As an investor, you should always worry when you don't know what you don't know. It's that irritating feeling that you forgot something, missed a detail, or don't fully understand a concept.
What if I told you that Ford Motor Company (NYSE:F) and General Motors (NYSE:GM) have both taken steps to improve their balance sheets, but that there is one obligation they both have that is overlooked by many investors and represents billions of dollars?
Well, it's true. Ford and GM's obligations go beyond their automotive debt. Many individual investors don't realize that the two largest Detroit automakers are taking two different stances on their pension funds; the difference is big, and the implications are even bigger.
How it works
Many large industrial companies have defined benefit plans (though that's a dying trend these days), which promise to pay retirees based on factors that include the length of their service and their salary at the time of retirement. The employer bears the risk of maintaining enough capital over time, and must estimate how much capital is required to pay out its employees' pensions. The difference between what capital the employer has stashed away in its pension fund and what its total projected pension benefit obligation (PBO) requires is its "underfunded/surplus status."
Now, there are multiple ways to become fully funded. The company could simply dump billions in cash into the fund. Or the company could wait for discount rates to rise -- as discount rates rise, the projected return value of plan assets rise accordingly, and the PBO will decline. A company can also offer lump-sum buyouts to its retirees, which, if accepted, remove that amount from the company obligation total and push the risk on the individual to maintain the lump sum of cash throughout retirement; it's beneficial to the company, because if discount rates drop, it has less PBO on its books to increase. Lastly, as the company has a lump sum of plan assets, it can invest these assets and try to turn a profit, much as investors do, which can help increase plan assets.
For those of you visual learners like me, here's a simple graphic from Investopedia.
A rule of thumb is that large companies want to be about 90% funded at any given time, if not fully funded. The equation is simple:
At the end of 2014, Ford had a global pension obligation of $79.54 billion and a fair value of plan assets of $70.5 billion. That means Ford's global pension plan is 89% funded, right about where you want it to be. GM, on the other hand, is a different story. Its global pension obligation was $104.62 billion at the end of 2014, with a fair value of plan assets at $80.49 billion -- a less healthy 77% funded status.
So how have Ford's and GM's strategies differed when it comes to their underfunded pension plans? And how does the difference impact shareholder value? Let's dig in.
Why it matters
The unsung hero behind Ford's much higher funded status when compared to GM was the former's willingness to dump billions of dollars into its pension funds. Starting in 2011, Ford has so far contributed $1.1 billion, $3.4 billion, $5.0 billion, and $1.9 billion annually. Looking at the graph below, over the last two years Ford's return on pension assets and voluntary contributions to the fund enabled its PBO to remain flat as discount rates declined. GM didn't follow the same playbook, causing a significant increase in its PBO from 2013 to 2014.
If you're asking why all of this matters, consider the following factors.
Ford is now able to wind down its pension contributions significantly, while GM will be forced to contribute more capital down the line. It also means that with lowered obligations Ford will be able to maintain or improve its credit rating, which decreases the borrowing cost of capital. It also means that Ford will free up cash flow to be spent differently; that $11.4 billion Ford poured into its pension fund between 2011 and 2014 could be spent in the future on increasing dividends, share buyback programs, more product development for future sales growth, or some combination of the three.
Let me preface my opinion by saying General Motors is healthier than it's been in a long time, with a huge $22 billion pile of cash and marketable securities. GM also has about $4 billion less in automotive debt than Ford as of the first quarter 2015. Despite GM being much healthier these days, I think its approach is short-sighted -- it's using $5 billion to repurchase shares instead of adding capital to its pension fund. Ford, on the other hand, is taking a long-term approach that will reward patient investors with a more stable business and improved balance sheet, preparing it to handle any economic downturn.
Seeing the differences in how the crosstown rivals approached this topic, is it shocking that Ford was the only Detroit automaker to avoid bankruptcy during the great recession? I think not, and this is one more reason to have confidence in Ford over the long haul.
Daniel Miller owns shares of Ford and General Motors. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.