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Pension Accounting and the Case of General Motors


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  • 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 became 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. G.M: Overview of the Company
    • Industries
    • Employees:
    • Financial Status (2002)
      • Net Sales:
      • Net income:
      • Assets (book):
      • Liabilities:
      • Market capitalization:
  • 14. GM’s DB Pension Plans
  • 15. Financial Status of GM Pensions
    • 2002 plan assets:
    • 2002 PBO:
    • Net Funding
    • Percent Funded
  • 16. What Caused It?
  • 17. Funding Status in Perspective
    • Underfunded pension obligation is:
    • Who bears the financial burden of the pension underfunding?
  • 18. What Are G.M.’s Funding Options?
  • 19. G.M.’s Debt Issuance
  • 20. Issuing Debt to Fund Pension
    • Winners?
    • Losers?
  • 21. Effect on Accounting Measures
  • 22. 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
  • 23. 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)
  • 24. 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?
  • 25. Why Do Firms Use Equity?
    • “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?
    • Justifies higher expected return (which allows lower pension expense)
  • 26. 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
  • 27. G.M.s Investment Strategy
    • General Motors Asset Management (GMAM)
      • Manages GM pensions and insurance portfolios
      • $____ billion in assets under management
    • Active vs. passive management
    • “ Alpha strategies”
  • 28. Financial Times, December 15, 2003
  • 29. The Wall Street Journal, December 10, 2003
  • 30. GM “Alpha”
  • 31. GM Today
  • 32. GM Health Care