Shares of General Electric (GE 1.65%) have soared this month after the company made the surprising decision to replace CEO John Flannery after just 14 months on the job. Investors appear to have far more confidence in his successor, Danaher veteran Larry Culp.
Nevertheless, many analysts and investors are still wary of GE stock. GE's weak balance sheet -- and particularly its $28.7 billion pension shortfall -- is high on their list of concerns. Yet despite this eye-popping number, General Electric is in good position to get a handle on its pension deficit within the next year or two.
Low interest rates caused the pension deficit to balloon
Ultra-low interest rates have been a major contributor to GE's pension deficit problem over the past decade. As long-term interest rates fell, General Electric gradually reduced the discount rate used to estimate its pension obligation, leading to a higher liability. (The discount rate roughly tracks interest rates for long-term investment-grade bonds.) Falling mortality rates also increased GE's estimated pension obligations.
By the end of 2017, GE was using a discount rate of 3.64% to calculate its principal pension plan obligation. That was down from a discount rate of 4.38% just two years earlier.
Falling demand for power equipment isn't the only thing worrying GE investors. Image source: General Electric.
The 2017 discount rate change alone increased GE's pension obligation by $3.3 billion. Luckily, the company was able to more than offset this headwind with strong investment performance. As a result, General Electric reduced its net pension liability to $28.7 billion at the end of 2017, compared to $31.1 billion at the end of 2016.
Interest rates are rising
Rising interest rates are a threat to many U.S. stocks, if only because higher interest rates on safe investments create more competition for risky ones. However, General Electric is one company that could benefit from rising rates, primarily because of the scale of its pension underfunding.
In its 2017 annual report, GE estimated that a 25-basis-point (0.25-percentage-point) discount rate increase would reduce its pension benefit obligation by approximately $2.4 billion.
Interest rates surged in early 2018. Following six months of stagnation, interest rates have moved sharply higher again since late August. The yield on 10-year Treasury bonds recently surpassed 3.2% for the first time since 2011, up from just 2.4% at the beginning of 2018. Some investors think rates could continue rising, as a tight job market, tariffs, and higher oil prices are all stoking inflation expectations.
The increase in interest rates this year should cause GE to use a higher discount rate when it recalculates its pension liability in early 2019. Interest rates have risen by more than 80 basis points already, which could knock between $7 billion and $8 billion off of GE's projected benefit obligation. If interest rates keep rising in 2019, GE's pension deficit would likely decline further.
Other actions will further reduce the pension deficit
While higher interest rates could have a particularly large impact on GE's pension shortfall, two other factors will also help the company quickly get its pension under control.
First, General Electric announced last fall that it planned to make a $6 billion debt-funded contribution to its pension plans in 2018. While it only contributed $900 million in the first half of the year, GE likely made the remaining contributions last quarter, which would have allowed it to deduct the payments at the 2017 federal tax rate of 35% instead of the new 21% rate.
Second, under a breakup plan revealed back in June, GE said that it would transfer $18 billion of debt and pension liabilities to its healthcare business in conjunction with spinning off that unit. Given that the healthcare division has about 54,000 employees -- compared to about 300,000 for GE as a whole -- this could shift perhaps $4 billion of the pension deficit to the healthcare spinoff in 2019.
Between the $6 billion planned contribution and a higher discount rate, GE might be able to slash its pension shortfall to just $15 billion by the end of 2018, down from $28.7 billion a year earlier. GE doesn't plan to make any contributions in 2019, but further interest rate increases and the healthcare spinoff could be enough to push the net liability below $10 billion. That will make GE's pension plan deficit look far more manageable in the future.
