Pension Accounting and the Case of General Motors

1. Pension Accounting and the Case of General Motors Thursday, September 6, 2007

2. By the end of today’s lecture, you should be able to: • Provide overview of how pension accounting works, as well as its flaws • ABO vs. PBO • Expected vs. actual returns • Describe GM’s 2003 pension funding scheme in detail • Debt issuance • How it created value (real, and accounting)

3. Understanding Pension Accounting • It is important for analysts, investors, plan participants, and other stakeholders to be able to determine how a company’s pension affects the financial status of the firm • The information reported on the face of the firm’s financial statements is often inadequate, and can even be misleading • One must “dig deeper” into supporting documentation

4. Relevant FASB Statements • SFAS 87: Guides employers on how to account for pensions • SFAS 88: Accounting for “settlements and curtailments” of DB plans • SFAS 132: Retiree benefit note disclosures provide additional info to aid in analysis of retiree benefit plans • SFAS 106: Accounting for non-pension benefits to retirees (e.g., health care, life ins.)

5. A Few Caveats Upfront • Assumptions and methods used for financial statement treatment of pensions often differs from those used for PBGC funding • Financial Accounting treatment also differs from tax treatment • Tax treatment follows cash flows, financial accounting follows accruals

6. Why Can Financial Statements be Misleading? • In 1987, when FASB adopted current rules, it decided to: • Ease the transition to the new rules • Reduce volatility of earnings arising from actual returns on plan assets • Ease the income statement impact from plan changes that granted future pension benefits based on past service • Result: income statement costs and balance sheet balances are often disconnected from underlying economics

7. Measuring Pension Obligations • Accumulated Pension Obligation (ABO): PV of amount of benefits earned to date, based on current salary levels • Projected Benefit Obligation (PBO): PV of amount of benefits earned to date, based on expected future salary levels that will determine the pension benefits

8. Which Measure to Use? • Controversial • Balance sheet disclosures of unfunded pension obligations use ABO • Income statement measures are based on PBO • Lots of supplemental disclosure required

9. Income Treatment • SFAS 87 Pension Expense (“Net Periodic Pension Cost”) • = Service cost (PV of newly accrued benefits) • + Interest cost on PBO (one year closer to payment) • - Expected return on plan assets • +/- Amortization of prior service cost (change in liability due to plan amendments amortized over future work life) • +/- Amortization of gains or losses (other amortized gains/losses, incl. difference between expected and actual returns)

10. Controversy: Expected Returns • FASB allows corporations to use an expected rate of return on plan assets rather than the actual return when computing the annual benefit cost • Ex: Even if company experiences a negative rate of return on plan assets, it can still report an 9% return on plan assets for that year • Provides misleading view of actual change in economic value of net liability

11. Controversy: Asset Smoothing • Rather than using the current fair market value of assets, firms are allowed to apply the expected rate of return to a trailing five-year smoothed fair value of plan assets • After stock market decline, assets used in calculation are overstated, thus further overstating income from asset returns

12. Increased Disclosure Requirements • Because balance sheets and income statements are confusing (misleading?), in 2003, SFAS 132 was revised to expand disclosures • General description of plans, changes arising from acquisitions/divestitures, effect of plan amendments, and dates on which assets and liabilities were measured • Table reconciling beginning and ending balances of for projected benefit obligations (for DB plans) • Changes in plan assets (including actual returns, contributions, benefits paid, etc.) • Lots of other details on ABOs, underlying assumptions, plan assets by asset class, etc.

13. FASB Status • New rules proposed March 31, 2006 • Would require that companies list the funding status of their pension and retiree benefit plans on their balance sheet as an asset or liability. • Would apply to both public and private companies, as well as not-for-profits • Would have to value pension assets on same day that they measure other corporate obligations • More rules to come “such as whether companies can rely on current investment performance expectation when gauging ability to meet obligations.” • “Pension Trouble Ahead” by Donna Block in Daily Deal 4/3/06

14. G.M: Overview of the Company • Industries • Autos (Buick, Cadillac, Chevrolet, Hummer, Saturn) • Hughes Electronics • Finance & Insurance • Employees: • 326,000 globally • Financial Status (2002) • Net Sales: $177 billion • Net income: $1.8 billion • Assets (book): $369 billion • Liabilities: $362 billion • Market capitalization: $21 billion

15. GM’s DB Pension Plans • “Hourly Pension Plan” • Adopted in 1950 • In 2002 paid $6.4 billion to 340,000 beneficiaries • “Salaried Retirement Program” • Also adopted in 1950 • In 2002 paid $2.1 billion to 117,000 beneficaries

16. Financial Status of GM Pensions • 2002 plan assets: $60.9 billion • 2002 PBO: $80.1 billion • Net Funding -$19.3 billion • Percent Funded 76%

17. What Caused It? • Perfect Storm • Interest rates fell (exhibit 9) • Stock market fell • Fair value of plan assets • $80.5 billion in 1999 • $60.9 billion in 2002 • “Mature” pension plan • 2.5 retirees per worker at GM

18. Funding Status in Perspective • Underfunded pension obligation is: •  General Motor’s market capitalization! • > G.M.’s long-term debt • Who bears the financial burden of the pension underfunding? • Shareholders • Unfunded pension obligation is > book value of shareholder equity ($19 billion vs. $6.8 billion)

19. What Are G.M.’s Funding Options? • Finance out of cash flows from operations • Would require giving up dividends and/or investments • Dividends = $1.1 billion per year • Investment = $6.8 billion per year • Highly competitive business environment! • Issue equity • Would have to issue amount roughly equal to current market cap! • Not tax efficient • Issue debt

20. G.M.’s Debt Issuance • $9.2 billion in GM debt • $4 billion in convertibles • Yield on 10 year note = 7.22% • 3.75 above treasury • 0.25 less than expected • This $13.2 billion used for pension fund • Another $4.5 billion in short term debt for general corporate use (not for pensions)

21. Issuing Debt to Fund Pension • Winners? • Shareholders • Gain present value of the tax shield = 35%*(r*Debt) / r = $4.62 billion • Cash flows freed for investment, etc. • Pensioners – benefits now funded • Losers? • Shareholders give up option to default • Existing bondholders  big increase in leverage

22. Effect on Accounting Measures • G.M. issues $13.2 billion in debt and places proceeds in pension • Must pay approx. 7.22% on the debt • =$950 million in interest expense • Takes credit for expected return on pension assets of 9% = $1,188 mil. • Difference = $238 million in “income” to reduce net periodic pension cost

23. Pension Fund Investments • Fiduciary relationship – when one party holds and administers money on behalf of another party • Covers the employer, the plan administrator, and the trustees of the plan • Fiduciary rules governing pensions are designed to protect workers, not to make life easy on plan administrators! • At least one fiduciary must be named. Note that actuaries, attorneys, consultants, etc, are typically not considered fiduciaries

24. Fiduciary Responsibilities(under ERISA) • Operate plan solely in interest of participants and beneficiaries • Act with the care, skill, prudence and diligence … that a “prudent man” would. Must consider • Diversification (DB max of 10% in Co Stk) • Liquidity & current return relative to cash flow needs • Projected returns relative to funding objectives • Diversify the investments to minimize the risk of large losses • Follow provisions of plan documents (unless inconsistent with ERISA)

25. Interest of Participants • Pension plan participants should want pension fund to be fully funded at all times • Sufficient assets on hand • Sufficient contributions as needed • Low risk: minimize mismatch between assets and liabilities • How minimize the mismatch? • Invest in bonds or stocks?

26. Why Do Firms Use Equity? • Do “stocks beat bonds in the long run”? • Historically, stocks have beaten bonds over every 30 year holding period in US over past century – the “equity premium” • But, may not be true going forward • May have been lucky draw? • Smaller equity premium going forward? • Used to “justify” higher expected return (which allows lower pension expense)

27. Boots Pension Plan • A leading retail chain in UK and Ireland • 2.3 billion pound assets in pension plan • Investment strategy was approximately 75% equity, 17% bonds, 4% real estate, 4% cash • In 2002, pension trustees and the firm decided to move 100% of assets into passively managed bond portfolio • Partially also motivated by tax considerations

29. G.M.s Investment Strategy • General Motors Asset Management (GMAM) • Manages GM pensions and insurance portfolios • $140 billion in assets under management • Active vs. passive management • 100% active • “Alpha strategies” • Trying to beat the market • Can it be done on risk-adjusted basis?

30. Financial Times, December 15, 2003

31. The Wall Street Journal, December 10, 2003

32. GM “Alpha” • Private equity • “Global tactical asset allocation” • Real estate • Hedge funds • High yield bonds • Small cap stocks • Now 35% instead of 15% of portfolio

33. GM Today • Pension funds now considered funded • No contributions made in 2004 • “Has likely met pension obligations through the end of the decade” • Good news for pensioners • But asset portfolio risk has increased • Bad for pensioners if things go sour • GM’s debt downgraded to “junk” status in Spring 2005

34. GM Health Care • GM expected to spend $5.6 billion in health care costs in 2005 for 1.1 million people. • Up from $3.9 billion in 2001 to cover 1.2 million • Estimates of $2000 per car • Rising at >10% per year • No requirement that they pre-fund health care costs, but they have begun to • Have trust fund of $20 billion • But present value of future health obligations is now on the order of $80 billion! • If GM were to go bankrupt, no legal obligation to pay health care

35. Has GM been a good investment? • Current price = $33.23 • Up substantially in 2006 • But still down vs. history • See price chart … • Current market cap = $18.8 billion • Earnings per share = -19.91