This Is Just The Beginning

Spencer is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Pensions, like Social Security, are fantastic ideas at the outset, but years of stimulus, changing regulations, and overzealous discount rates and assumed rates of return have ruined many pensions.  SS is a different story that has more to do with the Baby Boomer generation being about as large as the two subsequent generations combined, but the point is that guaranteeing employees or persons a specific retirement package throughout retirement is difficult to sustain during times of artificially low interest rates.

What’s going on

Recently, AT&T (NYSE: T) reported:

We [AT&T] expect to record a non-cash, pre-tax charge of approximately $10 billion related to actuarial gains and losses on pension and postemployment benefit plans. At December 31, we lowered our assumed discount rate to 4.3%, resulting in an actuarial loss of approximately $12.0 billion. Partially offsetting the impact of the discount rate is an asset gain, which is approximately $1.9 billion in excess of our assumed rate of return of 8.25%. Despite this gain, due to the continued uncertainty in the securities markets and U.S. economy in 2013, we have lowered our expected long-term rate of return on asset assumption to 7.75%. Gains on claims experience and other actuarial assumptions of approximately $100 million also partially offset the loss associated with the lower discount rate.

What does this mean for AT&T as a business?

This means absolutely nothing for AT&T's business. In fact, Verizon (NYSE: VZ) announced the exact same charge for $7B-$7.5B on January 7.  Both Telecom giants have identical verbiage in their respective 8Ks.  And fortunately for investors, these non-cash charges will simply bring negative sentiment, but ultimately we will not see any change in the business models.

However, this is a perfect example of what investors should expect in the future.  We have a scenario where companies have not updated their discount rates and assumed rates of return for their postemployment plans, thus these rates will have to be corrected at some point; or, perhaps the equities markets will return to producing 10% yearly gains and income securities will provide 8%-10% returns as well, or better yet, businesses will pay the difference in the assumed rate and the actual rate out of their own pockets.  A more reasonable approach is for businesses to provide employees with lower expected rates, just as AT&T lowered the assumed rate of return by 50bp.  While no business wants to cut the assumed interest rate for their loyal employees, the truth is this is inevitable.  The longer businesses wait to do this the deeper the hole they will dig for themselves.

The underlying problem is U.S. Treasuries 

The old adage of a safe investment still exists, but the return on the investment is utterly useless.  Only the 30 year T-Bond gives investors and pension accounts a chance to beat inflation each year.  Even if the Fed stops buying Treasuries, the simple fact is the rest of the world will continue to buy U.S. income securities because, contrary to popular belief, the U.S. is, compared to most nations, one of the most stable economies in the world.  Obviously if the Fed stops buying Treasuries it will help yields rise slightly, but this is years away at the very least anyways.

<img src="/media/images/user_13467/us-treasury-bond-interest-rate-history_large.jpg" />
 

Therefore other large pension plan holders such as General Electric (NYSE: GE) and ExxonMobil will likely face similar non-cash pre-tax charges as well.  GE has already taken advantage of July's rule change that allows businesses to lower their obligations by using a higher expected rate of return.  This does however pose an obvious problem: if businesses assume - by paying the government a higher premium to insure their pensions - that they will receive a higher return on pension accounts when in fact pensions will not achieve this result then businesses will dig a greater hole for themselves.  But I suppose kicking the can down the road is the new norm.

Nevertheless, it appears we are witnessing the results of what can be called unethical and illogical accounting practices.  Actuaries have used higher rates of return for years and have been given permission to use even higher rates moving forward.  How businesses will deal with this is something for investors to watch in the coming months and years.  We are not expecting any non-cash pre-tax write downs to effect share prices, but bad news is bad news and bad news usually comes all at once.  For instance, Verizon reported the pension charge at the same time as other writedowns due to Sandy.  The combination of this (mostly the bad news regarding Sandy) has caused the share price to sink about 6% in ten days.


sbeefyk1 has no position in any stocks mentioned. The Motley Fool owns shares of ExxonMobil and General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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