

Wilcoxon

test

(SAS,

-

1982).

Pension

accounting

research

and terminations

77

funding ratio in excess of 1.5: 1, the benchmark chosen by the IRS as an indication of overfunding. Therefore, it seems likely that excess pension funds represent contributions for safety cushions and future employee benefits rather than excess funds stored in pension plans. This seems particularly true of the terminator group which had the lowest funding levels in 1980. Results of comparisons between the three groups on average effective tax rate, debt, profitability and capital availability ratios for 1975-1980 are presented in Table 2. Since size often explains differences between groups, a size measure (total assets) is compared but no significant differences are found. Terminators have lower effective tax rateslg than contractors or maintainers, and therefore have less motivation to store excess assets in defined benefit pension plans. Terminators have significantly higher industry adjusted debt ratios than contractors or maintainers”. Firms with high debt ratios, relative to industry averages, may not be willing to enter into an overfunding strategy that overstates pension expense and lowers net income due to concerns about violating debt covenant constraints. Profitability is also different between the groups with terminators having the lowest and maintainers the highest ratios. Significant differences in capital availability are not found. Terminators have the lowest profitability and effective tax rates together with highest debt ratios which indicates that they should not have been as likely as the maintainer or contractor groups to enter into deliberate overfunding strategies. The next step in the analysis checks whether sample results conform to previous research findings on pension terminations. Table 3 presents averages of effective tax rate, debt ratio, profitability and capital availability by group for 1975 through 1986. Significant differences between groups are noted. Figures l-3 present the trends of the profitability, capital availability and debt ratios by group. All groups suffer a decline in profitability during the 1981 through 1986 period, but the 1975 through 1980 period is stable and the three groups maintain the same rank ordering throughout. The graph clearly shows the dip in profitability in the early 1980s which has caused researchers to conclude that terminations are related to financial distress and removal of financial slack. Figure 2 shows annual capital availability from 1975-1986. The same trends can be noted but the differences between the groups are not statistically significant or consistent over time. Finally, the plot of debt ratios by group from 1975 to 1986, presented in Figure 3, shows that terminators have higher debt ratios during the entire period. These trends are similar to those found by other researchers (Stone, 1987; Thomas, 1989; Mittelstaedt, 1989a) and have been interpreted as financial distress triggering removal of financial slack previously stored in the pension plans. Another explanation for terminations involves taking advantage of lower effective tax rates to withdraw previously stored funds more cheaply. While terminators had significantly lower effective tax rates than maintainers in several years, the differences were not very large and the effective tax rate of terminators was always lower than maintainers. Therefore, tax rate changes do not appear to explain pension terminations. This evidence is consistent with the financial slack theory in that the maintainer group suffered relatively less decline in profitability in the 1980s and therefore may not have needed to withdraw financial slack. The relatively

S. A. Reiter

78

Table 3. Means

of financial Mean

Year 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1966 * MT between minators,

Variable Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Debt ratio Profitability Profitability Profitability Profitability Profitability Profitability Profitabilitv Profitability Profitability Profitability Profitability Profitability Capital availability Capital availability Capital availability Capital availability Capital availability Capital availability Capital availability Capital availability Capital availability Capital availability Capital availability Capital availability Effective tax rate Effective tax rate Effective tax rate Effective tax rate Effective tax rate ,Effective tax rate .Effective tax rate Effective tax rate Effective tax rate Effective tax rate Effective tax rate Effective tax rate

and T. Omer

Maintainer -0.002 -0.015 -0.018 -0.016 -0.012 -0.013 -0.016 -0.020 -0.022 -0.017 -0.007 -0.016 0.182 0.189 0.192 0.194 0.189 0.187 0.188 0.178 0.183 0.189 0.171 0.167 0.016 0.019 0.004 -0.003 -0.004 -0.012 -0.016 -0.008 0.015 0.011 0.001 -0.001 0.335 0.381 0.382 0.379 0.347 0.342 0.315 0.287 0.295 0.266 0.284 0.281

ratios

(number

1975-1986 in sample)

Contractor (85) (85) i85j (85) (85) (85) (85) (85) (85) (84) (79) (741 i85j (85) (85) (85) (85) (85) (85) (85) (85) (85) (80) (75) (83) (83) (83) (85) (85) (85) (85) (85) i85j (85) (80) (75) (85) (85) (84) (85) (85) (85) i84j (85) (85) (WI (77) (73)

0.003 0.010 0.012 0.005 0.009 0.012 0.011 0.006 0.002 0.001 0.014 0.007 0.166 0.174 0.172 0.175 0.174 0.167 0.153 0.122 0.123 0.132 0.118 0.114 -0.007 -0.003 0.003 0.002 -0.001 -0.019 -0.018 -0.007 0.004 -0.008 -0.015 -0.005 0.317 0.331 0.334 0.378 0.324 -0.662 0.241 0.219 0.236 0.189 0.252 0.273

Terminator (60) (60) (60) (60) (60) (60) (60) (59) (57) (55) (52) (48) (60) (60) (60) (60) (60) (60) (59) (59) (57) (55) (52) (48) (58) (58) (59) (59) (60) (80) (57) (57) i53) (52) (47) (46) (59) (60) (59) (80) (80) (80) (57) (57) (56) (53) (49) (48)

Significant differences*

0.050 (71) MT, 0.042 (71) MT 0.036 (71) MT 0.027 (71) MT 0.031 (71) MT 0.040 (71) MT 0.039 (70) MT 0.043 (70) MT 0.059 (70) MT, 0.066 (70) MT, 0.097 (69) MT, 0.087 (66) MT, 0.159(71) MT 0.154 (71) MT, 0.151 (71) MT, 0.159 (70) MT 0.164(71) MT, 0.168 (71) MT, 0.151 (70) MT, 0.107 (70) MT, 0.106 (70) MT, 0.127 (70) MT, 0.114 (69) MT, 0.098 (66) MT, 0.002 (71 I MC 0.010 i7i j -0.001 (71) -0.005 (70) -0.010 (71) -0.009 (71) -0.016 (69) -0.034 (68) MT, -0.045 (68) MT, -0.027 (65) MT -0.020 (65) MT -0.028 i64j 0.307 (71) 0.338 (70) MC 0.297 (70) MT, 0.356 (70) 0.277 (71) MT 0.344 (71) 0.237 (68) MT 0.285 (70) 0.220 (66) 0.266 (67) 0.231 (63) 0.162 (60) MT

denotes a significant difference between maintainers maintainers and contractors, and CT between at the 0.10 level according to t-tests.

CT

CT CT CT CT CT MC, CT MC MC MC MC MC MC MC MC

CT CT

MC

and terminators, contractors and

MC ter-

Pension

1974

accounting

I976

research

and terminations

1980

1978

1982

79

1984

1986

1988

Year

Fire

1. Profitability

1975-1986. +,

Maintainer, contractors;

contractor --C,

and terminator maintainers.

firms.

-O-,

terminators;

high 1980 funding levels for maintainer and contractors indicate that these groups may have had excess funds stored in the pension plans by the mid-1980s. Firms that contracted pension funding were subject to greater declines in profitability than the maintainer group”. However, for the terminating group, these results call into question the financial slack story used to justify recapture of pension surpluses. Based on analysis of financial ratios in the late 197Os, terminating firms appear unlikely to have entered into deliberate pension overfunding schemes. Furthermore, the terminating firms had the lowest levels of pension funding in 1980, were considerably underfunded on an implicit contract basis and had termination funding levels too low to represent excess asset storage. While terminations appear to be

x 2 I) 5.s 2 z

0 -0.01

‘ii ”rh

-0.03

-0.02

I

-0.05 1974

I 1976

I

I 1978

I

I

I

1980

l‘fl 1982

I 1984

I 1986

I 1’9 88

Year Figure

2. Capital

availability 1975-1986. terminators; -O-,

Maintainer, contractors;

contractor and terminator --C, maintainers.

firms.

-+--,

S. A. Reiter and T. Omer

80

0.08 0.06 -

I

-0.04 1974

I 1976

I

I 1978

I

I 1980

I

I 1982

I

I 1984

I

I 1986

I 198X

Year Figure

3. Debt

ratios

1975-1986. -C-,

Maintainer, contractor contractors; --C,

and terminator maintainers.

firms.

-O-,

terminators;

triggered by declining profitability as previous researchers have found, it seems unlikely that the pension assets recaptured represented previously stored excess funds. The asset recaptures probably represented a mixture of windfall profits and funds stored as cushions against future pension plan losses and as reserves for future pension benefit increases. Employees and others taking an implicit contract view of pension obligations would conclude that terminations represented a expropriation of wealth from employees by shareholders22. Conclusions Accounting plays a critical role in economic and social choices (Tinker, 1985, p. 110). Pension accounting takes positions on issues of ownership of pension surpluses and on the resolution of conflicts between shareholders and employees. The adherence of accounting standards to the explicit contracts, or termination, point of view represents a strong position on a controversial distributional issue. Accounting may well have played an important role in termination occurrences through highlighting pension surpluses measured on a termination basis in annual report disclosures. This practice supports the contention that pension surpluses belong entirely to the employer and that pension surpluses can be made currently available for general corporate purposes. Disclosure of pension surpluses may have motivated take-overs and take-over attempts. Until 1986, accounting policies encouraged substantial breaches of pension arrangements by disallowing immediate gain recognition for terminations with similar replacement pension plans. Accounting practices may have other effects as well. Although accounting principle changes in the 1980s led to more detailed disclosures, balance sheet recognition of pension liabilities and uniform methods of determining pension obligations and expense, firms ended up presenting lower liabilities and lower pension expense amounts than before. Net income may be overstated and the

Pension

accounting

research

and terminations

Hl

ability of interested parties to estimate expected future cash flows compromised. In addition, the new accounting practices may undercut traditional conservative actuarial practices undertaken with employee’s interests in mind. Accounting practice and results of pension research may also have been influential in the passage of new IRS regulations that severely restrict pension funding. Both of these factors, as well as terminations, may result in a less private sector safety cushion in pension trusts and more possibility of taxpayer financed bailouts of underfunded pension plans. Just as accounting is inevitably involved in social conflict, interpretation of research is inevitably a partisan activity. Since results of research are used to influence corporate and public policy, it is important to recognize unstated assumptions and biases and limitations in research methods. An overview of pension research reveals an underlying assumption that empirical observations of market behavior can settle essentially normative questions such as who should have claims on pension surpluses. This assumption reflects the implicit belief that distributional issues are decided in socially optimal ways by market forces (Tinker, 1985). This same bias is evident when researchers provide rationalizations for corporate actions that downplay the interests of employees and other non-owners. The full complexity of competing claims and interests in business issues with social consequences is neither acknowledged nor investigated. Also underlying research in pension funding and termination policy is an implicit belief in the corporate financial perspective which regards pension assets and liabilities as corporate assets and liabilities to be managed in the interests of shareholders. This assumption emphasizes the interests of shareholders and marginalizes the interests of employees, taxpayers and others. It is, therefore, not surprising that pension researchers do not seem to be able to see that pension terminations may represent expropriations of employees’ wealth. There is a potential problem with using research results developed and interpreted within a narrow economic and political framework as input into public policy discussions, as is the case with pension research. These problems are accentuated by claims that research results are neutral, objective and scientific (Arrington, 1990). The assumption commonly made in pension termination research that employees’ interests are not affected in terminations because terminations represent withdrawal of assets previously stored in pension plans is questioned through an empirical analysis. While terminations appear to represent withdrawal of funds by firms in financial stress, these firms do not appear to have previously stored excess funds in pension plans. Asset reversions appear more likely to represent windfall profits and cushions against future pension plan losses and benefit increases than excess corporate funds on which employees had no implicit claim. Therefore, it seems likely that the recapture of pension surpluses involved some degree of expropriation of employees’ wealth. Acknowledgement

We would like to acknowledge the support of the Ernst & Young Tax Research Grant program. This paper has benefited from comments by the participants at the Critical

82

S. A. Reiter and T. Omer

Perspectives conference in New York in 1991, particularly from Jere Francis and David Cooper. We would also like to thank Dimitrios Ghicas, Tony Tinker and an anonymous reviewer for helpful suggestions. Any errors remain, of course, the responsibilities of the authors.

Notes 1. A firm contributing for the retirement benefits of employees can organize pension plans in two forms: defined benefit plans, where the employer specifies benefits to be paid to employees and is responsible for contributing sufficient funds to cover the benefits promised and defined contribution plans, where the employer’s only responsibility is to make the agreed upon contributions and employees bear the investment risk. 2. Before 1984, Administrative rules appeared to limit recapture of excess assets to situations where no similar successor plan was offered and getting administrative approval for a termination was a lengthy and uncertain process. Terminations that did occur were controversial, however, in the spirit of deregulation the administrative guidelines adopted in May of 1984 gave a complete carte blanche to terminations with recapture of pension surplus, even when substantially identical successor plans were offered. Administrators turned a deaf ear to proposals to allow withdrawal of excess assets without termination as long as an adequate cushion, such as 120% of obligations, was retained (Regan and Bleiberg, 1985). 3. In the Mittelstaedt (1989b) sample, 12% of terminating firms do not provide any successor plan. The remaining 88% of terminators equally split between providing defined benefit and defined contribution successors. 4. This is not necessarily the case in Canada, however, where a recent court case mandated a 50/50 split of the surplus (Ambachtsheer, 1987). 5. The firm has a liability to the Pension Benefit Guarantee Corporation (PBGC) for up to 30% of firm net worth in case pension assets do not cover guaranteed benefits. The firm’s obligation to the PBGC has the status of a tax lien and is therefore a senior security. 6. This view disingenuously leaves out the roles of government pension insurance and tax favoured status in pension arrangements which introduce other parties of interest into the equation. 7. Tinker (1985) criticized the focus on vested benefits under previous accounting standards which violated the going concern assumption by assuming employees would leave the firm before vesting. By SFAS No. 87, no distinction between vested and non-vested benefits is made. The probable reason for dropping the focus on vested benefits is that all accrued benefits are payable in a termination and a termination viewpoint has been taken in pension accounting. 8. As Jere Francis pointed out, the very language of pension regulation assumes sponsor ownership of excess pension assets through terms such as “reversion” and “asset recapture.” 9. The IRS considers that excesses arising from both the difference between expectations and realizations and use of projected benefit funding methods are due to actuarial error and, therefore, returned to the employer (Stein, 1986). 10. Actuaries generally use projected benefit attribution methods to provide for the cost of future obligations as a level percent of salaries over time. This involves prefunding in the early and middle years of an employee’s life. Pension expense under SFAS No. 87 is figured using the unit credit method which determines the cost of future benefits earned by workers during each period. This amount rises steeply as employees near retirement (McGill, 1984). Furthermore, SFAS No. 87 uses a discount rate representing current termination rates rather than generally lower long-term investment return rates used by actuaries. 11. Note that purchase of annuities for retired or other employees removes the possibility of future benefit increases and removes the liability from coverage by the Pension Benefit Guarantee Corporation. With a rash of current failures among large insurance companies (the principal providers of annuities), this could be a serious problem (Castro, 1991). 12. Interested readers are referred to tests such as Paper Prophets by Tinker (1985) for an overview of development of valuation theory and Ghicas and Tinker (1989) for a discussion of alternate economic theories in relation to pension terminations. 13. Thomas (1989) dismisses the possibility of expropriation of wealth due to breach of implicit contracts by pointing to the legality of termination. This implies that administrative and tax law are efficient, socially desirable wealth distribution mechanisms.

Pension

accounting

research

and terminations

83

14. I do not mean to infer the private beliefs of researchers from statements in published studies. As Arrington and Francis (1989) point out, accounting research and publication outlets are dominated by the “disciplining forces of a hegemonic academic elite” whose power is enforced by “specific institutional arrangements for the production and dissemination of accounting knowledge which form a ‘market’ for accounting research . (p. 4)“. Publications in journals sponsored by the University of Chicago or the University of Rochester not surprisingly reflect “political beliefs in deregulation and libertarian economics (Arrington and Francis, 1989, p, 14).“. 75. It is possible to make reasonably objective measures of pension funded status on a termination basis, but the implicit contract basis is more difficult. This may be one of the reasons why accounting standard setters have been more comfortable with a termination viewpoint. 16. While the cut-off figures are arbitrarily chosen, the definitions are based on those used by Mittelstaedt (1989a) and Thomas (1989). The change in pension expense between 1984 and 1985 was the last usable change since many sample firms adopted SFAS 87 for 1986. SFAS 87 pension expense is measured in a very different way and is not comparable to pension expense reported prior to adoption. 17. The formula for estimating standardized pension liabilities is:

(iI

L, = L, x (in/&) where LE = Estimated

liability

L, = Accounting iE = Estimated

liability interest

iR = Accounting

interest

rate rate

(Bulow, 1979) 18. lppolito (1986b) develops an approximation of the sensitivity of pension benefits to variation in interest rates from empirical data using Department of Labor reports. lppolito derives an economic model of pension liability valuation and estimates an equation using data from over 4000 plans in 1978. The formulas which are used to estimate pension obligations are:

19.

20..

21.

22.

for

active

participants:

L,/L,

= exp (-O.O77(i,

- iR))

(ii)

for

retired

participants:

L,/L,

= exp

- iR))

(iii)

(-O.O57(i,

To estimate economic benefit obligations, we start with the accounting estimates of pension obligations. Total benefits (vested plus non-vested) reported in SFAS 36 footnote disclosures are used in the calculations. The discount rates used to determine the SFAS 36 disclosure amounts are reported in footnote disclosures and the average of the high and low rates is used when a range of rates is reported. The appropriate current interest rate is the annuity settlement rate of 8.9% published by the Pension Benefit Guarantee Corporation (PBGC) for 1980. The percentage of active and retired participants is determined for each firm from the Blue Book information. Economic benefits are determined by discounting pension benefits at real rather than nominal rates (Ippolito, 1986b). Benefits for retired participants are adjusted to a rate of 1.5% plus half of the inflation rate (8.9% minus 1.5%) to reflect the experience of the 1970s when retired participants received increasses in benefits representing about half of inflation. Benefits for active participants are adjusted to a real rate of 3%. Extreme values of the effective tax rate ratio can occur because of the use of an income measure in the denominator. We have truncated effective tax rates at 1 and -1 so that extreme values do not distort averages and variances. ,Debt ratios are adjusted for industry averages because debt contracts are expected to specify constraints in an industry-adjusted manner (Francis and Reiter, 1987). The other financial ratios are not industry adjusted because there is no supposition or evidence that storage of .financial slack is related to industry averages. Results for maintainers and contractors are also consistent with the hypothesis that firms take high pension deductions in profitable years to create a “hidden income pool” from which they can draw in times of declining profitability (Briloff, 1972). Whether terminators could realize immediate accounting gains on termination depended on the type of successor plan. ‘Wealth expropriation may also be involved for the firms that contracted pension plan contributions in the 1980s. However, contracting firms had the highest surpluses in 1980 and contraction does not necessarily remove the entire surplus as happens in termination so that employee interests may not have been affected.

84

S. A. Reiter and T. Omer References

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