GE Botches Its Pension Math?

Nir Kaissar of Bloomberg reports, GE Botches Its Pension Math:

It’s time for General Electric Co. to do some soul-searching about its pension problem.

As Bloomberg News reported last week, GE’s pension was underfunded by a staggering $31.1 billion at the end of 2016 -- the biggest shortfall among S&P 500 companies.

So far, GE seems to be pointing fingers at everything but itself. Company spokeswoman Jennifer Erickson has attributed the pension predicament to the 2008 financial crisis and subsequent low interest rates.

In fairness, GE’s pension was in good health before the financial crisis. It was overfunded every year from 1999 to 2007, and GE’s surplus was $15.2 billion at the end of 2007. But in 2008, the pension portfolio tumbled by roughly 28 percent, and suddenly it was underfunded by $6.8 billion.

Turning Point

GE's pension fell deeper into the red after the 2008 financial crisis (click on image):

That’s when GE made some classic blunders. First, it panicked when markets declined and sold its risky assets when it should have hung on to them -- or bought more of them. GE allocated 80 percent of its pension portfolio to risky assets during the boom years leading up to the crisis from 2003 to 2006. The decline in the value of those assets in 2008 reduced GE’s risk allocation to 68 percent. But after the recovery in 2009, GE lost its nerve and sold some risk assets. By the end of 2010, GE’s allocation to risk was 66 percent, which is roughly where it remains today.

All Shook Up

GE lost its taste for risk after the 2008 financial crisis (click on image):

GE also blundered by chasing alternative investments after the crisis. From 1999 to 2008, the pension had no alternative investments. But by the end of 2009, GE had allocated 14 percent of its portfolio to alternatives.

It’s easy to see why alternatives were appealing at the time. Alternatives held up far better than the market during the crisis, in large part because of their ability to short stocks. The HFRI Fund Weighted Composite Index was down 19 percent in 2008, while the S&P 500 was down 37 percent, including dividends. Overseas stocks fared even worse.

Traumatized by the crisis and dazzled by alternatives, GE sold more of its beaten-down risk assets to make room for alternatives -- a classic case of looking in the rear-view mirror instead of the windshield. The S&P 500 has returned 18 percent annually since March 2009 through May, while the HFRI Index has returned just 6.2 percent. Overseas stocks, too, have outpaced the HFRI Index by a wide margin.

GE’s biggest blunder, however, predates the financial crisis. A critical assumption in every pension plan is the expected return from the pension’s portfolio. The higher the expected return, the less the company must contribute to its pension to meet future obligations, and vice versa.

In 1999, GE assumed that its pension portfolio would return 9.5 percent annually. At first glance, that seems like a reasonable assumption. GE’s pension portfolio is highly correlated with a 75/25 portfolio of U.S. stocks and bonds, as represented by the S&P 500 and long-term government bonds. That correlation was 0.92 between 1999 and 2016.

This 75/25 portfolio returned 9.4 percent annually from 1926 to 2016, including dividends -- the longest period for which returns are available.

But the devil is hiding in that return. It happens that the two decades before GE chose its expected return of 9.5 percent in 1999 included one of the biggest bull markets in history. From 1981 to 1998, the 75/25 portfolio returned 16 percent annually. Before that, it had returned half as much, or 8.3 percent annually, from 1926 to 1980.

Given the moment, the prudent assumption in 1999 would have been that returns would be lower over the next two decades. And that’s exactly what happened. That 75/25 portfolio returned 6.4 percent annually from 1999 to 2016, far lower than GE’s expected return of 9.5 percent. GE’s portfolio returned roughly 6 percent annually over that period.

In Step

GE's pension portfolio has been highly correlated with a simple portfolio of U.S. stocks and bonds (click on image):

GE has since tempered its expectations. It now assumes a 7.5 percent annual return. But that may still be too high. Long-term government bonds currently yield 2.2 percent to 2.7 percent, depending on maturity. The S&P 500’s earnings yield is roughly 4 percent, based on 10-year trailing average positive earnings. Earnings yields are higher for overseas stocks, but even so, it’s hard to cobble together an expected return of 7.5 percent.

Lower Expectations

I suspect GE knows all this, which points to a bigger problem than basic arithmetic. A lower expected return would require GE to increase its pension contributions. That would strain GE’s financial condition in the near term -- and by extension its stock price. That’s not what shareholders want to hear.

But GE has little choice. The longer it puts off the hard decisions, the costlier its pension problem will become. The market will eventually acknowledge that reality, and perhaps it already has. Since Bloomberg reported GE’s pension woes last Friday, its stock is down 3 percent through Tuesday, while the S&P 500 is up 0.2 percent.

The right answer is simple. The only question is whether GE has the stomach to acknowledge it.

Michael Hiltzik of the Los Angeles Times also reports, GE spent lavishly on shareholders, shortchanged pensions and still landed in a deep hole:

It’s customary to laud a departing corporate chief executive as a giant of industry and a management genius. That’s the tongue bath General Electric’s Jack Welch received when he retired in 2001. Not so much his successor Jeffrey Immelt, whose legacy already is being panned weeks ahead of his Aug. 1 scheduled departure.

Among other things, a close look is being taken at Immelt’s lavish spending on stock buybacks, especially over the last two years at the behest of the company’s biggest and richest shareholders. A new analysis by Bloomberg contrasts the nearly $46 billion GE spent to appease those shareholders in 2015 and 2016 with its chronic and growing underfunding of its pension plans.

By Bloomberg’s reckoning, the $31-billion shortfall in all GE’s pension plans — about 30% — is the biggest among companies in the Standard & Poor’s 500 by far. Rectifying the shortfall could create a long-term drag on earnings for Immelt’s successor as CEO, John Flannery.

Despite that, Flannery delivered the obligatory paean to Immelt’s leadership when his ascension was announced. (Immelt will remain chairman until Dec. 31.) “I am privileged to have spent the last 16 years at the company working for Jeff, one of the greatest business leaders of our time,” Flannery said, praising Immelt for having “created a vision for the GE of the future.”

Yet Immelt’s tenure has been nothing for investors to laud. Since he took over in September 2001, GE shares have returned a total of about 18% in price appreciation and dividends. In the same period, the S&P 500 has returned 195%.

Immelt gained nothing by paying off investors such as Nelson Peltz, whose Trian Partners held a $2.5-billion stake in GE as of October 2015. Peltz proposed that GE return to shareholders as much as 40% of its market capitalization (then about $260 billion) by the end of 2018, a process he said would raise its share price to $40 to $45 by the end of this year.

As we write, GE is short of both goals: Its current share buyback program totals $50 billion, about half what Peltz advocated, though the company has said that buybacks, dividends and spinoffs will return $90 billion to investors by the end of next year. Its share price is just shy of $29, never having risen higher than $30.86 (last December).

The company’s share repurchases coincided with a distinct underfunding of its pension plans. The buybacks came to $23.7 billion in 2015, including the equivalent of $20.4 billion from its spinoff of much of its GE Capital unit as Synchrony, and $22 billion more in 2016. Meanwhile the pension plans received only about $2 billion.

Partially as a result, the company’s financial disclosures show the shortfall growing within its main plan, covering 231,000 retirees and families and about 242,000 current and former workers and other plans, including those inherited via acquisitions, covering about 120,000 current and former workers. In 2015, the pension obligations of those plans came to about $90.3 billion and their assets to $63.1 billion, for a shortfall of about 30%. Last year, obligations had grown to about $94 billion and assets to about $63 billion, for a shortfall of about 33%.

As Bloomberg observes, GE’s options for closing the gap are limited. It could borrow to cover the expense, except it’s already a highly leverage corporation. And its expectation for long-term growth within the pension portfolio is 7.5% annually, which implies it will have to keep the portfolios heavily stocked with equities, which currently constitute about 56% of their holdings. One analyst cited by Bloomberg suggests that, given the ramp-up in premiums being charged on underfunded plans by the government’s Pension Benefit Guarantee Corp., which insures corporate pension plans, it may be worthwhile for GE to spend less on share buybacks and use the money to close the pension gap.

As a final irony, consider that Immelt has little to worry about in his own pension. As part of his retirement package, according to corporate disclosures, he’s due personal pension benefits worth nearly $82 million.

Of course, what else is new? Corporate America's CEOs have discovered the value of pensions -- their own pension -- as a source of lucrative compensation to add on top of their already egregious compensation package which they manipulate through share buybacks, all part of profits without prosperity.

Now, I'm not going to castigate Jeff Immelt, the outgoing CEO. GE is a monster conglomerate and I personally think even if God was its CEO, it wouldn't have made much of a difference. In my opinion, GE is way too big, too bulky, too lethargic and needs to rethink its entire strategy, talk to Blackstone and other PE shops to sell off more assets and refocus its strategy.

But GE's pension problem won't go way. I read Bloomberg's analysis on the $31 billion pension hole and I'm afraid to say, it's only going to get worse in the next few years as rates plunge and stay at ultra-low levels, and risk assets get clobbered.  The pension storm cometh and it will impact all pensions, public and private.

This is why it's hard for me to get excited about GE's stock (GE) going forward. Yes, the company pays out a decent dividend but a slowing US and global economy and growing pension problem don't bode well for its shareholders in the future, which is why I would be cautious buying shares at these levels (click on image):

Sure, the company can increase share buybacks but not if its pension deficit keeps growing and not if credit markets get roiled, which will make it more difficult for a highly levered GE to borrow to buy back shares or to contribute to its pension plan.

While GE needs to rethink its pension strategy, I strongly believe America needs to rethink its pension policy as public and private pensions crater, leaving millions exposed to pension poverty.

Let me be blunt. In order to "make America great again", you need to bolster corporate and public defined-benefit plans, introduce realistic investment assumptions, improve governance, and adopt some form of risk-sharing when plans run into trouble (read more about this in my comment on the pension prescription).

Is the solution to GE's pension woes more hedge funds and more private equity funds? I actually would beef up alternatives in a deflationary environment but I would choose my partners and strategies very carefully.

But let me be clear, more alternative investments won't cure America's growing pension crisis. I personally think the time has come to enhance Social Security to adopt a similar model to what we have in Canada with CPP assets being managed by the CPPIB. In order to to do this properly, they need to get the governance right.

In fact, I envision a future where all corporations get out of the pension business to focus only on their core business and retirement will be handled by the federal and state (provincial) governments using large, well-governed public pension plans. There will be resistance to such change but it's the only way forward and it makes good pension and economic sense to do this.

One thing is for sure, the status quo isn't working and is leaving too many Americans exposed to pension poverty. It's not just GE's botched pension math that worries me, it's that of the entire country where too many public and private pensions are chronically underfunded.

Below, Bloomberg reports GE's new head will focus on cash and growth. Mr. Flannery will need to focus on a few things, including the pension time bomb. I suggest he talks with the folks at the Caisse who just signed a deal with GECAS. They are in a better position to guide him on how to address the company's growing pension woes. All I can say is don't ignore this problem, it will get much worse.