Thursday, June 30, 2005

Pension and Post Retirement Obligations:
Do your homework

Before you purchase that large cap stock you are interested in, do yourself a favor: delve into the readily available information regarding that companies defined benefit pension, and post retirement healthcare obligations (if applicable). For some companies, this will not change your mind, or reveal any red flags. But for others, this may(should) be the factor that scares you away from becoming an owner.

Three weeks ago, my brother in-law and I were talking about General Motors, a company near and dear to our hearts if only because three of our combined four grandfathers worked there. He remarked that his grandmother, who had never been a GM employee, received post-retirement benefits from the automaker for many years longer than her husband had actually worked for the company; not an uncommon situation these days, the result of which is bringing with it costly consequences.

Companies which have defined benefit pension and post-retirement healthcare plans made commitments to their retirees. Whether based on years of service, or other factors, these employees were promised benefits (in some cases) for life. Now, through a combination of factors which include increased life expectancy, more costly healthcare, lackluster investment returns, and challenging business conditions (among others), some companies are feeling the squeeze. Ultimately, as a shareholder, you will suffer too if companies you own need to cough up additional funds to support these plans.

Doing your homework
There is a great deal of information available to investors these days in order to assess these situations. In fact, disclosure of pension/post retirement assets, liabilities, funded status (whether the company has enough pension assets to meet liabilities, (the buzzwords are ”overfunded” or “underfunded”), assumptions about what the company believes the return on plan assets will be, as well as a current breakdown of how the money is allocated, is required by the SEC. You can find all this information, and much more, in company’s 10K(annual) filings. ( There is some data also available in the 10Q (quarterly) filings, but it is typically not as detailed.)

General Motors
Suffice it to say, that GM’s pension and postretirement liabilities are of mammoth proportions. The company lists three separate categories of obligations (all listed in the 10K): US Pensions Benefits, Non-US Pension Benefits, and Other Benefits(post-retirement healthcare).

Benefit Obligations
As of 12/31/04, GM calculated the following as the current obligation for each plan. This is often referred to as the Projected Benefit Obligation, or PBO, and represents the present value (PV) of benefits owed, for service performed in the past.
US Plan: $89.384 billion
Non US Plan: $18.056 billion
Other Benefits: $77.474 billion
While these amounts may seem staggering, they need to be taken in context. GM does have invested assets in each plan to meet liabilities, but it’s the comparison of the plan assets and benefit obligation which is meaningful.

Fair Value of Plan Assets
This represents the amount of invested assets in each plan, which is used to meet plan liabilities.
US Plan: $90.866 billion
Non US Plan: $9.023 billion
Other Benefits: $16.016 billion

Funded Status
Here is where the rubber meets (or doesn’t) the road. This is calculated by subtracting the Fair Value of Plan Assets from the Benefit Obligation. A negative number means the plan is under-funded, while positive means that its over-funded.
US Plan: $1.502 billion (over-funded)
Non US Plan: ($9.033) billion (under-funded)
Other Benefits: ($61.458) billion (way under-funded)

While the US Plan looks healthy due to the fact that it’s over-funded, it’s downhill from there. The Non US plan is significantly under-funded relative to the size of plan assets, and the Other Benefits category—in this case post-retirement healthcare—is simply in deep trouble.

General Motors must make up the difference over time—remember, the company made a promise to its retirees. The question is not whether the company can meet these obligations, but rather at whose expense. This should raise significant concerns to current and prospective shareholders, who will be footing the bill.

Health care for retirees and current employees are substantial to the point that they allegedly add more than $1500 to the cost of each vehicle produced! This at a time when GM’s market share has been dropping.

Optimistic Expectations
Perhaps the most alarming aspect of GM’s situation is the company’s own expectations for the three plans investment returns. (Expected Return On Plan Assets, 2004)
US Plan: 9.0%
Non US Plan: 8.4%
Other Benefits: 8.0%

While these projected returns seem achievable on the surface, in the context of GM’s asset allocation strategies, they are overly optimistic, at best. Typical disclosure of defined benefit asset allocations includes the past three years return assumptions, along with a breakdown of investments by Equity, Debt, Real Estate, and Other. Some companies provide more detail.

GM’s Asset Allocations/b>
US Plan:

Equity: 47%
Debt: 35%
Real Estate: 8%
Other: 10%

Non US Plan:
Equity: 61%
Debt: 31%
Real Estate: 8%
Other: 0%

Other Benefits:
Equity: 41%
Debt: 48%
Real Estate: 2%
Other: 9%

Keep in mind, I have no argument with the companies asset allocations, per se. I believe they have made efforts to build better risk adjusted portfolios, and in some cases have reduced plan return expectations over the years. For instance the US Plan’s expected return is down from 2002's 10 percent, while the same for the Non US plan is down from 8.8 percent in 2002, and 8.5 percent in 2003. However, GM raised the expected return for Other Benefits from 7 percent in 2003 to 8 percent in 2004, and that’s where the trouble is.

The question is, whether its conceivable that GM’s plans can achieve the expected returns given the respective asset allocation? Can the “Other Benefits” plan realistically expect to return 8 percent with 48% of the portfolio in fixed income securities? (We are assuming that the expected return for 2005 is the same as 2004, the 2005 expected return has not yet been disclosed) An 8 percent return on a portfolio which has half it's assets in fixed income securities, given a rising interest rate environment?

Here at Cheap Stocks, we believe it will be difficult for GM to meet the expected return figure, making an already bad situation--a severely under-funded post retirement healthcare plan--even worse. GM needs to change the asset allocation, lower the expected return, or both.

We are not picking on General Motors, its simply an example. There are many other companies with pension issues. However, we are concerned about the company's future. Besides a looming pension-postretirement crisis, the companies market share is falling. They are slashing prices by offering everyone the employee discount. Surely, they will move inventory with this plan, but will lose money in the process. Several years of 0 percent financing also come with a cost, especially as rates rise. The company is also struggling to come to terms with the unions on health insurance cuts for current employees. Stay tuned

We hope you will perform similar analysis on other companies of interest that have defined benefit plans. We'll consider doing more analysis on the subject.

Despite the negative tone of this piece, your author has a soft spot for the company. My grandfather Clyde worked for General Motors for 38 years, until 1975. During World War II, his plant in Ewing, New Jersey was transformed into an airplane manufacturing plant--they built the Avenger there, the same plane George H. W. Bush was shot down in. They, like many others, were part of the Greatest Generation, contributing to a common cause, one which helped win our freedom. Here's to you, Clyde, happy 98th birthday. We miss you dearly.

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