Looking Into the FASB’s Crystal Ball: What’s Ahead for Balance Sheet Consolidation?

The Financial Accounting Standards Board (FASB) concluded the first phase of its two-part project on postretirement benefit accounting reform last year with the issuance of Statement of Financial Accounting Standards (SFAS) 158. Although the FASB is pleased with the first phase of its accounting reforms, which moved market-based measures of funded status from the footnotes of financial statements to the balance sheet, the board left many of the biggest issues for Phase Two.

As plan sponsors and their advisers complete the implementation of Phase One, this article, the third in a planned series about Phase Two, focuses on balance sheet consolidation and its potential impact on leverage metrics.

Phase Two Overview
The FASB’s Phase Two reforms will reexamine the foundation of postretirement benefit accounting. The board is expected to meet shortly to decide on the scope and approach to Phase Two.

In a recent letter, Watson Wyatt encouraged the FASB to (1) address Phase Two with a single, comprehensive project rather than as a series of incremental projects, and (2) tackle liability measurement early in the project in a joint effort with the International Accounting Standards Board (IASB).

While we can’t predict the FASB’s final decisions, we understand the issues the board intends to tackle. The Watson Wyatt Insider series about key Phase Two issues includes:

• Income statement – The first article discusses the income statement implications for Phase Two (see Watson Wyatt Insider, March 2007). It is available online at http://www.watsonwyatt.com/us/pubs/insider/showarticle.asp?ArticleID=17098.
• Liability measurement – The second article discusses the concepts at issue in liability measurement (see Watson Wyatt Insider, April 2007). It is available online at http://www.watsonwyatt.com/us/pubs/insider/showarticle.asp?ArticleID=17303.
• Balance sheet consolidation – this issue.

What Is Balance Sheet Consolidation?
FAS 158 requires sponsors to report the net funded status of their postretirement benefit plans on their balance sheets. But in full balance sheet consolidation, sponsors would enter plan assets on the asset side of the balance sheet and plan liabilities on the liability side — thus putting two large items on opposite sides of the balance sheet. This would consolidate plan assets with corporate assets and plan liabilities with corporate liabilities. While consolidation would not change net shareholders’ equity, it could affect risk and leverage metrics such as debt-to-market capitalization and debt-to-equity ratios, which in turn could affect the way equity and credit analysts perceive plan sponsors’ risk profiles.

Why Does Balance Sheet Consolidation Matter?
Many investment analysts and economists consider postretirement benefit obligations as “debt-like,” because they represent a promise to provide retirees with a guaranteed stream of future cash payments. This is conceptually similar to the promise imbedded in a bond or debt transaction. A logical extension of this concept is including postretirement benefit obligations in the corresponding debt ratios, such as the debt-to-market capitalization and debt-to-equity ratios. Such consolidation would significantly change the current metrics. What would these new metrics mean for sponsors and for financial statement users?

To answer this question, we start by considering pension plans within the framework of financial leverage, which we define as incurring debt to finance risky investments in pursuit of higher returns. Since a pension liability is a debt-like promise to plan participants, often collateralized by a mix of stocks and bonds, pension plans could be considered as leveraged investment vehicles within the sponsor’s capital structure. Leverage is neither good nor bad — it holds properties of both risk and return — but sponsors need to understand how their pension plans affect their leverage in order to determine how to best manage their plan and company on an integrated basis.

Take a simple example. A pension plan¹ has $4 billion in assets and $4 billion in liabilities. The plan is fully funded, so FAS 158 would put the $0 net funded status on the sponsor’s balance sheet. Many analysts believe that putting $0 on the balance sheet accurately characterizes the value of the plan, but some also believe it masks this large plan’s risks. In fact, some have described postretirement benefit plans as “off balance sheet” entities, because, under FAS 158, the balance sheet reflects only the net funded status.

Balance sheet consolidation would address this concern. While the FASB considers FAS 158 as a successful step in incorporating postretirement benefit plan obligations into sponsors’ balance sheets, the board will discuss balance sheet consolidation as a possible means of making the role postretirement benefit plans play in their sponsors’ capital structure more transparent.

To delve deeper into our example, suppose the plan sponsor has the following characteristics:

Consider the ratio as a leverage metric, where we treat the pension obligation as debt-like. The net balance sheet treatment under FAS 158 would show the pension obligation as $0, because the plan is fully funded, so the ratio would be [6/20 = 30%]. However, a fully consolidated balance sheet treatment could show the $4 billion pension liability as debt-like, in which case the new ratio would be [(6+4)/20 = 50%].² The change from 30 percent to 50 percent is dramatic, and swings of this magnitude would not be uncommon if the FASB required full balance sheet consolidation. In fact, Watson Wyatt’s analysis indicates that full consolidation would have increased the ratio for the combined FORTUNE 1000 sponsors of postretirement benefit plans by approximately an incremental 16 percent.

It is important to understand that metrics such as the ratio measure an enterprise’s leverage and risk profile — not its value. Credit rating agencies often use similar metrics. While some major credit rating agencies already approximate balance sheet consolidation by using information from the pension footnotes to calculate financial metrics, most do not incorporate this treatment into their primary metrics for financial analysis. However, if the FASB decides to require consolidation, those metrics might play a more prominent role in their analyses.

But even if the FASB required consolidation — and debt ratios for some plan sponsors increased from 30 percent to 50 percent —a wholesale downgrade in credit ratings is unlikely. Rather, credit rating agencies would probably recalibrate their models to deal with the new metrics without any major upheaval in credit ratings. While consolidation would move large numbers from the financial statement footnotes to the balance sheet, it may not dramatically change the conclusions of financial statement analysis, because all of the information is already available. It could, however, encourage Wall Street to think about pension plan risk within the context of corporate capital structure, rather than as a separate entity.

Balance Sheet Consolidation: Pros and Cons
While balance sheet consolidation presents many conceptual advantages, it also poses some problems. Earlier we characterized pension plans as leveraged investment vehicles, because they carry debt-like liabilities that are collateralized by assets. Investing all the assets in high-risk vehicles, such as stocks, is similar to issuing debt-like liabilities whose assets are invested in the stock market in search of higher returns, which is essentially financial leverage.

On the other hand, investing pension assets entirely in bonds that match the duration of the debt-like liabilities is a hedging strategy that significantly reduces both risk and return potential. As such, this strategy does not use a pension plan as a source of leverage. While most plan sponsors invest in a mix of stocks and bonds (and other investments such as real estate), these extreme examples can help us understand the concepts better.

To further simplify these concepts, consider three hypothetical companies that are identical in every respect, except in the ways they manage their pension plans:

• Company A’s pension plan holds $4 billion in assets and $4 billion in liabilities. Although the pension liability is debt-like, the company invests all its assets in equities in search of high returns.
• Company B has no defined benefit pension plan.
• Company C’s pension plan has $4 billion in assets and $4 billion in liabilities. The company invests all its assets in bonds, immunizing its liability and pension-related financial risk to allow a larger risk budget for its core business.

Table 1
Effects of Full Consolidation for Three Companies

All three companies have the same net ratio of 30 percent but have different risk and leverage profiles. For the consolidated debt/market cap ratio of Company C, we entered “???” in Table 1 to indicate a question: Which ratio best reflects the leverage of Company C?

Although full consolidation would assign a ratio of 50 percent to Company C — the same ratio assigned to Company A — many claim that this would be misleading, because the leverage profile of Company C more closely resembles that of Company B. While Company A hopes to receive credit for the strong returns its aggressive investment strategy may deliver, shouldn’t Company C also receive credit for reducing its risks? For this reason, economists might want to assign ratios that incorporate the allocation of plan assets.

As this analysis shows, neither the entirely net nor the entirely consolidated approach is optimal. Might the FASB consider a compromise between the two approaches, perhaps involving the asset allocation? Anything is possible, and it is far too early to predict the outcome of Phase Two.

Implications and Conclusions
From an investor’s perspective, what matters most is the way investment analysts use the balance sheet, rather than whether the FASB requires balance sheet consolidation for postretirement benefit obligations. Will investors change the way they value a company’s stock or judge its credit risk? Broad disclosures about plan asset allocations already exist in a company’s financial statement footnotes, so how much would putting them directly on the balance sheet change things?

Watson Wyatt believes that sophisticated institutional investors will understand that a purely net approach would leave something to be desired, as would a purely consolidated approach. Although financial analysts could use either approach and capture investment risk with supplemental metrics, it’s important to understand that the FASB’s goal is to create an accounting structure that clearly conveys useful financial information. While some people are comfortable with less robust accounting accompanied by excellent footnote disclosures, Watson Wyatt believes that the balance sheet itself should accurately reflect pension finance. The way a sponsor allocates pension assets affects its leverage profile and capital structure, and financial statements should reflect this economic reality. Specifically, balance sheet accounting should take into account that leverage metrics such as the ratio are most transparent when they reflect the pension asset allocation.

Balance sheet consolidation could strongly affect the way plan sponsors think about their postretirement benefit plan assets and liabilities within their capital structure. Is the plan a stand-alone entity? Or are plan assets and liabilities considered part of corporate assets and liabilities? Can financial statements transparently display the risk/return potential of different investment strategies? Should plan sponsors be proactive in discussing these issues with their investors? The answers to these questions will affect a sponsor’s investment policies, funding policies and plan design.

¹ While this example uses a pension plan, the results would be similar for another postretirement funded plan, such as retiree medical, although these plans are less often funded.

² Although consolidation would increase both assets and liabilities, the denominator of this ratio would not change, because market capitalization is determined separately from accounting requirements. Had there not been any plan assets, the market capitalization likely would have been lower.