U.S. Carmakers Climb Out of Pension Abyss?
Big improvement in pension plays, GM and Ford say:
While drawing car buyers and praise from the likes of Consumer Reports, General Motors Co. and Ford Motor Co. are getting a grip on pensions that will free up cash to develop future hits.Detroit's cries of betrayal are not being felt by the car companies which took the decision to offload pension risk to insurers so they can focus on their core business. Others will follow their lead.
Over the long term, this should allow more spending on the core business and less on retirees. That in turn creates a brighter outlook for the companies, which are already delivering more competitive cars like the Chevrolet Impala and Ford Fusion, and better-than-estimated profits.
"It's one less thing investors have to worry about on the risk side," said Michael Razewski, a New York-based principal at Douglas C. Lane & Associates, which oversees $3.1 billion, including Ford shares. "The less Ford has to focus on funding the pension, the more they can focus on driving innovative products and services and meeting customer demand."
"We won't have to allocate as much capital to pensions as we have the last couple of years and certainly this year," Bob Shanks, chief financial officer of Dearborn, Mich.-based Ford, said. "That will give us the ability to take the cash that we're generating and invest it in other parts of the business that can support further growth."
Ford's pension plans were underfunded by $18.7 billion last year. Only Detroit based GM, with a shortfall of $27.8 billion, General Electric Co. and Boeing Co. had bigger holes at the end of 2012, according to data compiled by Bloomberg.
"We've made good progress since the end of last year from a pension-funded position perspective, given the rise in interest rates that's clearly helped our overall funding position," GM CFO Dan Ammann said. On a conference call he said the stronger fund "gives us more rather than less flexibility."
Both automakers have taken big steps to contain their pension costs for salaried workers. A year ago, GM said it would spend as much as $4.5 billion to shift salaried retirees to a group annuity handled by a unit of Prudential Financial Inc. The annuity, and lump-sum buyout offers to 42,000 retirees, was forecast by GM to shave $26 billion from its pension load.
Ford is also offering lump-sum buyouts to salaried retirees. The automaker has said it wants to eliminate remaining shortfalls in its pension funds by mid-decade.
For several years, GM and Ford could blame Treasury yields, a benchmark in their pension calculation, for at least part of their shortfalls. Yields plunged after the 2008 financial crisis as the Federal Reserve embarked on unprecedented bond-purchase programs to lower borrowing costs and encourage spending.
Interest rates have risen the last two months after Federal Reserve Chairman Ben Bernanke said the central bank may reduce its asset purchases this year and stop in the middle of 2014 if economic growth meets policy makers' projections.
The increase in rates will help reduce the funding needs at all types of pensions, whether run by corporations or governments. Detroit, long dubbed the Motor City, this month filed the largest municipal bankruptcy in U.S. history and is struggling under a large unfunded pension obligation that could lead to benefit cuts for 30,000 current and former city workers.
A deeper analysis is provided by Deepa Seetharaman of Reuters who reports Ford could close its U.S. pension funding gap by the end of 2014:
Thanks to rising rates and an injection of cash, Ford Motor Co could be in a positions that would have been unthinkable only a few years ago - with a fully funded U.S. pension fund.
Ford, which went through a searing restructuring in 2006, but avoided the bankruptcy route of its rivals General Motors and Chrysler, could cut its U.S. pension shortfall by half or even more by the end of this year from $9.7 billion at the end of 2012, according to securities analysts and Reuters calculations.
And the gap could be eliminated by the end of 2014 provided interest rates rise as economists expect and the stock market remains robust. That may give Ford added resources to pay down debt, invest in its businesses, or boost dividend payments, analysts said.
"It is a true obligation of the company right now and it's taking quite a bit of capital," Ford Chief Financial Officer Bob Shanks said of the automaker's pension gap in an interview.
"Once we get it fully funded, de-risked and sort of put it in a box, it gives us the ability not to worry about it so much and take future cash flow and put it wherever we want," he said.
If Ford fully funds its U.S. pension plan by the end of next year that would be quicker than many analysts had expected. GM could be about one to two years behind Ford in closing its U.S. pension gap, said Guggenheim Securities LLC analyst Matt Stover.
But critical to this scenario is that interest rates used to calculate retiree pension obligations continue to rise. Ford would also have to be willing to contribute at least $1 billion in 2014 to close its U.S. pension gap, analysts said.
Eliminating the shortfall is "possible by the end of 2014 and it's going to be because interest rates climb," said Stover, who predicts Ford's U.S. pension plans will be underfunded by about $4 billion by the end of 2013.
Ford's U.S. pension obligation was $52 billion at the end of last year, while GM's was about $82 billion.
GM was the first of the U.S. automakers to establish a pension plan in 1950 as part of the "Treaty of Detroit," a contract negotiated by legendary United Auto Workers union leader Walter Reuther. Ford and Chrysler followed suit.
But by the mid-2000s, pensions and other retiree benefits became an ever-increasing liability that automakers said added as much as $2,000 to the cost of a vehicle and put them at a disadvantage against foreign rivals.
Since then, GM and Ford have both taken steps to "de-risk" their pension plans by closing off their plans to new participants, offering lump-sum buyouts and shifting to more conservative investments.< Last year, GM cut $29 billion, or one-fifth, of its global pension liability when it shifted management of white-collar pension plans for 118,000 salaried retirees to a unit of Prudential Financial Inc. But underfunding remains an issue, partly because that shortfall is viewed by credit ratings agencies as debt.
Ford plans to inject $5 billion cash into its global pension plans this year to help reduce the underfunding - though some of that will go towards pension plans elsewhere in the world.
To put the underfunding and Ford's cash injection in context, the automaker spent $5.5 billion in 2012 on product development, building factories and other capital expenditures.
A $4 BILLION BOON
Companies calculate the present value of their future pension liabilities using a so-called discount rate, which is based on corporate bond rates. A higher rate means lower liabilities, meaning that a company doesn't have to set aside as much cash now to pay retirees in the future.Rising rates are critical for restoring the funding gap of public and private pension plans. Once the carmakers' plans get back to fully funded status, the increase in their credit rating will allow them to issue debt to free up cash flow which can be used to boost dividends, develop new vehicles or pay off debt.
Based on the most optimistic scenario laid out by actuarial firm Milliman, higher rates alone could narrow Ford's pension gap by about $4 billion by the end of 2014. Stover said higher rates could close about half of Ford's U.S. pension shortfall.
"The auto companies have always been associated with having these big pension liabilities," Citi analyst Itay Michaeli said. "It becomes a frustration for investors to deal with more volatility on top of already volatile industry dynamics."
Closing the U.S. pension gap "takes an element that has arguably weighed on investor sentiment and just takes that issue away," Michaeli added.
The discount rate, which is based on corporate bond yields and is used to determine the present value of payments they make over the life of their plans, has risen this year to 4.74 percent in June from 3.96 percent in December, according to Milliman.
By the end of 2013, the discount rate could be as high as 5.04 percent, and by the end of 2014 it could be up to 5.64 percent, Milliman estimates.
A smaller pension gap would likely pave the way for Standard & Poor's to upgrade Ford's credit ratings upgrade to investment grade, Michaeli said. That would allow the automaker to fund the remaining U.S. pension gap with unsecured debt.
"By issuing debt, what you're doing is freeing up free cash flow," he said, adding that could be used to boost dividends, develop new vehicles or pay off debt.
For Ford, a one percentage point increase in the discount rate alone could lower its U.S. pension liability by $2.3 billion, Shanks said during Ford's second-quarter earnings call.
The improvement in their pension plans is one of the reasons behind the outperformance of Ford and GM vs. the S&P 500, with their shares almost doubling over the last year (click on image):
Going forward, the critical issue will be whether rates continue to rise at a steady pace. Rising rates will help restore the health of underfunded private and public plans. While some very smart people like AIMCo's Leo de Bever see the end of the bull market in bonds, the folks at Hoisington Investment Management argue persuasively that the secular low in bond yields has yet to be recorded. If that turns out to be true, there will be more pension pain ahead.
Finally, no matter where bond yields head, there is a theme I keep referring to, namely, pensions should be treated as a public good and managed by well-governed public pension funds that operate at arms-length from the government. Companies like Ford and GM are doing the logical thing to "de-risk" their pension plans and focus on their core business but workers deserve the security that comes with a defined-benefit pension plan. As companies offload pension risk to insurers and shut down DB plans to new and existing workers, I worry that millions more will succumb to pension poverty down the road.
Below, Robert Shanks, chief financial officer of Ford Motor Co., talks about the automaker's second-quarter earnings, prospects for the company’s growth and the City of Detroit’s bankruptcy. Ford, the second-largest U.S. automaker, earned more than estimates and raised its full-year profit forecast as the Focus compact and Fusion sedan led a stable of more competitive cars from the Detroit Three. Shanks speaks with Adam Johnson on Bloomberg Television's "Street Smart."