This past week General Motors (NYSE:GM) took on $13 billion in debt in a giant offering. Seems like a pretty good thing to do, what with interest rates as low as they are. Several companies have done the smart thing over the last year by replacing their older high-cost debt with notes prices at today's prevailing rates. To no small extent, that's the kind of activity the Federal Reserve is seeking to promote with ever lower federal funds rates. Companies borrow more, or manage to lower their interest payments, they spend some of the proceeds on capital projects, which require staffing, and around and around we go.
GM's debt offering, on the other hand, is largely earmarked for a completely different purpose -- more than $10 billion of the new debt will be used to shore up its dramatically underfunded employee pension plan. Just how underfunded is it? According to a comprehensive study by UBS (NYSE:UBS), GM had a $25 billion deficit at year-end 2002. Just this past week, Moody's (NYSE:MCO) lowered its debt ratings on GM due, in part, to its pension liabilities.
There are a few crazy things about this. First, due to the vagaries of Generally Accepted Accounting Practices in the U.S., this massive liability doesn't show up on GM's consolidated balance sheet. Further, the nearly $10 billion in losses GM's pension suffered in the last two years are reflected nowhere in the company's income statement, replaced instead by a number that represented what was expected to happen based upon assumptions drawn up by GM itself. To mark the absurdity of this treatment, consider this: According to GAAP, GM got to report an expected gain on its pension in 2002 of $7.1 billion, even though its actual return on assets was a negative $4.9 billion. Big difference.
GM is sort of the worst case scenario of pensions, but its funding problems and its solutions are instructive to investors in any company with a pension fund. It ought to also serve as a warning. The company you hold, or the one you are analyzing, may have an enormous pension liability that you cannot see on the balance sheet or income statement, but is instead buried in the footnotes. As I'll show with GM, none of the options for fixing a dramatic underfunding are very palatable to investors. Strangely enough with GM, though, investors seem not to have noticed. Yet.
Combine the 360 companies among the S&P 500 that have pensions. The total deficit approaches $239 billion as of the end of May 2003, an increase of more than 12.7% from just five months prior. This in the midst of a fairly substantial equity rally, which -- one would think -- would increase the value of the pension fund portfolios. It hasn't worked that way, because low interest rates have the effect of increasing liabilities in pension funds. So the last two years have been a nightmare for pension managers -- rapidly decreasing asset values and spiraling liabilities.
Pensions are a funny thing. Companies don't really know how much they're going to be paying, or whom, or even for how long. So that $239 billion in total liability may very well disappear well before much of it needs to be paid out as market conditions improve. A great deal of this is guesswork. What is not guesswork is that a large portion of the obligations (or even an amount larger than the actuarial assumptions) will at some point have to be paid. If companies' pensions lack the assets to do so, they get to come up with the money from someplace else. Like shareholder's equity, for example. What's scary is that this risk is quite obscured from shareholders. See that line item on the balance sheet "pension shortfall?" No? That's because it doesn't exist.
Behavioral finance by the billions
Statutes on funding don't really let companies cut it that close. GM, for example, could have ridden out the shortfall and taken a gamble that its asset values would eventually rebound. Instead, they took on debt. This choice (and the company's justification thereof) offers a creepy view into just how beholden to accounting appearances companies are. It's going to cost their shareholders, big time.
When GM issues this $13 billion in debt, it is committing to repay this amount in the future, along with semi-annual coupon payments (interest) in the range of 6.5% - 7%. Companies, as I stated at the outset, generally take on debt for capital projects. GM, on the other hand, is sending most of this money down the rat hole that is its pension program. What GM is doing is taking a leveraged bet on the direction of the stock market, as well as on interest rates.
GM is effectively playing the market on margin. Don't believe me? GM's CFO Robert Devine called the new debt "somewhat accretive" to earnings. How can this be? Remember, earnings on pensions are reported based not on performance, but on estimates. GM just lowered its estimated gains on pension assets from 10% per annum down to 9%. So there's a spread between the 9% gain on pension assets and the 7% cost of the money used to fund it. There's one problem -- that 9% isn't real, it's a guess. It's also a wildly aggressive one, the equivalent of GM thinking it can generate 12-13% gains on its stock portfolio every year. That's fantasy.
There are plenty of other ways GM could have gone. It could have cut its 5.6% dividend yield and funneled some of that money into the pension system. It could have issued more shares, though this is generally more expensive than debt at issuance, and further GM shares don't exactly trade at a premium. It could have dropped further its assumed rate of return to a more reasonable level, but that would have come at an enormous cost to reported earnings. It could have done a combination of these things. Instead the company went all debt.
The upshot is this: Let's just say that GM does manage to earn 9% per year on its pension assets over the next 30 years -- a Herculean task. It still will have been paying interest on the debt it raised -- an after-tax rate of 4-5%. In such a case, this will have been a good move. But what if stocks tank once again (due in no small part to -- ahem! -- earnings quality problems from obscured pension shortfalls)? GM's got a new boatload of debt, and it still has big pension problems.
I'm not sure that there is a good solution for GM. Its collapsing pension shows the danger of actuarial assumptions that are set too high. When a company demands 10% return per year, bonds and treasuries simply are not good enough, even if they are the most prudent. Worse, the GM exercise shows what a sham current pension accounting and reporting standards are -- the Federal Accounting Standards Board (FASB) backed away from more substantive, descriptive requirements 16 years ago under pressure from political elements concerned that its proposed changes would make earnings appear too volatile.
Well, great, those earnings are smooth. They're also fiction. Great solution. Individual investors had better have a grip on the pension risks at companies they own, lest they be in for a nasty surprise. For regardless of whether or not pension liabilities appear on the balance sheet, they will eventually need to be paid.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
OK, Yankees, get this straight. "Barbecue" is a noun. Bill Mann owns none of the companies mentioned in this article. GM, however, is featured in "The Motley Fool Stock Advisor" as a stock to avoid. Given the above, we cannot for the life of us figure out why. The Motley Fool is investors writing for other investors.
