Pensions poser and sky-high US shares

THE DAY after Tony Blair addresses a joint session of Congress is a good time to look at Wall Street. It has always amused me that a bit of uncertainty about the quality of US financial reporting as illustrated by Enron, WorldCom and the rest should cause mass panic among investors and put Wall Street on the slide when what American companies are allowed to do quite legitimately is far more flaky then anything a bent finance director could dream up.

So if you want to know why Wall Street is at least 50% overvalued, it is because American companies are not forced to account for stock options and pension fund issues in a sensible way. If they were, the profits of many leading US businesses would vanish.

The debate on options is for another day, but Warren Buffett, the legendary American investor, reckons pension accounting rules mislead investors, so let us focus on that point.

In the US, companies with pension plans are told to assume investments in the scheme will grow at a certain rate per year. They have some discretion about the rate they choose but for some years now it has been between 7% and 10% and the average rate for companies in the S&P 500 index in the 2001 accounting year was 9.2%, shading to 8.8% for 2002.

Companies are allowed, indeed instructed, to assume the funds actually grow at this rate, take this into their profit and loss account and show it as a gain. They put in this hypothetical figure regardless of the fact that they may have made nothing like that amount of investment return, or even made a loss.

Thus General Electric showed an $806m profit boost from growth in its pension investments in its 2002 figures when the reality was that it lost $5.25bn. Verizon, the company where Vodafone owns a major chunk, showed a $2.5bn profit on investments which actually accounted for 40% of its 2002 earnings. The true position, revealed in a footnote, is that it lost $4.68bn, which makes the whole group barely profitable. Six others among the biggest companies lost more than $1bn but reported a gain.

The logic for this rule is that assuming a constant rate of return smooths the effect of the ups and downs in the market and therefore keeps artificial volatility out of the profit figures. Unfortunately, this only works if the actual outcome is near the estimate - if, for example, it is 1% above or below the assumed figure. But when the market moves violently, as it has in recent years, the rule results in a massive mis-statement of true profitability.

According to CSFB's David Zion the $219bn total profits of the S&P 500 companies in 2001 were in fact only one-third of that amount - $68.7bn. And in the two years since that analysis, pension schemes have racked up a further $200bn of losses, which is enough to wreak similar havoc with the later figures. And remember, this is before other possible adjustments for options and suchlike.

So the question that has to be asked as we look to Wall Street is, if the true profitability of the S&P 500 companies for the past three years is only one-third of its reported level, shouldn't share prices also be just one-third of their current level? And if not, why not?

Picking holes

INTERESTING that most commentators quoted with approval that Citigroup's Sandy Weill had chosen 'a close ally' as his successor.

Given all the focus these days on corporate governance, this raises an issue of more substance perhaps than some things that seem to exercise the experts. Is it right that the outgoing boss should choose his successor, or exert such influence that his choice is rubber-stamped?

Such a policy has at least two adverse effects. First, the chief executive will inevitably seek to choose someone whom he thinks either is most like him or has been his most fawning sycophant. Neither will necessarily be the right person to take the business forward.

Second, a change at the top should be the cue for some fresh thinking and a change of leadership style to help the business keep up with a changing world.

But people of independent mind will frequently clash with their boss and if they know he determines the succession they will see no point in hanging around for a job they are not going to get. So the pool of talent left will be long on yes men and short on original thinkers - not the brief a board would normally give to a headhunter.

So if Weill did really handpick his successor as the spinners imply, it means only one thing: time to sell Citigroup.