Pension Accounting and the Case of General Motors

Thursday September 6, 2007

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. PBOExpected vs. actual returns

Describe GM’s 2003 pension funding scheme in detail

Debt issuanceHow it created value (real, and accounting)

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 firmThe information reported on the face of the firm’s financial statements is often inadequate, and can even be misleadingOne must “dig deeper” into supporting documentation

Relevant FASB Statements

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

A Few Caveats Upfront

Assumptions and methods used for financial statement treatment of pensions often differs from those used for PBGC fundingFinancial Accounting treatment also differs from tax treatment

Tax treatment follows cash flows, financial accounting follows accruals

Why Can Financial Statements be Misleading?

In 1987, when FASB adopted current rules, it decided to:

Ease the transition to the new rulesReduce volatility of earnings arising from actual returns on plan assetsEase 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

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

Which Measure to Use?

ControversialBalance sheet disclosures of unfunded pension obligations use ABOIncome statement measures are based on PBOLots of supplemental disclosure required

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)

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

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 assetsAfter stock market decline, assets used in calculation are overstated, thus further overstating income from asset returns

Increased Disclosure RequirementsBecause 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 measuredTable 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.

G.M: Overview of the CompanyIndustries

Employees:

Financial Status (2002)Net Sales:Net income:Assets (book):Liabilities:Market capitalization:

GM’s DB Pension Plans

Financial Status of GM Pensions

2002 plan assets:2002 PBO:Net FundingPercent Funded

What Caused It?

Funding Status in Perspective

Underfunded pension obligation is:

Who bears the financial burden of the pension underfunding?

What Are G.M.’s Funding Options?

G.M.’s Debt Issuance

Issuing Debt to Fund Pension

Winners?

Losers?

Effect on Accounting Measures

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 planFiduciary 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

Fiduciary Responsibilities (under ERISA)

Operate plan solely in interest of participants and beneficiariesAct 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 needsProjected returns relative to funding objectives

Diversify the investments to minimize the risk of large lossesFollow provisions of plan documents (unless inconsistent with ERISA)

Interest of Participants

Pension plan participants should want pension fund to be fully funded at all times

Sufficient assets on handSufficient contributions as neededLow risk: minimize mismatch between assets and liabilities

How minimize the mismatch?Invest in bonds or stocks?

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)

Boots Pension Plan

A leading retail chain in UK and Ireland 2.3 billion pound assets in pension planInvestment strategy was approximately 75% equity, 17% bonds, 4% real estate, 4% cashIn 2002, pension trustees and the firm decided to move 100% of assets into passively managed bond portfolio

Partially also motivated by tax considerations

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”

Financial Times, December 15, 2003

The Wall Street Journal, December 10, 2003

GM “Alpha”

GM Today

GM Health Care