Pension Accounting and the
Case of General Motors
Monday September 11, 2006
By the end of today’s lecture, you
should be able to:
Provide overview of how pension
accounting works, as well as its flaws
ABO vs. PBO
Expected vs. actual returns
Describe GM’s 2003 pension funding
scheme in detail
Debt issuance
How it created value (real, and accounting)
Understanding Pension Accounting
It is important for analysts, investors, plan
participants, and other stakeholders to be
able to determine how a company’s pension
affects the financial status of the firm
The information reported on the face of the
firm’s financial statements is often
inadequate, and can even be misleading
One must “dig deeper” into supporting
documentation
Relevant FASB Statements
SFAS 87: Guides employers on how to
account for pensions
SFAS 88: Accounting for “settlements and
curtailments” of DB plans
SFAS 132: Retiree benefit note disclosures
provide additional info to aid in analysis of
retiree benefit plans
SFAS 106: Accounting for non-pension
benefits to retirees (e.g., health care, life ins.)
A Few Caveats Upfront
Assumptions and methods used for
financial statement treatment of
pensions often differs from those used
for PBGC funding
Financial Accounting treatment also
differs from tax treatment
Tax treatment follows cash flows, financial
accounting follows accruals
Why Can Financial Statements
be Misleading?
In 1987, when FASB adopted current rules, it
decided to:
Ease the transition to the new rules
Reduce volatility of earnings arising from actual
returns on plan assets
Ease the income statement impact from plan
changes that granted future pension benefits
based on past service
Result: income statement costs and balance
sheet balances are often disconnected from
underlying economics
Measuring Pension Obligations
Accumulated Pension Obligation (ABO):
PV of amount of benefits earned to
date, based on current salary levels
Projected Benefit Obligation (PBO): PV
of amount of benefits earned to date,
based on expected future salary levels
that will determine the pension benefits
Which Measure to Use?
Controversial
Balance sheet disclosures of unfunded
pension obligations use ABO
Income statement measures are based
on PBO
Lots of supplemental disclosure required
Income Treatment
SFAS 87 Pension Expense (“Net Periodic Pension
Cost”)
= Service cost (PV of newly accrued benefits)
+ Interest cost on PBO (one year closer to payment)
- Expected return on plan assets
+/- Amortization of prior service cost (change in liability due to
plan amendments amortized over future work life)
+/- Amortization of gains or losses (other amortized
gains/losses, incl. difference between expected and actual returns)
Controversy: Expected Returns
FASB allows corporations to use an expected
rate of return on plan assets rather than the
actual return when computing the annual
benefit cost
Ex: Even if company experiences a negative rate
of return on plan assets, it can still report an 9%
return on plan assets for that year
Provides misleading view of actual change in
economic value of net liability
Controversy: Asset Smoothing
Rather than using the current fair market
value of assets, firms are allowed to apply the
expected rate of return to a trailing five-year
smoothed fair value of plan assets
After stock market decline, assets used in
calculation are overstated, thus further
overstating income from asset returns
Increased Disclosure Requirements
Because balance sheets and income statements
are confusing (misleading?), in 2003, SFAS 132
was revised to expand disclosures
General description of plans, changes arising from
acquisitions/divestitures, effect of plan amendments,
and dates on which assets and liabilities were
measured
Table reconciling beginning and ending balances of for
projected benefit obligations (for DB plans)
Changes in plan assets (including actual returns,
contributions, benefits paid, etc.)
Lots of other details on ABOs, underlying assumptions,
plan assets by asset class, etc.
FASB Status
New rules proposed March 31, 2006
Would require that companies list the funding
status of their pension and retiree benefit plans on
their balance sheet as an asset or liability.
• Would apply to both public and private companies, as
well as not-for-profits
• Would have to value pension assets on same day that
they measure other corporate obligations
More rules to come “such as whether
companies can rely on current investment
performance expectation when gauging
ability to meet obligations.”
– “Pension Trouble Ahead” by Donna Block in Daily Deal 4/3/06
G.M: Overview of the Company
Industries
Autos (Buick, Cadillac, Chevrolet, Hummer, Saturn)
Hughes Electronics
Finance & Insurance
Employees:
326,000 globally
Financial Status (2002)
Net Sales:
Net income:
Assets (book):
Liabilities:
Market capitalization:
$177 billion
$1.8 billion
$369 billion
$362 billion
$21 billion
GM’s DB Pension Plans
“Hourly Pension Plan”
Adopted in 1950
In 2002 paid $6.4 billion to 340,000
beneficiaries
“Salaried Retirement Program”
Also adopted in 1950
In 2002 paid $2.1 billion to 117,000
beneficaries
Financial Status of GM Pensions
2002 plan assets:
2002 PBO:
Net Funding
Percent Funded
$60.9 billion
$80.1 billion
-$19.3 billion
76%
What Caused It?
Perfect Storm
Interest rates fell (exhibit 9)
Stock market fell
• Fair value of plan assets
– $80.5 billion in 1999
– $60.9 billion in 2002
“Mature” pension plan
2.5 retirees per worker at GM
Funding Status in Perspective
Underfunded pension obligation is:
 General Motor’s market capitalization!
> G.M.’s long-term debt
Who bears the financial burden of the
pension underfunding?
Shareholders
Unfunded pension obligation is > book value of
shareholder equity ($19 billion vs. $6.8 billion)
What Are G.M.’s Funding Options?
Finance out of cash flows from operations
Would require giving up dividends and/or
investments
• Dividends = $1.1 billion per year
• Investment = $6.8 billion per year
– Highly competitive business environment!
Issue equity
Would have to issue amount roughly equal to
current market cap!
Not tax efficient
Issue debt
G.M.’s Debt Issuance
$9.2 billion in GM debt
$4 billion in convertibles
Yield on 10 year note = 7.22%
3.75 above treasury
0.25 less than expected
This $13.2 billion used for pension fund
Another $4.5 billion in short term debt for
general corporate use (not for pensions)
Issuing Debt to Fund Pension
Winners?
Shareholders
• Gain present value of the tax shield
= 35%*(r*Debt) / r
= $4.62 billion
• Cash flows freed for investment, etc.
Pensioners – benefits now funded
Losers?
Shareholders give up option to default
Existing bondholders  big increase in leverage
Effect on Accounting Measures
G.M. issues $13.2 billion in debt and
places proceeds in pension
Must pay approx. 7.22% on the debt
=$950 million in interest expense
Takes credit for expected return on
pension assets of 9% = $1,188 mil.
Difference = $238 million in “income” to
reduce net periodic pension cost
Pension Fund Investments
Fiduciary relationship – when one party holds
and administers money on behalf of another
party
Covers the employer, the plan administrator, and
the trustees of the plan
Fiduciary rules governing pensions are designed to
protect workers, not to make life easy on plan
administrators!
At least one fiduciary must be named. Note that
actuaries, attorneys, consultants, etc, are typically
not considered fiduciaries
Fiduciary Responsibilities (under ERISA)
Operate plan solely in interest of participants
and beneficiaries
Act with the care, skill, prudence and diligence
… that a “prudent man” would. Must consider
Diversification (DB max of 10% in Co Stk)
Liquidity & current return relative to cash flow needs
Projected returns relative to funding objectives
Diversify the investments to minimize the risk of
large losses
Follow provisions of plan documents (unless
inconsistent with ERISA)
Interest of Participants
Pension plan participants should want
pension fund to be fully funded at all times
Sufficient assets on hand
Sufficient contributions as needed
Low risk: minimize mismatch between assets and
liabilities
How minimize the mismatch?
Invest in bonds or stocks?
Why Do Firms Use Equity?
Do “stocks beat bonds in the long run”?
Historically, stocks have beaten bonds over
every 30 year holding period in US over
past century – the “equity premium”
But, may not be true going forward
• May have been lucky draw?
• Smaller equity premium going forward?
Used to “justify” higher expected return
(which allows lower pension expense)
Boots Pension Plan
A leading retail chain in UK and Ireland
2.3 billion pound assets in pension plan
Investment strategy was approximately 75%
equity, 17% bonds, 4% real estate, 4% cash
In 2002, pension trustees and the firm
decided to move 100% of assets into
passively managed bond portfolio
Partially also motivated by tax considerations
Article Handed Out Last Time
International Paper
If invest pension assets in bonds, then they
move the same way liabilities do as interest
rates change
Need bond and liability duration to match
Alternative: use interest rate swaps
• Idea is the same. Use financial instruments to
hedge against the interest rate risk
G.M.s Investment Strategy
General Motors Asset Management (GMAM)
Manages GM pensions and insurance portfolios
$140 billion in assets under management
Active vs. passive management
100% active
“Alpha strategies”
Trying to beat the market
Can it be done on risk-adjusted basis?
Financial Times, December 15, 2003
The Wall Street Journal, December 10, 2003
GM “Alpha”
Private equity
“Global tactical asset allocation”
Real estate
Hedge funds
High yield bonds
Small cap stocks
Now 35% instead of 15% of portfolio
GM Today
Pension funds now considered funded
No contributions made in 2004
“Has likely met pension obligations through the
end of the decade”
• Good news for pensioners
But asset portfolio risk has increased
Bad for pensioners if things go sour
GM’s debt downgraded to “junk” status in
Spring 2005
GM Health Care
GM expected to spend $5.6 billion in health
care costs in 2005 for 1.1 million people.
Up from $3.9 billion in 2001 to cover 1.2 million
Estimates of $2000 per car
Rising at >10% per year
No requirement that they pre-fund health
care costs, but they have begun to
Have trust fund of $20 billion
But present value of future health obligations is
now on the order of $80 billion!
If GM were to go bankrupt, no legal obligation to
pay health care
Has GM been a good investment?
Current price = $33.23
Up substantially in 2006
But still down vs. history
See price chart …
Current market cap = $18.8 billion
Earnings per share = -19.91