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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. PBO Expected vs. actual returns
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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. PBO • Expected vs. actual returns • Describe GM’s 2003 pension funding scheme in detail • Debt issuance • How 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 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
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.)
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
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
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? • Controversial • Balance sheet disclosures of unfunded pension obligations use ABO • Income statement measures are based on PBO • Lots 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 assets • After stock market decline, assets used in calculation are overstated, thus further overstating income from asset returns
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.
G.M: Overview of the Company • Industries • Employees: • Financial Status (2002) • Net Sales: • Net income: • Assets (book): • Liabilities: • Market capitalization:
Financial Status of GM Pensions • 2002 plan assets: • 2002 PBO: • Net Funding • Percent Funded
Funding Status in Perspective • Underfunded pension obligation is: • Who bears the financial burden of the pension underfunding?
Issuing Debt to Fund Pension • Winners? • Losers?
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
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)
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?
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 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
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”
