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Saturday, February 28, 2009

The next huge debacle

In a bit more than an hour, we'll soon have Berkshire Hathaway's latest report. But I want to take you to last years report first.

Here's what Warren had to say about the accounting for pension plans:

Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.

This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments –must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation?


Some companies have pension plans in Europe as well as in the U.S. and, in their accounting, almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.

What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire.

After decades of pushing the envelope – or worse – in its attempt to report the highest number possible for current earnings, Corporate America should ease up. It should listen to my partner, Charlie: “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”
http://www.berkshirehathaway.com/letters/2007ltr.pdf

After the markets are down 50% across the board, these pension liabilities are going to be a blackhole of liabilities for many stocks with household names.

Karl Denninger, has the right idea, of what these obligations could entail:

A huge number of big multinational companies - firms that have so far held up reasonably well in the indices (and in fact are all that is holding up the indices) have tremendous unfunded pension obligations on their books.

These firms have in many cases seen half of their net equity value destroyed due to MTM losses on these funds. These liabilities can only be discharged through a bankruptcy (transferring them to the PBGC), and yet that would wipe out their common stockholders.

Now here is your exercise for the weekend:

Take the large-cap companies that have held up "reasonably well" thus far and also are "legacy" firms - that is, firms that have been around for a long time and thus have pension obligations on their books.

Zero the stock price of 30-50% of those.

Now compute what that does to the index they are in.

Make sure you're sitting down when you do this computation.

I gotta run. I have a tee time.

And if Obama wants to to really help this economy, he should take a little of Charlie's advice.

"Aim a little to the right on the next swing"

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