Borrowing from Peter to pay Paul?

Global Finance, Sep 2003 by Neville, Laurance

PENSIONS FUNDING

When General Motors issued nearly $18 billion in debt to fund its pension liabilities, it was derided for trading one liability for another. But with pensions funding becoming an increasingly hot topic, the auto giant may turn out to be a trailblazer.

General Motors gained plaudits at the end of June with a $17.6 billion combined euro, dollar and sterling bond deal that was the largest in debt capital markets history. More laudable than the deal's size was the aim of neutralizing GM's $19.3 billion pension deficit as a drag on company performance. Could it be a model for other embattled corporates?

The choices for companies with pension deficits are few. They can fund liabilities from operating income in the medium term-a financially stressful option disliked by stockholders-or replace the funds in bulk from either operating revenue or new fundraising and bet on improved returns from the markets. If liabilities go unfunded, they face risk premiums imposed by the Pension Benefit Guarantee Corporation (PBGC).

For GM, bond issuance-with $13-2 billion of the proceeds channeled to its pension plan-appears to have made sense. "To avoid paying risk premiums to the PBGC, we needed to contribute $15 billion in cash between 2003 and 2007," notes Jerry Dubrowski, spokesperson for GM. "Instead, we have termed-out that liability with bonds." A liability of $15 billion over four years has been replaced with one of approximately $13.2 billion with an average maturity of 20 years.

The circumstances of the bond issue are unusual. While GM's finance arm, GMAC (which raised funds concurrently), is a regular issuer, GM rarely taps fixed-income investors. "The deal increases debt servicing costs but has little impact on GM as a borrowing entity as it rarely comes to market," says Dubrowski. As most of the debt is callable in seven years, GM can be flexible should the deficit be cleared by a booming stock market.

Mixed Reactions

Not everyone is convinced of the merits of the issue. "GM has effectively replaced one form of debt, its pension liabilities, with another, bonds," says David Bianco, head of the US valuation and accounting group at UBS. "Whether they made the right decision from a cost-offunding point of view is largely immaterial. It's what they do with the money that matters."

Dubrowski says that GM is transparent in revealing asset allocations. "These new funds will dovetail with existing allocations, but it's a lot of money and we may make allocation changes." GM's pension plan is currently invested 30% in US equity, 20% in international equity, and 30% in fixed income, with the remainder in private equity, real estate, hedge funds and other assets.

Bianco believes allocation changes are likely. "Aggressive investment in equities might make up the remainder of the deficit. If investment is largely in fixed income, it's hard to see the point of the fundraising." Most bonds would pay less than GM's cost of funding.

The timing of GM's bond issue to fund the deficit was controversial for two reasons. While GM cites low interest rates as a motivation for the issue, the consensus view is that rates will fall again this year. "That's a tough bet to make," says GM's Dubrowski. "We wanted to remove the pension issue as an overhang on our stock price. This was a good opportunity." Stock markets did react positively, with shares closing up 17 cents to $36.11 on the day of the bond issue. Since then they have traded in line with the market.

Equally, did GM act prematurely in dealing with its pension deficit when the Rush Administration is aiming to change pension deficit measurement? A bill giving companies a three-year breathing space by allowing them to use corporate bond yield rates rather than 30-year treasury bonds as a discount for potential returns is now before the House of Representatives. It will probably become law by the end of the year.

The change will not alter the amount to be paid, simply the period over which it can be paid. "It could lower the minimum funding requirements for pension deficits, and GM may have acted prematurely with this issue," says Bianco. But Dubrowski insists GM was right to go ahead in advance of possible legislative changes. "We wanted to make an aggressive statement that we are on top of this problem."

Gambling on the Markets

Changing the discount rate from 30-year treasuries to corporate bond yield makes sense-not least because they are no longer issued. Hut Phillip Gainey, an analyst in the US valuation and accounting group at Smith Barney, believes there is a more fundamental problem with discount measurement: "Under either measurement, the discount rate changes with [interest] rates, but what is paid out remains a fixed dollar amount. It's an indication of how problems are caused by regulations as much as anything else." David Zion, an analyst at Credit Suisse First Boston, agrees in a recent report, noting that while a rising stock market has relieved some of the pressure on pension funds, falling interest rates lead to falling discount rates and therefore higher obligations.