Understanding Pension Expense Adjustments

Companies with defined benefit pension plans report pension-related gains and losses in earnings that are often disconnected from operational performance. A sudden decline in stock market valuations or changes in interest rates can trigger massive pension losses on the income statement, reducing reported earnings without any deterioration in the company's underlying business. Conversely, pension gains in strong market years can inflate earnings. For investors analyzing companies with large pension obligations—particularly industrial manufacturers, utilities, and mature financial institutions—pension adjustments are essential to isolating true operating performance from the noise of pension accounting. Understanding pension expense, identifying non-recurring pension items, and removing them from earnings provides a clearer view of sustainable profitability.

Quick definition: Pension expense includes the cost of promised retirement benefits earned by employees, plus or minus gains and losses from changes in pension fund valuations, interest rates, and actuarial assumptions. Non-operating pension gains and losses should be adjusted out to reveal core operational earnings.

Key takeaways

• Pension expense includes both the service cost (employee benefits earned) and non-operating gains/losses from pension fund valuation changes
• Pension fund gains and losses result from market returns, interest rate changes, and changes in actuarial assumptions, not operational performance
• A company's GAAP earnings can be inflated or depressed by pension accounting that is largely outside management's control
• Adjusting out non-operating pension items is standard practice among equity analysts and provides a clearer earnings picture
• Different assumptions about future returns, mortality rates, and discount rates create volatility in pension accounting
• Large pension obligations represent long-term liabilities that impact financial flexibility but are separate from operational earnings

What Pension Expense Includes

Companies offering defined benefit pension plans promise employees a specified retirement income, typically based on salary and years of service. Accounting for this promise is complex and creates two types of pension-related charges in earnings:

Service cost: This is the present value of pension benefits earned by employees during the current year. If an employee is entitled to $50,000 in annual pension for each year of service, and the employee works another year, the company recognizes the present value of that additional $50,000 lifetime obligation as service cost. Service cost is a real economic cost because it represents the value of benefits promised. It's part of the actual expense of employing someone and should not be adjusted out of earnings.

Net periodic pension cost (or benefit): This is the net of several components that fluctuate based on market and actuarial factors, not operational performance:

• Interest cost on the pension liability: The company's pension obligation grows each year as the liability accrues interest. This is comparable to interest expense on debt.
• Expected return on pension assets: The company's pension plan holds investments (stocks, bonds, real estate) that are expected to earn returns. This offsets the interest cost.
• Actuarial losses (or gains): Changes in mortality assumptions, discount rates, or revised estimates of employee turnover create gains or losses. If interest rates fall, the present value of pension liabilities rises, creating an actuarial loss. If fewer employees than expected leave the company, the actuarial loss decreases.
• Amortization of previous gains and losses: Rather than recording all pension gains and losses immediately in earnings, accounting rules allow companies to amortize prior-year gains and losses over multiple years. This creates smoothing but also lags between economic events (like market crashes) and their earnings impact.

The net of these items can be either a pension expense (reducing earnings) or a pension benefit (increasing earnings) depending on whether the fund is overfunded or underfunded and market returns.

The Volatility Problem: Pension Gains and Losses

The most critical issue for investors is that pension gains and losses are largely disconnected from business operations and create significant earnings volatility.

Market-driven losses: When stock markets decline, pension fund values drop, increasing the apparent underfunding of the plan. Under GAAP, companies may be required to recognize losses to bring the pension liability to fair value. In 2022, when equity markets declined approximately 18%, many companies reported significant pension losses. General Electric, with massive pension obligations, reported pension losses of several hundred million dollars despite the company's core operations performing reasonably well. Investors not aware of these one-time losses might have misinterpreted the earnings decline as operational deterioration.

Interest rate losses: Pension obligations are valued as the present value of future benefit payments, discounted at a rate tied to corporate bond yields. When interest rates fall, the discount rate falls, increasing the present value of the liability and triggering an actuarial loss. The opposite occurs when rates rise. During 2021–2023, as the Federal Reserve raised rates from near zero to 5%, companies with large pension obligations reported pension gains from higher discount rates. These gains had nothing to do with operational performance; they were purely a function of monetary policy and market interest rates.

Assumption changes: Actuaries periodically revise assumptions about employee turnover, mortality rates, and retirement ages. A company that revises down expected employee turnover (meaning employees will work longer and collect pensions longer) must increase the pension liability and record a loss. Similarly, improvements in mortality rates (people living longer) increase pension costs. These assumption changes are often small adjustments but can occasionally be material.

Overfunded vs. underfunded plans: The magnitude of pension gains and losses depends on whether the pension plan is overfunded (assets exceed liabilities) or underfunded. A company with a well-funded plan has more asset volatility, creating bigger swings in net periodic pension cost. A company with an underfunded plan faces larger liability volatility.

Real-world example: General Motors pension volatility

General Motors (GM) has one of the largest pension obligations in the automotive industry, reflecting decades of union agreements promising defined benefits. GM's pension accounting has been a source of earnings volatility:

• In 2021, GM reported a pension gain of approximately $1.8 billion as interest rates rose and stock markets performed well, boosting asset values.
• In 2022, GM reported a pension loss when equity markets declined and interest rates spiked, reducing asset values and increasing the present value of liabilities.
• The swings between $1.8 billion gain and large loss had nothing to do with GM's vehicle sales, profitability margins, or operational decisions—they were purely accounting adjustments based on market and interest rate movements.

Analysts covering GM adjust for these pension gains and losses when evaluating true operational earnings and setting price targets. Using headline GAAP earnings without this adjustment would lead to misinterpretation of GM's profitability trend.

How to Identify and Adjust for Pension Items

Companies disclose pension expense and gains/losses in their footnotes and earnings releases. Most companies break out the components:

• Service cost (operational cost of employee benefits earned)
• Interest cost on pension liability
• Expected return on pension assets
• Actuarial losses (or gains) recognized
• Amortization of deferred gains/losses

To adjust earnings, investors should separate the service cost (which is a legitimate operating expense) from the non-operating components.

The basic approach:

GAAP Net Income
  - Net periodic pension benefit (or add back expense) excluding service cost
  = Adjusted Net Income excluding non-operating pension items

Many companies provide adjusted EPS that already excludes these items, but it's important to understand which pension components are included in the adjustment.

For example, a hypothetical industrial company might report:

Pension Component	Impact on GAAP EPS
Service cost	$(0.20)
Interest cost	$(0.15)
Expected return on assets	$0.10
Actuarial losses recognized	$(0.25)
Amortization of deferred gains	$0.05
Total net pension expense	(0.45)

Of this, only the service cost of $(0.20) is a legitimate operating expense. The remaining $(0.25) represents non-operating pension losses. Adjusted EPS would add back $(0.25) to GAAP EPS to show what the company would have earned without the pension accounting volatility.

Flowchart

Comparing Companies with Different Pension Funding Status

Pension adjustments are particularly important when comparing companies in the same industry with different pension funding levels.

Overfunded pension plan: A company with more pension assets than liabilities reports pension gains in strong market years and losses in weak years. The net periodic pension cost can swing from a significant benefit to a significant expense. For example, in 2021 equity bull market, an overfunded plan might report a $2 per share pension benefit. In 2022 bear market, the same company might report a $1 per share pension loss. The operating business may have been identical, but earnings per share moved $3 due to pension accounting.

Underfunded pension plan: A company with more liabilities than assets faces consistent pension expense pressure. Interest costs on the liability exceed expected returns on assets, and actuarial losses are more likely. But the magnitude of swings may be smaller because the company is less exposed to asset volatility.

When comparing two companies in the same industry, an apples-to-apples comparison requires adjusting out the pension effects to isolate operational performance differences.

The Relationship Between Pension Accounting and Funded Status

A company's pension accounting affects cash flow and balance sheet, not just earnings. A company with an underfunded plan must make cash contributions to catch up over time. These are actual cash expenses that reduce financial flexibility but may not be fully reflected in current earnings due to the smoothing effect of amortizing deferred gains and losses.

Conversely, a company with an overfunded plan may reduce or suspend pension contributions, freeing up cash for dividends or buybacks. This improves near-term cash flow but doesn't change the long-term liability. Investors should evaluate pension funding status (disclosed in the pension footnote) separately from pension accounting impacts on earnings.

Pension Terminations and Lump-Sum Buyouts

Companies sometimes terminate pension plans or offer lump-sum buyouts to reduce long-term pension obligations. These actions trigger large one-time charges or gains in the period of the action.

If a company terminates an overfunded pension plan and transfers assets to a buyout annuity company, it may recognize a gain equal to the excess of plan assets over the actuarial liability. Conversely, if underfunded, it recognizes a loss. These are one-time events that should be removed from adjusted earnings.

For example, in recent years, several large corporations (including some tech and aerospace companies) have offered lump-sum buyouts to retirees, allowing them to take a single payment instead of lifetime pension payments. These transactions reduce long-term pension obligations but trigger immediate one-time charges that inflate or suppress reported earnings in the period of the buyout.

Common mistakes when analyzing pension adjustments

Mistake 1: Ignoring service cost when making adjustments. Service cost is a real operating expense and should not be removed when adjusting earnings. Only non-operating pension items (interest, returns, actuarial losses, amortization) should be adjusted out.

Mistake 2: Comparing companies without adjusting for pension funding differences. Two utilities with similar operational performance can report very different earnings if one has an overfunded pension and the other is underfunded. Comparisons require adjusting out pension effects.

Mistake 3: Assuming pension gains in strong market years will repeat. In 2021 and early 2022, many companies reported pension gains as equity markets soared and interest rates rose. Investors who incorporated these gains into earning power forecasts were disappointed when markets reversed in late 2022.

Mistake 4: Forgetting about pension contributions and funded status. A company might report reasonable GAAP earnings but have an underfunded pension plan requiring substantial cash contributions going forward. This cash burden reduces financial flexibility and should factor into valuation.

Mistake 5: Mixing up pension expense with pension plan funding. Pension expense (on the income statement) and pension funding (cash contributions to the plan) are related but distinct. A company can reduce pension expense through accounting changes without improving funded status. Conversely, required cash contributions might increase even if pension expense decreases.

Frequently asked questions

Why do companies report pension accounting as part of earnings if it's so volatile?

GAAP requires companies to recognize the economic effects of changes in pension obligations and asset values, even if the timing is volatile. Without this, earnings would not reflect the true economic position. The tradeoff is that investors must understand and adjust for the volatility.

How much of a company's total net income can pension accounting represent?

For companies with large pension obligations (utilities, mature industrials, some financial companies), pension gains and losses can range from 5–20% of net income in volatile years. For companies with smaller obligations or frozen plans, the impact is minimal. Technology companies often have minimal pension obligations because most grew up when 401(k) plans were the norm. This is one reason tech earnings are less volatile than industrial earnings.

Are pension gains and losses more volatile than operating earnings?

Often yes. A 10% equity market decline or 1% interest rate shift can create pension losses equal to several years of operating earnings growth. This is why adjusting out pension items is so important for identifying the stability and trend in core operations.

Can a company eliminate its pension obligation entirely?

Practically, no, though some companies have frozen or closed pension plans to new employees and shifted to 401(k) plans. Closing a plan to new entrants reduces future obligations but does not eliminate past promises. Companies often terminate overfunded plans or offer buyouts to reduce obligations, but eliminating a large plan takes many years and requires substantial cash.

How does negative pension funding (being underfunded) affect stock valuation?

An underfunded pension plan is a liability that will eventually require cash contributions or operational changes. Some investors view this as a claim on future cash flow similar to debt. However, if the company is generating strong operational cash flows, modest underfunding is often manageable. Severe underfunding in a declining business is a red flag.

What's the difference between an actuarial gain and a realized gain?

An actuarial gain results from assumption changes or changes in the present value of liabilities due to market movements. A realized gain occurs when pension assets are sold at a profit. Both are non-operating and should be adjusted out, but they result from different economic events.

Related concepts

• What is GAAP Earnings? — Understand the accounting standards governing pension expense reporting
• Reconciling GAAP to Non-GAAP Earnings — Learn how companies build reconciliations that adjust for pension items
• One-Time Write-Offs and Restructuring Costs — Distinguish between restructuring charges and pension gains/losses
• Tax Adjustments and Their Impact — Understand how tax effects apply to pension gains and losses
• Impact on Valuation Ratios — Learn how pension adjustments affect P/E ratios and other metrics
• Investor Best Practices for Using Adjustments — Develop a framework for properly adjusting for pension items

Summary

Pension accounting creates significant earnings volatility that is largely disconnected from business operations. Service costs (the true economic expense of providing pension benefits) are legitimate operating costs and should be retained in earnings. However, gains and losses from pension fund valuations, interest rate movements, and actuarial assumption changes are non-operating items that distort reported earnings and should be adjusted out to reveal true underlying profitability. Companies with large pension obligations—particularly utilities, industrial manufacturers, and some mature financial institutions—experience the most significant pension-driven earnings volatility. By separating service costs from non-operating pension items and adjusting headlines earnings accordingly, investors can focus on sustainable operational performance and make more informed valuations unaffected by pension accounting noise.

Next

→ Best Practices for Using Adjustments