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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

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by the end of today s lecture you should be able to
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
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
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
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
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
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
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
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
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
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
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
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
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
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
Financial Status of GM Pensions
  • 2002 plan assets: $60.9 billion
  • 2002 PBO: $80.1 billion
  • Net Funding -$19.3 billion
  • Percent Funded 76%
what caused it
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
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
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
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
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
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
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
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
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
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
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
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
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?
gm alpha
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
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 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
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