(MONEY Magazine) – One week, the Wall Street Journal proclaims on the front page that there is no pension crisis; the next week, Fortune compares pension problems to the lurking menace in Nightmare on Elm Street. All the while, Wall Street analysts churn out reams of thick reports on the subject. Suddenly, the state of corporate America's pension plans is the hot investing debate du jour.

What's all the fuss about? The past three years of market mayhem have left many of the nation's pension plans deep in the hole. And companies that routinely boosted annual earnings with pension plan gains during the bull market are now booking pension losses.

Try to get your mind around these numbers: At the end of 2000, the 348 S&P 500 companies offering traditional pension plans had squirreled away more than $1 trillion in investments--yes, that's a T--to cover their estimated $982 billion in future obligations to retirees. Two years later, that kitty has shrunk to an estimated $892 billion, while payments owed to retirees have swelled to $1.2 trillion--a $323 billion gap.

Sure sounds like a problem, doesn't it? Unless the market roars back, many companies will have to dip into corporate coffers to make up shortfalls. Goldman Sachs senior economist Jan Hatzius estimates that companies will have to boost their annual pension contributions from $40 billion to $120 billion--a year. That's $80 billion they won't have to invest in their businesses, pay down debt or hike their dividends.

Does that mean the companies in your portfolio are about to be whacked? Not necessarily. In this article, we'll explain how pension accounting works and how to tell whether a company you own--or are considering investing in--has a pension problem.

The big issue: underfunding

Understanding pensions involves hacking through a thicket of actuarial calculations and accounting rules. We'll get to those in a moment. But the basic idea is pretty simple: A plan is underfunded when the amount in the plan, assuming a conservative growth rate, is not enough to meet its obligations to current and future retirees. When a plan is significantly underfunded, the company may have to increase contributions to bring it back in line, usually within three to five years. Consider General Motors' predicament. Even with $60 billion in assets, GM's plan was expected to be at least $21 billion underfunded at the end of 2002. GM contributed $2.2 billion to the plan last summer and expects to kick in at least $10 billion more over five years--one reason its stock is down 44% since May.

Old-line industrial companies with massive work forces are hardest hit. But the problem is by no means limited to them. By the end of 2002, 87% of the S&P 500 companies with traditional plans were expected to have underfunded plans, including American Express, ExxonMobil, Harley Davidson and Hewlett-Packard, according to Merrill Lynch estimates. (The table below shows some of the companies with the greatest percentage of plan underfunding in 2001.) Many companies will have to funnel cash into plans. IBM, for example, which has not put money into its plan since 1995, kicked in $1.5 billion in cash for 2002.

Some observers say that the situation is even worse than it appears. In order to estimate future pension obligations, companies use a discount rate--essentially, what the plan would earn if its assets were invested entirely in high-quality bonds. The higher the rate, the lower the obligation and the less a company needs on hand today to pay benefits over time (see the chart above).

The discount rate is supposed to reflect prevailing interest rates. But while interest rates have come down sharply in recent years, many companies have been slow to lower their discount rates. As a result, argues economist William Strauss, who has analyzed decades of pension data, corporate America has been underestimating pension obligations. More than half of private pension plans use rates a full point higher than what accounting rules recommend. Strauss figures that pension liabilities are underestimated by 10% to 20%.

The phantom issue: annual earnings

While badly underfunded pensions can create a real drain on corporate cash, pension plan gains and losses affect a company's reported earnings but have no impact on cash flow.

Here's how it works. Companies count annual pension costs, including the additional benefits employees earn each year (called the service cost), as operating expenses. According to accounting rules, if the plan's investment earnings exceed those costs, the company must add the excess to its reported profits for that year. If not, it subtracts the difference (see the chart below).

But companies don't use the pension plan's actual earnings (or losses) in these calculations. To dampen the effects of market volatility, they must use an expected investment return, which they have some discretion in setting. The higher that return, the more likely a company will get an earnings boost from its pension plan. Of the 348 S&P 500 companies with traditional pension plans, 64 used expected returns of 10% and higher for 2001.

Companies are now under pressure to lower expected returns; General Electric earlier this year shaved its anticipated return from 9.5% to 8.5%; IBM expects to lower its from 9.5% to as low as 8%. And these lower returns will be applied to shrunken pension assets, magnifying their impact. That's why many companies are lowering 2003 earnings estimates, citing pension costs.

By influencing earnings, annual pension gains and losses affect such valuation measures as price/earnings ratios, and therefore the stock price. But remember: They have no bearing on actual cash flows or even the status of the pension fund itself. That's why many seasoned investors factor out annual pension results when scrutinizing earnings.

Spotting pension problems

How do you know if you should worry about a particular company's pension funding? Your first stop is the footnotes to the annual report. Companies report pension data in a section typically called Pension Plans or Benefit Plans. Footnotes list how the projected amount of pension payouts and plan assets have changed over the year, as well as the assumptions used to arrive at the numbers. Here's what to watch for.

Funded status. Look for the table spelling out the difference between the projected benefit obligation and plan assets. Divide assets by the obligation to calculate the percentage of over- or underfunding. Generally, a plan that's less than 85% funded will have to pony up over the next three to five years.

Assumptions. Check the discount rate. The federal Pension Benefit Guaranty Corporation recommended a 5.8% discount rate in 2001. If your company's is higher, it's likely underestimating liabilities. And if its expected investment return is above 9%, pension income may be inflating current earnings.

The debate over pension shortfalls will continue, but one thing is clear: Investors ignore corporate America's pension plans at their own peril.