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New accounting rule could cost DoD billions

Feb. 27, 2012 - 06:00AM   |  
By SARAH CHACKO and ZACHARY FRYER-BIGGS   |   Comments
A new federal accounting rule will require the government to increase reimbursements to contractors for their employee pension costs, a move that could cause the Defense Department to pay billions of dollars more for weapons programs. "I'm hoping that our vendors realize in tight fiscal times that they need to work with us to hold down weapons costs," Pentagon comptroller Robert Hale said.
A new federal accounting rule will require the government to increase reimbursements to contractors for their employee pension costs, a move that could cause the Defense Department to pay billions of dollars more for weapons programs. "I'm hoping that our vendors realize in tight fiscal times that they need to work with us to hold down weapons costs," Pentagon comptroller Robert Hale said. (DEFENSE DEPARTMENT)

The Pentagon may pay billions of dollars more for weapons programs in coming years because of an obscure new federal accounting rule.

The rule, which takes effect this week, requires the U.S. government to reimburse its contractors to a far greater degree for their employee pension costs.

The Defense Department has not yet budgeted for the additional pension costs, but estimates they "could be billions of dollars, conceivably," Defense Department Comptroller Robert Hale told "This Week In Defense News" on Feb. 23.

"I'm hoping that our vendors realize in tight fiscal times that they need to work with us to hold down weapons costs," Hale said. "We think there may be modest added cost, we'll just have to see, but we are going to have to start budgeting for them, and it is a question I'm asking internally as we look into our next budget plan."

The cost to the Pentagon will depend on how the companies' pension funds fare in the stock market, Hale said. If investments do well and earn money, a greater part of the plans will be funded, he said.

However, if investments do poorly and pension funds become further underfunded, affected contractors would be forced to make greater payments to cover those liabilities, pension experts said. And that will mean more cost to the Pentagon.

The new rule stems from the 2006 Pension Protection Act, which set new accounting standards for companies to use in calculating their pension fund liabilities. The law anticipated a conflict with federal cost accounting standards and ordered an five-member group called the Cost Accounting Standards Board to fix the problem.

Late last year, the board which consists of both federal and private-sector officials and is overseen by the Office of Management and Budget issued the new rule, which requires the government to recognize more costs that contractors pay into their pension plans as reimbursable.

Specifically, the cost accounting rule allows contractors to recoup all of their pension costs over four years.

Starting in 2014, contractors can add 25 percent of the difference between what they are required to pay under the Pension Protection Act and what they can charge the government under cost accounting standards. The percent of additional costs that can be charged increases to 50 percent in 2015, 75 percent in 2016 and 100 percent in 2017.

Take the example of a contractor who is required to pay $120 million to its pension fund under the Pension Protection Act, and yet federal cost accounting rules recognize only $100 million of that as reimbursable by the government. In 2014, the contractor would be able to add a quarter of that difference $5 million to what it can charge the government, for a total of $105 million. Under the same circumstances, the contractor by 2017 could bill the government $120 million.

With its roots in a 2006 law, the rule's impact should have been anticipated, giving Defense Department officials plenty of time to budget for the expected costs, said David Berteau, director of the Center for Strategic and International Studies Defense-Industrial Initiatives Group.

"How can this have snuck up on us and caught us unaware?" he said. "I didn't hear any alarm bells."

Estimating the likely impact of the new rule is tricky. The annual 10-k financial reports filed by contractors provide some idea of the impact they report the market value of a contractor's pension plan assets and its future benefits costs. But the accounting standards used for those 10-k estimates are different from those used for contract reimbursement purposes, so those figures offer only a rough approximation of how much the government may have to pay in the future.

According to the 10-k reports of four major defense contractors, the difference between pension plan assets and future pension liabilities ranged from $2.9 billion to $13.5 billion.

Lockheed Martin's plan assets, for example, are $13.5 billion short of future liabilities, meaning it is about 33 percent short of being fully funded. Northrop Grumman is $2.9 billion short on assets for its projected benefit costs, or 13 percent underfunded. General Dynamics' plan assets are $3.9 billion below projected benefits costs, or 40 percent short of fully funded. Raytheon's plan assets are $6.1 billion short of future benefit costs, or 28 percent underfunded.

Contractors are required to fund their employee pension plans according to the federal Pension Protection Act standards. But until now, federal cost accounting rules have calculated pension costs at a lower rate, meaning contractors have been unable to recoup all those costs from the government, said Terry Albertson, a partner with Crowell and Moring government contracts group.

The new rule will not mean that contractor pension plans will be fully funded by 2017, said Don Fuerst, senior pension fellow at the American Academy of Actuaries.

The gap between what contractors have been paying toward their plans and what the government has reimbursed will narrow, he said.

"But most contractors will still be contributing more than they're reimbursed," he said.

The cost accounting rule change also shrinks from 15 years to 10 years the amount of time contractors have to pay for past unfunded accrued liabilities, Fuerst said. The goal is to have pension plans fully funded in 10 years.

The impact of the new rule on government contracting costs could be dramatic given the tight budget environment most Defense Department agencies are operating under, Berteau said.

"This is way more than a bookkeeping question," he said.

Vago Muradian contributed to this report.

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