Pension Accounting

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Pension Accounting

  1. 1. Pension Accounting and the Case of General Motors Monday September 11, 2006
  2. 2. By the end of today’s lecture, you should be able to: <ul><li>Provide overview of how pension accounting works, as well as its flaws </li></ul><ul><ul><li>ABO vs. PBO </li></ul></ul><ul><ul><li>Expected vs. actual returns </li></ul></ul><ul><li>Describe GM’s 2003 pension funding scheme in detail </li></ul><ul><ul><li>Debt issuance </li></ul></ul><ul><ul><li>How it created value (real, and accounting) </li></ul></ul>
  3. 3. Understanding Pension Accounting <ul><li>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 </li></ul><ul><li>The information reported on the face of the firm’s financial statements is often inadequate, and can even be misleading </li></ul><ul><li>One must “dig deeper” into supporting documentation </li></ul>
  4. 4. Relevant FASB Statements <ul><li>SFAS 87: Guides employers on how to account for pensions </li></ul><ul><li>SFAS 88: Accounting for “settlements and curtailments” of DB plans </li></ul><ul><li>SFAS 132: Retiree benefit note disclosures provide additional info to aid in analysis of retiree benefit plans </li></ul><ul><li>SFAS 106: Accounting for non-pension benefits to retirees (e.g., health care, life ins.) </li></ul>
  5. 5. A Few Caveats Upfront <ul><li>Assumptions and methods used for financial statement treatment of pensions often differs from those used for PBGC funding </li></ul><ul><li>Financial Accounting treatment also differs from tax treatment </li></ul><ul><ul><li>Tax treatment follows cash flows, financial accounting follows accruals </li></ul></ul>
  6. 6. Why Can Financial Statements be Misleading? <ul><li>In 1987, when FASB adopted current rules, it decided to: </li></ul><ul><ul><li>Ease the transition to the new rules </li></ul></ul><ul><ul><li>Reduce volatility of earnings arising from actual returns on plan assets </li></ul></ul><ul><ul><li>Ease the income statement impact from plan changes that granted future pension benefits based on past service </li></ul></ul><ul><li>Result: income statement costs and balance sheet balances are often disconnected from underlying economics </li></ul>
  7. 7. Measuring Pension Obligations <ul><li>Accumulated Pension Obligation (ABO): PV of amount of benefits earned to date, based on current salary levels </li></ul><ul><li>Projected Benefit Obligation (PBO): PV of amount of benefits earned to date, based on expected future salary levels that will determine the pension benefits </li></ul>
  8. 8. Which Measure to Use? <ul><li>Controversial </li></ul><ul><li>Balance sheet disclosures of unfunded pension obligations use ABO </li></ul><ul><li>Income statement measures are based on PBO </li></ul><ul><li>Lots of supplemental disclosure required </li></ul>
  9. 9. Income Treatment <ul><li>SFAS 87 Pension Expense (“Net Periodic Pension Cost”) </li></ul><ul><ul><li>= Service cost (PV of newly accrued benefits) </li></ul></ul><ul><ul><li>+ Interest cost on PBO (one year closer to payment) </li></ul></ul><ul><ul><li>- Expected return on plan assets </li></ul></ul><ul><ul><li>+/- Amortization of prior service cost (change in liability due to plan amendments amortized over future work life) </li></ul></ul><ul><ul><li>+/- Amortization of gains or losses (other amortized gains/losses, incl. difference between expected and actual returns) </li></ul></ul>
  10. 10. Controversy: Expected Returns <ul><li>FASB allows corporations to use an expected rate of return on plan assets rather than the actual return when computing the annual benefit cost </li></ul><ul><ul><li>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 </li></ul></ul><ul><li>Provides misleading view of actual change in economic value of net liability </li></ul>
  11. 11. Controversy: Asset Smoothing <ul><li>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 </li></ul><ul><li>After stock market decline, assets used in calculation are overstated, thus further overstating income from asset returns </li></ul>
  12. 12. Increased Disclosure Requirements <ul><li>Because balance sheets and income statements are confusing (misleading?), in 2003, SFAS 132 was revised to expand disclosures </li></ul><ul><ul><li>General description of plans, changes arising from acquisitions/divestitures, effect of plan amendments, and dates on which assets and liabilities were measured </li></ul></ul><ul><ul><li>Table reconciling beginning and ending balances of for projected benefit obligations (for DB plans) </li></ul></ul><ul><ul><li>Changes in plan assets (including actual returns, contributions, benefits paid, etc.) </li></ul></ul><ul><ul><li>Lots of other details on ABOs, underlying assumptions, plan assets by asset class, etc. </li></ul></ul>
  13. 13. FASB Status <ul><li>New rules proposed March 31, 2006 </li></ul><ul><ul><li>Would require that companies list the funding status of their pension and retiree benefit plans on their balance sheet as an asset or liability. </li></ul></ul><ul><ul><ul><li>Would apply to both public and private companies, as well as not-for-profits </li></ul></ul></ul><ul><ul><ul><li>Would have to value pension assets on same day that they measure other corporate obligations </li></ul></ul></ul><ul><li>More rules to come “such as whether companies can rely on current investment performance expectation when gauging ability to meet obligations.” </li></ul><ul><ul><ul><ul><ul><li>“ Pension Trouble Ahead” by Donna Block in Daily Deal 4/3/06 </li></ul></ul></ul></ul></ul>
  14. 14. G.M: Overview of the Company <ul><li>Industries </li></ul><ul><ul><li>Autos (Buick, Cadillac, Chevrolet, Hummer, Saturn) </li></ul></ul><ul><ul><li>Hughes Electronics </li></ul></ul><ul><ul><li>Finance & Insurance </li></ul></ul><ul><li>Employees: </li></ul><ul><ul><li>326,000 globally </li></ul></ul><ul><li>Financial Status (2002) </li></ul><ul><ul><li>Net Sales: $177 billion </li></ul></ul><ul><ul><li>Net income: $1.8 billion </li></ul></ul><ul><ul><li>Assets (book): $369 billion </li></ul></ul><ul><ul><li>Liabilities: $362 billion </li></ul></ul><ul><ul><li>Market capitalization: $21 billion </li></ul></ul>
  15. 15. GM’s DB Pension Plans <ul><li>“ Hourly Pension Plan” </li></ul><ul><ul><li>Adopted in 1950 </li></ul></ul><ul><ul><li>In 2002 paid $6.4 billion to 340,000 beneficiaries </li></ul></ul><ul><li>“ Salaried Retirement Program” </li></ul><ul><ul><li>Also adopted in 1950 </li></ul></ul><ul><ul><li>In 2002 paid $2.1 billion to 117,000 beneficaries </li></ul></ul>
  16. 16. Financial Status of GM Pensions <ul><li>2002 plan assets: $60.9 billion </li></ul><ul><li>2002 PBO: $80.1 billion </li></ul><ul><li>Net Funding -$19.3 billion </li></ul><ul><li>Percent Funded 76% </li></ul>
  17. 17. What Caused It? <ul><li>Perfect Storm </li></ul><ul><ul><li>Interest rates fell (exhibit 9) </li></ul></ul><ul><ul><li>Stock market fell </li></ul></ul><ul><ul><ul><li>Fair value of plan assets </li></ul></ul></ul><ul><ul><ul><ul><li>$80.5 billion in 1999 </li></ul></ul></ul></ul><ul><ul><ul><ul><li>$60.9 billion in 2002 </li></ul></ul></ul></ul><ul><li>“Mature” pension plan </li></ul><ul><ul><li>2.5 retirees per worker at GM </li></ul></ul>
  18. 18. Funding Status in Perspective <ul><li>Underfunded pension obligation is: </li></ul><ul><ul><li> General Motor’s market capitalization! </li></ul></ul><ul><ul><li>> G.M.’s long-term debt </li></ul></ul><ul><li>Who bears the financial burden of the pension underfunding? </li></ul><ul><ul><li>Shareholders </li></ul></ul><ul><ul><li>Unfunded pension obligation is > book value of shareholder equity ($19 billion vs. $6.8 billion) </li></ul></ul>
  19. 19. What Are G.M.’s Funding Options? <ul><li>Finance out of cash flows from operations </li></ul><ul><ul><li>Would require giving up dividends and/or investments </li></ul></ul><ul><ul><ul><li>Dividends = $1.1 billion per year </li></ul></ul></ul><ul><ul><ul><li>Investment = $6.8 billion per year </li></ul></ul></ul><ul><ul><ul><ul><li>Highly competitive business environment! </li></ul></ul></ul></ul><ul><li>Issue equity </li></ul><ul><ul><li>Would have to issue amount roughly equal to current market cap! </li></ul></ul><ul><ul><li>Not tax efficient </li></ul></ul><ul><li>Issue debt </li></ul>
  20. 20. G.M.’s Debt Issuance <ul><li>$9.2 billion in GM debt </li></ul><ul><li>$4 billion in convertibles </li></ul><ul><li>Yield on 10 year note = 7.22% </li></ul><ul><ul><li>3.75 above treasury </li></ul></ul><ul><ul><li>0.25 less than expected </li></ul></ul><ul><li>This $13.2 billion used for pension fund </li></ul><ul><li>Another $4.5 billion in short term debt for general corporate use (not for pensions) </li></ul>
  21. 21. Issuing Debt to Fund Pension <ul><li>Winners? </li></ul><ul><ul><li>Shareholders </li></ul></ul><ul><ul><ul><li>Gain present value of the tax shield </li></ul></ul></ul><ul><ul><ul><ul><li>= 35%*(r*Debt) / r </li></ul></ul></ul></ul><ul><ul><ul><ul><li>= $4.62 billion </li></ul></ul></ul></ul><ul><ul><ul><li>Cash flows freed for investment, etc. </li></ul></ul></ul><ul><ul><li>Pensioners – benefits now funded </li></ul></ul><ul><li>Losers? </li></ul><ul><ul><li>Shareholders give up option to default </li></ul></ul><ul><ul><li>Existing bondholders  big increase in leverage </li></ul></ul>
  22. 22. Effect on Accounting Measures <ul><li>G.M. issues $13.2 billion in debt and places proceeds in pension </li></ul><ul><ul><li>Must pay approx. 7.22% on the debt </li></ul></ul><ul><ul><li>=$950 million in interest expense </li></ul></ul><ul><li>Takes credit for expected return on pension assets of 9% = $1,188 mil. </li></ul><ul><li>Difference = $238 million in “income” to reduce net periodic pension cost </li></ul>
  23. 23. Pension Fund Investments <ul><li>Fiduciary relationship – when one party holds and administers money on behalf of another party </li></ul><ul><ul><li>Covers the employer, the plan administrator, and the trustees of the plan </li></ul></ul><ul><ul><li>Fiduciary rules governing pensions are designed to protect workers, not to make life easy on plan administrators! </li></ul></ul><ul><ul><li>At least one fiduciary must be named. Note that actuaries, attorneys, consultants, etc, are typically not considered fiduciaries </li></ul></ul>
  24. 24. Fiduciary Responsibilities (under ERISA) <ul><li>Operate plan solely in interest of participants and beneficiaries </li></ul><ul><li>Act with the care, skill, prudence and diligence … that a “prudent man” would. Must consider </li></ul><ul><ul><li>Diversification (DB max of 10% in Co Stk) </li></ul></ul><ul><ul><li>Liquidity & current return relative to cash flow needs </li></ul></ul><ul><ul><li>Projected returns relative to funding objectives </li></ul></ul><ul><li>Diversify the investments to minimize the risk of large losses </li></ul><ul><li>Follow provisions of plan documents (unless inconsistent with ERISA) </li></ul>
  25. 25. Interest of Participants <ul><li>Pension plan participants should want pension fund to be fully funded at all times </li></ul><ul><ul><li>Sufficient assets on hand </li></ul></ul><ul><ul><li>Sufficient contributions as needed </li></ul></ul><ul><ul><li>Low risk: minimize mismatch between assets and liabilities </li></ul></ul><ul><li>How minimize the mismatch? </li></ul><ul><ul><li>Invest in bonds or stocks? </li></ul></ul>
  26. 26. Why Do Firms Use Equity? <ul><li>Do “stocks beat bonds in the long run”? </li></ul><ul><ul><li>Historically, stocks have beaten bonds over every 30 year holding period in US over past century – the “equity premium” </li></ul></ul><ul><ul><li>But, may not be true going forward </li></ul></ul><ul><ul><ul><li>May have been lucky draw? </li></ul></ul></ul><ul><ul><ul><li>Smaller equity premium going forward? </li></ul></ul></ul><ul><li>Used to “justify” higher expected return (which allows lower pension expense) </li></ul>
  27. 27. Boots Pension Plan <ul><li>A leading retail chain in UK and Ireland </li></ul><ul><li>2.3 billion pound assets in pension plan </li></ul><ul><li>Investment strategy was approximately 75% equity, 17% bonds, 4% real estate, 4% cash </li></ul><ul><li>In 2002, pension trustees and the firm decided to move 100% of assets into passively managed bond portfolio </li></ul><ul><ul><li>Partially also motivated by tax considerations </li></ul></ul>
  28. 28. Article Handed Out Last Time <ul><li>International Paper </li></ul><ul><ul><li>If invest pension assets in bonds, then they move the same way liabilities do as interest rates change </li></ul></ul><ul><ul><li>Need bond and liability duration to match </li></ul></ul><ul><ul><li>Alternative: use interest rate swaps </li></ul></ul><ul><ul><ul><li>Idea is the same. Use financial instruments to hedge against the interest rate risk </li></ul></ul></ul>
  29. 29. G.M.s Investment Strategy <ul><li>General Motors Asset Management (GMAM) </li></ul><ul><ul><li>Manages GM pensions and insurance portfolios </li></ul></ul><ul><ul><li>$140 billion in assets under management </li></ul></ul><ul><li>Active vs. passive management </li></ul><ul><ul><li>100% active </li></ul></ul><ul><li>“Alpha strategies” </li></ul><ul><ul><li>Trying to beat the market </li></ul></ul><ul><ul><li>Can it be done on risk-adjusted basis? </li></ul></ul>
  30. 30. Financial Times, December 15, 2003
  31. 31. The Wall Street Journal, December 10, 2003
  32. 32. GM “Alpha” <ul><li>Private equity </li></ul><ul><li>“Global tactical asset allocation” </li></ul><ul><li>Real estate </li></ul><ul><li>Hedge funds </li></ul><ul><li>High yield bonds </li></ul><ul><li>Small cap stocks </li></ul><ul><li>Now 35% instead of 15% of portfolio </li></ul>
  33. 33. GM Today <ul><li>Pension funds now considered funded </li></ul><ul><ul><li>No contributions made in 2004 </li></ul></ul><ul><ul><li>“ Has likely met pension obligations through the end of the decade” </li></ul></ul><ul><ul><ul><li>Good news for pensioners </li></ul></ul></ul><ul><li>But asset portfolio risk has increased </li></ul><ul><ul><li>Bad for pensioners if things go sour </li></ul></ul><ul><li>GM’s debt downgraded to “junk” status in Spring 2005 </li></ul>
  34. 34. GM Health Care <ul><li>GM expected to spend $5.6 billion in health care costs in 2005 for 1.1 million people. </li></ul><ul><ul><li>Up from $3.9 billion in 2001 to cover 1.2 million </li></ul></ul><ul><ul><li>Estimates of $2000 per car </li></ul></ul><ul><ul><li>Rising at >10% per year </li></ul></ul><ul><li>No requirement that they pre-fund health care costs, but they have begun to </li></ul><ul><ul><li>Have trust fund of $20 billion </li></ul></ul><ul><ul><li>But present value of future health obligations is now on the order of $80 billion! </li></ul></ul><ul><ul><li>If GM were to go bankrupt, no legal obligation to pay health care </li></ul></ul>
  35. 35. Has GM been a good investment? <ul><li>Current price = $33.23 </li></ul><ul><ul><li>Up substantially in 2006 </li></ul></ul><ul><ul><li>But still down vs. history </li></ul></ul><ul><ul><li>See price chart … </li></ul></ul><ul><li>Current market cap = $18.8 billion </li></ul><ul><li>Earnings per share = -19.91 </li></ul>

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