General Electric (NYSE:GE) has taken aggressive steps to reduce its debt this year. In fact, CEO Larry Culp recently told investors that the company is on track to reap $38 billion in asset sale proceeds in 2019, with the biggest chunk coming from GE's pending deal to sell its biopharma business to Danaher for $21 billion.

However, General Electric has lots of liabilities on its balance sheet other than debt, most notably a massive pension deficit. GE's pension funding shortfall peaked at more than $31 billion as of the end of 2016 before improving significantly over the following two years. Unfortunately, GE's pension underfunding is on pace to jump by about $7 billion this year due to a big decline in interest rates. Yet that looming increase in the company's pension deficit is less of a problem than it might seem at first glance.

A large pile of hundred-dollar bills.

Low interest rates have caused GE's pension deficit to grow dramatically. Image source: Getty Images.

Digging into the discount rate

Most corporate debt calls for periodic interest payments, while all principal is repaid at the end of the term. As a result, the principal balance is a good estimate of the "value" of the debt. By contrast, pension plans don't involve a lump-sum principal payment. The payments to retirees are spread out over decades and depend on a variety of factors. That makes it far more complex to determine a company's pension obligation compared to measuring its debt.

The first step in computing a company's pension obligation entails estimating the stream of payments it will need to make to retirees. Accounting rules require companies to turn that long-term stream of payments into a lump sum using a "discount rate". An easy way to think about the discount rate is that it approximates the rate of return the company's pension fund could earn by investing in safe instruments like investment-grade debt.

The higher the discount rate, the lower a company's pension obligation will be, all else being equal. By contrast, as the discount rate declines, more and more capital would be needed up front to meet a given stream of payments based on the assumed low rate of return available.

While the discount rates used for corporate pension plans are not identical to interest rates, discount rates and interest rates do tend to move in the same direction. As a result, changes in interest rates can have a big impact on a company's pension funding situation.

Low interest rates will undo much of GE's hard work

During 2017, GE reduced its pension deficit from $31.1 billion to $28.7 billion, as strong investment returns and nearly $3 billion of pension contributions more than offset the impact of a roughly 0.5-percentage-point decrease in the discount rate. The pension deficit fell again in 2018. While investment returns were negative, a sharp increase in interest rates allowed General Electric to increase the discount rate by 0.7 percentage points. GE also contributed more than $6 billion to its pension plans, enabling it to reduce the underfunding to just $22.4 billion.

However, interest rates have plummeted over the past year. The U.S. benchmark 10-year interest rate rose from 2.4% at the beginning of 2018 to a peak above 3.2% last October before sliding to 2.7% at the end of 2018, 2% by mid-2019, and a low of just 1.5% earlier this month. The 10-year rate bounced back to 1.9% as of the end of last week. The 30-year rate started 2018 around 2.8%, peaked above 3.4% last fall, fell to around 3% by the beginning of 2019, and bottomed out below 2% a few weeks ago before recovering to 2.4%.

As things stand now, GE would have to reverse the discount rate increase it implemented last year and then some. Considering that every quarter-point change in the discount rate affects the company's projected benefit obligation by $2 billion or more, it shouldn't be surprising that the total impact could be $7 billion. That would put the pension deficit close to $30 billion again.

Two big reasons investors shouldn't be worried

While the expected $7 billion increase to GE's pension deficit may seem scary, there's no reason for investors to panic. First, interest rates have been extremely volatile recently, as described above. Just in the past two months, the 10-year rate has fallen from 2.1% to 1.5% and then bounced back to 1.9%. Interest rates could continue to rebound between now and year-end, in which case the final impact to GE's pension deficit would probably be less than $7 billion.

Second, the standard pension accounting rules vastly overstate the burden on the company -- particularly when interest rates are unusually low. A company's projected benefit obligation roughly measures the amount of money it would need to make its required pension payments if it invested in safe assets. However, only around 45% of GE's pension assets are invested in debt securities. The rest is split between stocks, real estate, and private equity investments, all of which should earn higher long-term returns.

As a result, GE expects to earn 6.75% a year over the long term, a rate of return that dramatically exceeds the discount rate it uses to measure its projected benefit obligation. If its pension plans actually earn that rate of return, General Electric will never have to contribute anything close to the amount of its reported pension deficit. In fact, while GE's main pension plan was only 80% funded last year under the GAAP rules used for its financial statements, it was 91% funded under the ERISA rules that determine contributions, because those rules assume a higher discount rate.

In short, while pension liabilities may seem like a huge problem for GE's finances, the big numbers being thrown around are ultra-conservative estimates that assume very low rates of return. If GE's pension investments produce decent returns over the next few decades, the pension deficit will shrink over time without General Electric having to contribute tens of billions of dollars.