Under new CEO Larry Culp, General Electric (GE 1.12%) has moved aggressively over the past year to reduce its debt load. It has made substantial progress, but the company's massive pension liabilities have remained a major headache. Low interest rates are the primary culprit. Last month, Culp warned that despite strong investment returns for GE's pension plan assets, falling interest rates would cause the company's pension deficit to widen by about $7 billion in 2019.

On Monday, GE announced a radical move to mitigate its soaring pension liabilities. The company will freeze its pension plans for certain U.S. employees at the end of 2020. Together with its decision to contribute up to $5 billion to its pension plan and offer lump-sum payments to some former employees, this should significantly improve GE's pension funding and reduce its net debt.

What General Electric is doing

The biggest change coming is that GE will freeze the pension benefits of 20,000 current salaried employees. It will also freeze its supplementary pension plan for 700 high-paid executives. Both moves will go into effect on Jan. 1, 2021. The affected employees will still keep all of the benefits they have earned (plus whatever they accrue between now and the end of next year). However, they will not be able to accrue any additional pension benefits in 2021 and beyond.

Instead, the salaried employees will be enrolled in a typical 401(k) program. GE will contribute 3% of eligible compensation to each employee's 401(k) plan each year and will offer a 50% match for contributions up to 8% of an employee's compensation. For the first two years after the change, GE will make an additional 2% contribution in a bid to mollify employees who may be upset about the pension plan being frozen.

A GE gas turbine.

GE is freezing some employees' pension benefits at the end of 2020. Image source: General Electric.

For executives whose retirement benefits exceed IRS limits on 401(k) plans, GE will provide an alternative retirement scheme to replace the supplementary pension plan that is being frozen.

GE also intends to reduce its pension benefit obligation by offering approximately 100,000 former employees who have not yet begun drawing benefits a limited-time option to receive a lump-sum settlement instead. The lump sum would be paid in December from the pension plan's assets.

Finally, General Electric said that it will make a $4 billion to $5 billion contribution to its pension plan later this year, using the proceeds from its 2019 asset sales. This will pre-fund most or all of its required contributions for 2021 and 2022.

How this will help GE

By freezing its pension plans, GE will reduce its pension benefit obligation, because it will no longer have to factor in future salary increases -- which impact pension payouts -- in determining the payments to be made. The lump-sum offer will also reduce GE's pension benefit obligation, albeit at the expense of using existing pension assets. (As a result, it won't help to fix the pension plan's current underfunding problem.) The planned pre-funding contribution will offset the drawdown of assets related to the lump-sum offer.

In tandem, these moves will reduce General Electric's pension deficit by between $5 billion and $8 billion, more or less offsetting the expected headwind from lower interest rates. These moves will also reduce industrial net debt by $4 billion to $6 billion.

Another move on the road back to health

Entering 2019, GE's pension and other postretirement plans were underfunded by about $27 billion. This pension deficit now represents a substantial proportion of the company's industrial net debt, and falling interest rates were set to send this liability soaring past $30 billion by year-end.

This pension deficit was never as scary as it looked, as the amount GE needs to contribute over time could be substantially lower if the pension fund's investments perform well. Nevertheless, the volatility of GE's pension deficit has complicated the company's leverage-reduction efforts. The actions that General Electric announced this week will both reduce the company's pension deficit and net debt in the short term and mitigate the volatility of its pension deficit going forward.

General Electric's asset sales are also making a big dent in its debt load. Moreover, the core business is starting to improve, as evidenced by the company raising its 2019 earnings forecast a few months ago. Some of GE's turnaround initiatives have been painful, but at least they seem to be putting the company on a sustainable footing.