The US government ended up losing about $10 Billion on the General Motors bailout, but that is pennies compared to what shareholders and bondholders of GM, the old company, lost. Today, GM’s pension liabilities have been periodically in the news. For example, in this Wall Street Journal article by Nina Trentmann from March of 2017, Nina points out that GM had recently raised $3 Billion in the debt market to fund a pension obligation from its European business. GM had already sold that business to Peugeot, but in selling its European business, it had agreed to make a one time payment of $3 Billion to the underfunded pension. GM had neglected its European pension fund for 15 years. Why? Because as the article states,
“…it had agreed to sell its European operations, including its Adam Opel AG subsidiary, for about $1.4 billion, withdrawing from a region where it hasn’t made a profit in more than 15 years.”
GM hadn’t made money selling cars in Europe for 15 years. In selling the business, it was throwing in the towel. In comparison, Peugeot, the company buying GM’s European business,
“…expects to take a continuing charge of around $160 million a year for the pension plans it takes over from General Motors, Peugeot CFO Jean-Baptiste De Chatillon told CFO Journal. Peugeot’s existing plans are “fully funded,” he said.”
The question that must be asked then is, why would Peugeot have fully funded pensions, while GM is taking out debt to pay off pension liabilities in lump-sum as it exits an entire continent? Both companies are selling cars in Europe. They are competitors, sure, but Peugeot has also had a rough go of it in the car business. The answer I believe, is in the governing rules around pensions. For example, according to Investopedia, companies can either make cash contributions to the pension fund, or they can make stock contributions. The problem is that most companies will do anything to avoid making a cash contribution, because that will reduce profits, and shareholders don’t like that. So as much as they are allowed to, companies throw stock into the pension fund. What’s the problem with that?? Well, think Enron. From the New York Times in September of 2001,
“At the end of last year, the 401(k) plan had $2.1 billion in assets. More than half was invested in Enron, an energy conglomerate. Since then, the stock has lost 94 percent of its value.”
Employees of Enron were wiped out, because the Enron 401 K program (which is similar to a pension in the sense that it is a retirement plan for employees) held over half of its investments in Enron stock. Enron was matching employee cash contributions to 401k with its own contributions, in stock. When GM went bankrupt, there is no doubt its pension fund suffered, as it surely held GM stock. With that said, after ENRON, ERISA laws that regulate how retirements plans are administered, restricted how much stock employees and employers could hold in 401K and pension funds. Still, in very dramatic downturns, this affects the value of the pension fund. In this Forbes article, the author talks about how US public pension funds, meaning State, City, and other government pensions, use different accounting rules to decide what their current pension liabilities are. Why is this important? Because the interest rate you use to determine the value of money in the future makes all the difference to how you will need to invest today. For example, if you assume that interest rates today are 10%, and you want to have $110 in your account next year to pay a bill that will come due, then how much do you need to have in your account today? Well, the answer is $100. It’s all about the interest rate. At 10% annual interest, $100 today will turn into $110 next year, and voila, you can pay the bill with no issues! Now, the hard part is finding that thing that will give you a 10% return, at minimal risk. With interest rates as low as they are today, the risk-free rate, for example, on a 12 month CD, is at most 2.75%. I know because I just opened a 12 month CD so that I can pay a bill coming due next year. If I needed $110 though, the risk-free CD would not work for me. So what do I do? I need to take risk! That means stocks, or corporate bonds, or venture capital, or a hedge fund. The problem with these investments is that I could easily end up with less than $100 after 1 year, because risky investments make no promise of a positive return. Public pension funds are doing the same thing; they are trying to reduce the amount of liability they must declare today. Essentially, they are discounting their future liabilities at a far higher rate than the risk-free rate. From Forbes,
“…in Canadian and European funds – both public and private – liability discount rates are “typically … a function of current interest rates,” an approach which (assuming the interest rate is chosen appropriately) is much more in line with basic economic theory.”
So by the above quote, the discount rate used today should be in the range of ~3%, because the risk-free rate across the yield curve (across various durations, 2 year, 5 year, 10 year, 30 year) is about 3%. Can you see why this would be a problem for public pension funds? A city like Chicago for example, has a pension liability crisis. In order to present lower liabilities today (so that taxes can stay low, and deficits can stay controlled), Chicago would love to use a discount rate far higher than 3%. But the only way they can do that is if they find investments that will yield much more than 3% over the long haul, since pension liabilities are long term liabilities. The only way Chicago can do this is by investing in far riskier investments than US treasury bonds. They need to go into stocks and other high risk/high return investments, like hedge funds. So again from Forbes, to summarize the issue here,
“… ‘in the past two decades, U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities.’ This really is a case of the tail wagging the dog…we have provided incentives for public pension fund managers and their boards to over-invest in risky assets.”
Do you notice a recurring theme here? The federal government gave public pension GASB, the unique accounting standard strictly used by governments, and SEC approved. This standard allows governments to use a discount rate that doesn’t match prevailing interest rates. This encourages public pension fund managers to take excessive risk to meet unrealistic discount rate assumptions. Governments then reduce their present cash liabilities to, instead relying on investment returns to fund future liabilities. In a way, GASB is a form of government guarantee; it authorizes the use of unrealistic discount rate. When a hedge fund blows up, and loses 50% of its value, and the City of Chicago announces it had billions invested in said fund, the scapegoat will be GASB. Who are the losers? Retirees of course. Socialist policy makes only one guarantee: the working class will always bear the brunt of loses.
Just to give you an idea of how GASB compares to GAAP, the accounting rules private companies abide by, take a look at the recent General Electric 10K report. On page 63, GE tells you what discount rate they are using to assess present day pension liabilities:
“Looking forward, our key assumptions affecting 2018 postretirement benefits cost are as follows: Discount rate at 3.64% for our principal pension plans, reflecting current long-term interest rates. Assumed long-term return on our principal pension plan assets of 6.75% , a decrease from 7.5% in 2017.”
The discount rate GE is using to calculate present day pension liabilities is 3.64%. Is it somewhere in the range of the current long term risk-free rate, as measured by the 30 Year Treasury bond? If we take a look at FRED, we see that when GE 10K report was released on February 23, 2018, the 30 Year Treasury bond was yielding 3.13%. A spread of 0.5% over the risk-free rate is perfectly reasonable. Notice that the 10K also gives an expected long term return on pension fund investments. At 6.75%, this is again reasonable, given that the long term return on the S&P 500, quoting Investopedia,
“Adjusted for inflation, the historical average annual return is only around 7%.”
Notice that the Federal Reserve is ultimately the root cause of excessive risk taking. The Federal Reserve controls the holy grail of interest rates, the rate that all other rates are based on. It is the Federal Funds target rate. Pension funds have benefitted from taking higher risks recently because of high stock market returns; but they haven’t benefited as much as you would think. Ten years removed from the Great Recession and the bankruptcy of General Motors, GM still has an underfunded pension liability. According to GM’s latest 10K filing, on page 71, GM ended 2017 with a negative pension balance, underfunded by $5.811 Billion. With that said, it has been going down; at EOY 2016, the balance was -$7.205 Billion. At EOY 2015, it was -$10.414 Billion. This is positive. What has not been going down is the underfunded status of GLOBAL OPEB Plans; what are those? Health care costs for retirees. Although the pension deficit is falling, it is still a substantial deficit. In my opinion, after a historic rally in the stock market, it’s actually a very bad sign that there is still a deficit. The S&P 500, since it bottomed in March of 2009, is up 330%. The technology heavy Nasdaq is up 511%. The Russell 2000, a measure of the value of small publicly traded companies in the US, is up 401%. Intuitively, one would think pension funds should have surpluses at this point. Btw, some do, but if a pension fund has a surplus, company executives often get penalized. Why? Because shareholders would ask, why? Shareholders would want as much of profits as possible, returned to them, in either dividends, or share repurchases. The short-sightedness greedy nature of shareholders forces company execs into walking a very tight rope when funding their pension liabilities, and they most always air on the side of shareholder value.
But back to the original question, why are some pensions still in deficit? The answer to that is in GM’s 10K:
Target Allocation Percentages The following table summarizes the target allocations by asset category for U.S. and non-U.S. defined benefit pension plans:
December 31, 2017 December 31, 2016
U.S. Non-U.S. U.S. Non-U.S.
Equity 15% 18% 15% 21%
Debt 61% 56% 61% 51%
Other(a) 24% 26% 24% 28%
Total 100% 100% 100% 100% __________
(a) Primarily includes private equity, real estate and absolute return strategies which mainly consist of hedge funds.
You can see above that there simply is not enough Equity exposure. At 15%, most of the portfolio is not exposed to the stock market rally. Is this wrong? Absolutely not. Pension funds are retiree money. The risk levels should not be on par with stock market exposure. That is too much risk for retiree funds. The more applicable question is, why didn’t the bond/debt investments have better returns? Bonds have also been a good investment since the Great Recession. The Federal Reserve assured helped out by itself buying bonds to the tune of $4 Trillion, to drive down long term interest rates. It worked, and that’s why pension fund bond investments did not. Interest payments on bonds, which pension funds depend on to provide income to retirees, were so small, they could not cover the outflows. In addition, even pension fund exposure to hedge funds (“Other” includes hedge fund exposure, at 24%), didn’t help. As a whole investment sector, hedge funds have dramatically underperformed in the last 10 years. There is no shortage of articles on that fact, from this recent piece in the WSJ to this piece, also in the WSJ. What’s probably a bit shocking, but true, is that pension funds are actually currently increasing their exposure to hedge funds, as noted by this piece in Bloomberg. Proving our earlier statement that public pension funds are taking more and more risk to meet their discount rate assumptions, Bloomberg states the following:
“Hedge funds have accumulated $3 trillion, with a substantial portion of it coming from public pensions. That these funds don’t deliver outperformance is almost beside the point. What they are selling is an inflated estimate of expected returns. This serves a crucial purpose for elected officials, letting them lower the annual contributions states and municipalities must make to the pension plans for government employees.”
So let’s summarize; hedge funds have underperformed, and continue to underperform, the market (index fund, such as S&P 500) since the 2008 crisis. To quantify the underperformance, Bloomberg states the following:
“Hedge funds that invest in stocks returned 7.2 percent annually from 2009 to 2017, which was less than half the S&P 500’s return, according to data from Hedge Fund Research.”
Pension funds are continuing to invest in hedge funds for two reasons: one, they have very little other choice. Hedge funds claim they can outperform the market going forward. Pension funds need investments that can meet their discount rate assumptions. Hedge funds are feeding their fancy. Second, pension funds are betting on mean reversion. They are betting that hedge funds will return to glory going forward, and they don’t want to miss out when/if it happens.
General Electric is another company that struggled big-time during the 2008 crisis. In this article from Fortune, dated October 9th, 2008, the author states,
“GE Capital, headed by 29-year GE veteran Michael Neal, has ventured into practically every kind of financial service, from making car loans in Europe to investing in commercial real estate in Florida. If you have a credit card from Walmart or Lowe’s, it’s really from GE Capital. The business owns almost 1,800 commercial airplanes and leases them to 225 airlines. Until last year it made subprime mortgages in the U.S.”
GE Capital, according to Propublica, relied heavily on the Federal Reserve to borrow short-term funds (commercial paper) during the crisis. It also used the FDIC to guarantee it’s debt; the FDIC is the federal agency that guarantees the cash deposits in your checking and saving account. The FDIC program, known as the Temporary Liquidity Guarantee Program, allowed GE to sell commercial paper at low interest rates to operate its day to day business. The New York Times reported that GE was allowed to sell as much as $139 Billion worth of commercial paper, guaranteed by the federal government. The interesting thing is that GE, minus GE Financial, was a great business. It’s cost of capital was lower than any of the major Wall Street Banks in 2008. GE had a real business outside of finance. It’s lenders considered it a cash cow; they could always get paid because GE had an industrial revenue stream. With that said, GE Capital was delivering over 50% of GE’s revenue at the height of the real estate boom prior to the crisis. When GE Capital crashed due to the credit crisis, people suddenly realized that GE Capital’s liabilities could take down the entirety of GE, several times over. Today, after shedding most of GE Capital, GE is in a new kind of trouble; like GM, that trouble is pension liabilities.
“Between 2010 and 2016, GE spent about $40 billion to buy back its own stock, according to FactSet.”
How could GE buy back stock, but not fund its pension? $40 Billion could have easily covered the pension deficit, plus some. Let’s take a look at GE’s stock price since 2006 and see if there is a correlation between the pension deficit and the stock price.
Notice that between 2010 and 2016, while GE was performing the share buybacks to the tune of $40 Billion, the share price went from ~$12/share to nearly $30/share. Since the beginning of 2017, the share price has fallen all way back to 2010 levels. This gives credence to the argument that share buybacks are nothing more than stock price manipulation. It also gives credence to the argument that ultimately, they have a temporary effect. If GE funded their pension with repurchased stocks, it was a double whammy; they overpaid for repurchases on the way up, and increased pension deficit on the way down. In other words, it wasted a whole lot of that $40 Billion. Just like GM recently used $3 Billion of debt to fund a European pension liability, GE did the same thing in November of 2017, announcing plans to,
“…tackle the pension problem by taking advantage of cheap borrowing costs. GE said it will borrow $6 billion in 2018 to cover mandatory pension payments through 2020.” (From CNN)
This is called borrowing money to pay your off other borrowed money. It’s the kind of thing that has led to the US government’s $21 Trillion of outstanding debt; using new debt to pay down old debt. I’m sure GE and GM are saying, “hey, if it’s good enough for Uncle Sam, it’s good enough for General ___.” Remember what we said earlier: in the end, if this house of cards falls, GE and GM retirees will bear the brunt of it.