From the perspective of a corporation, a pension liability is a strange beast. Most of the financial reportings of a company are cash flows: revenue, expenses, profit, etc. But a pension liability is a fund, a large amount that will be owing at some time in the future. Due to accounting standards, changes in the value of this future liability, and the fund that has been accumulated to meet the future liability, are treated as flows and affect current profitability.
This wouldn’t be a problem if the pensions owing stayed relatively stable and the current value of the pension funds grew steadily. But both values fluctuate, sometimes wildly. This not only creates difficulty planning, but it creates perverse incentives, due to the impact of these values on the perception of current performance. For example, if interest rates rise, the current value of bond investments fall. At the same time, the future value of the pension liability is discounted using the higher rate, the results of which depend on the age profile of employees. Add to that increasing longevity, and the results are unpredictable.
Unpredictable, that is, in the direction and magnitude of the changes. But we know for sure that pension liabilities will fluctuate over time. As the dollar value of the liability fluctuates, it will cause the pension fund target value to oscillate. As interest rates go up and down, the current dollar value of the liability will increase and decrease. When employers report the new numbers, they are pressured to adjust the pension fund value (generally through deposits) to reach the new number. Since the target is based on a number that is moving in a trend, it will be a moving target. In order to reach that amount, the employer may (however unlikely) overcompensate by depositing enough to reach last quarter’s goal, plus enough to hit next quarter’s number. Then, when interest rates reverse course, the overcompensation will become apparent.
In the past, this has resulted in employee groups demanding withdrawals from the pension fund, to supplement current earnings. It could also result in a funding holiday, which would result in underfunding when rates again reverse course. As an investor in publicly-traded companies, this concerns me. It results in a number of problems. A pension fund should not be the most economically profitable choice to commit the corporation’s capital. (If it is, there are bigger issues.) Having misleading signals surrounding pension funding and liability distort other choices that involve capital decisions, such as reinvesting in production factors (buildings, machinery, labour, etc) or research and development. It also translates into fluctuating estimates of the company’s intrinsic value, which partly contributes to fluctuations in market value of its shares.
If the accounting standards would allow companies to smooth out interest rate fluctuations in order to slow the movement of the pension funding target, it would make it easier for the company to adjust and meet the funding needs, without overshooting during each cycle, resulting in oscillation that affects the apparent profitability of the company from quarter to quarter. The same idea applies to marked-to-market investments. I understand a little better now why corporate executives sometimes seem cynical about unfunded pension liabilities.