IBM: I’ve Been Mauled

Easy come, invisible go.

In its Annual Report for 2001, released early this year, IBM told shareholders it had earned $15.7 billion in the last two years. It earned $7.7 billion in 2001, a modest decline from the $8.0 billion earned in 2000. Nearly 16 percent of that $15.7 billion, some $2.5 billion, came from excess earnings of the companies’ U.S. and overseas defined benefit pension plans.

Unfortunately, during exactly the same time that the pensions were contributing so handsomely to earnings, the strength of the same pension plans was deteriorating by $16.5 billion.

Yes, you read that right: $16.5 billion. To put the number in perspective, the total cost of the accounting mis-deeds at now bankrupt WorldCom has been put at $7.2 billion— less than half as much.

The real difference, of course, is that the $7.2 billion at WorldCom was fraudulent. IBM, on the other hand, is reporting pristine and completely legitimate results. Their results are based on generally accepted accounting principles blessed by the Financial Accounting Standards Board. No one will be leaving IBM’s Armonk, New York headquarters surrounded by television cameras and handcuffed to an officer of the law.

At issue for investors: Does it make any difference? Does it matter that crooks ran one company while upstanding businessmen run the other? Sadly, shareholders can now be as misled by generally accepted accounting principles as by fraud.

The villain here is an accounting rule known as FAS 87, a standard that was issued after the pension crisis that followed the 1973-74 market crash and the passage of ERISA, the Employee Retirement Income Security Act.

Needless to say, FAS 87 seemed reasonable at the time. Indeed, when it was first put in use there was widespread worry that it might reduce company earnings and depress stock prices. Instead, FAS 87 turned company pensions into a profit center during the roaring bull market of the nineties.[v] IBM, along with many other companies, found that FAS 87 allowed them to show that their pension plan was a source of income, not a source of expense.

No more.

With pension assets down and pension obligations up, we’re about to see the other side. While the typical pension plan was under-funded by the end of 2001, IBM’s maintained a small surplus over obligations. It’s a good bet that surplus disappeared this summer.  Within a few quarters, an increasing number of companies may be forced to make new contributions to their pension funds, reducing earnings.

But we’re getting ahead of ourselves.

To see what really happened over the last two years, take a close look at the table below. While IBM’s total pension assets plummeted $12.3 billion, their total pension obligations rose $4.2 billion. The $16.5 billion shift vaporized the comfortable $17.2 billion surplus of assets over obligations, leaving the company with a narrow surplus of $687 million by the end of last year.

None of this, of course, was very visible. You can find this $16.5 billion item on page 98 of their annual report.  On page 97 you can see how the magic of FAS 87 helped the pension plans contribute $1.3 billion to earnings, 17 percent of the total for 2001— even as the pension plan portfolio actually lost money.

Source: IBM, 2001 annual report: ftp://ftp.software.ibm.com/annualreport/2001/ibm2001_financials.pdf

How did this happen?

In FAS 87, your accountants and actuaries get to “assume” a return on plan assets in the same way that physics professors “assume” a frictionless world. IBM entered the bear market by raising its assumed pension earnings from 9.5 percent in 1999 to 10.0 percent for 2000 and 2001. For 2002 they’ve reduced their earnings assumption back down to 9.5 percent. Most human beings would consider that an inadequate concession to reality.

What will the reduction do?

It will reduce the amount the pension plan contributes to earnings— but the 2002 report may still show a positive contribution.

As I said before, this is not fraud.  IBM is being absolutely ordinary and conventional. They are doing what hundreds of major American corporations do. They are following generally accepted accounting procedures in general and FAS 87 in particular.

The only problem is the one shareholders have. They fly blind and hold the bag.

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

(c) Scott Burns, 2022