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:$177 billion Net income: $1.8 billion Assets (book):$369 billion Liabilities:$362 billion Market capitalization:$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:$60.9 billion 2002 PBO:$80.1 billion Net Funding-$19.3 billion Percent Funded76%

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 =