Pension Plan Income

Most corporations establish pension plans for employees. Older corporations maintain defined-benefit plans, meaning that the company funds the plans with cash that the plan invests in stocks and other assets. Theoretically, the plan’s assets should approximate its future obligations, that is, the money it will be required to pay out to its retired employees.

The defined-benefit’s pension plan’s assets depend, however, on the returns it receives from investing the assets. The assets total will not necessarily match the plan’s liabilities at any given time. If assets exceed liabilities, the plan is said to be over-funded. It’s under-funded if its assets fall short of liabilities.

If the plan is over-funded, the company can count the plan’s annual returns (income less costs) on its income statement, thereby increasing reported income. These pension plan credits can be substantial. For instance IBM added $1.3 billion to its reported income in 2000. The SEC doesn't require firms to show pension plan credits as separate line items on their income statements, so they are frequently buried in other income. The SEC does require companies to detail pension plan benefits in the footnotes to their annual reports, so you can find them by searching (Ctrl-F on a PC; Cmd-F on a Mac) for “pension” or “retirement.”

There’s an easier way, however. The pension plan’s contribution to reported income is an accounting entry; it’s not real money, and no cash moves anywhere. That brings us back to operating cash flow. IBM’s reported net income increased from $7.7 billion in 1999 to $8.1 billion in 2000, but its operating cash flow dropped from $10.1 billion to $9.8 billion in the same period. The divergence between reported net income and operating cash flow signaled earnings quality issues. By the way, newer companies offer 401k type defined-contribution plans instead of defined-benefit plans. The sponsoring company’s contributions to defined-contribution plans are deducted from its profits each year, and there is no ongoing interaction as with defined benefit plans.