Pension Accounting and the Case of General Motors Thursday September 6, 2007.
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Transcript of Pension Accounting and the Case of General Motors Thursday September 6, 2007.
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Pension Accounting and the Case of General Motors
Thursday September 6, 2007
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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)
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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
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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.)
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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
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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
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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
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Which Measure to Use?
ControversialBalance sheet disclosures of unfunded pension obligations use ABOIncome statement measures are based on PBOLots of supplemental disclosure required
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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)
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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
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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
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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.
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G.M: Overview of the CompanyIndustries
Employees:
Financial Status (2002)Net Sales:Net income:Assets (book):Liabilities:Market capitalization:
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GM’s DB Pension Plans
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Financial Status of GM Pensions
2002 plan assets:2002 PBO:Net FundingPercent Funded
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What Caused It?
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Funding Status in Perspective
Underfunded pension obligation is:
Who bears the financial burden of the pension underfunding?
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What Are G.M.’s Funding Options?
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G.M.’s Debt Issuance
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Issuing Debt to Fund Pension
Winners?
Losers?
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Effect on Accounting Measures
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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
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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)
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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?
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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)
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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
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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”
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Financial Times, December 15, 2003
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The Wall Street Journal, December 10, 2003
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GM “Alpha”
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GM Today
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GM Health Care