First of all, I want to apologize for the delay in posting this last part of the pension disclosure article series. The lack of action is inexplicable and inexcusable. But better late than never, so here goes the last part of this pension disclosure series, in which we’ll take a look at GM’s pension assumptions and its pension plan asset mix. You can review Part I, Part II and Part III from my earlier posts.
Let’s take a look at the assumptions GM used in determining the pension obligations and benefit expenses. For the purpose of illustration, we will again focus on the U.S Plans.
I’ve mentioned previously that it is often helpful to compare the assumptions to those used by a competitor. Below I’ve pulled Ford’s pension assumption table from Ford’s 2012 annual report.
Let’s start with the discount rate. Discount rates are used to calculate the present value of pension obligations and the service and interest cost components of net periodic pension cost. The discount rate is intended to represent the rate at which pension benefit obligations could be effectively settled. U.S. GAAP prescribes that the discount rate may be based on the rates implicit in current annuity rates or available rates on high-quality corporate bond yields.
Some readers may have noticed that the discount rates used are different for pension obligations versus pension costs. This is because the former is selected at the end of the current fiscal year while the latter was selected at the prior year-end.
Discount rates are typically based on corporate bond yields. Given that the Triple A bond yields during 2012 were between 3.3% and 4%, I would argue that both Ford and GM’s discount rates are reasonable. GM’s discount rates are actually lower compared to Ford, which could be an indication that GM’s management is using a more conservative rate.
Moving on to the expected rate of return on assets, here again GM’s assumptions seem more conservative than Ford’s assumptions. The difference could be attributed to differences of asset mix, which we will explore later. In order to assess the reasonableness of the rate of return used, we will have to take a further look at the pension plan assets.
The last assumption is the average rate of increase in compensation, which is usually affected by the following factors:
- Productivity improvements
- Price inflation
- Promotional increases
- Seniority increases.
Again, GM appears to be more conservative by using a higher rate of increase in salaries compared to Ford.
Let’s then compare GM and Ford’s pension plan asset mix to get a better understanding of the investment strategy utilized by each company’s pension asset managers.
GM's Pension Assets Allocation:
Ford's Pension Plan Assets Allocation:
What’s striking and obvious is GM”s very low allocation to equity. Compared to Ford’s 30% allocation to equity, GM’s pension manager only allocated 14% to equity. This explains why the expected return on plan asset is lower for GM’s pension plan asset. GM’s asset mix immediately reminds of Buffett’s observation in his 1975 memo to Kay Graham:
During a period when equities had produced fabulous returns, many of the plans had been invested largely in bonds – which not only bore low fixed rates of 3%-5% in the earlier periods but also had suffered significant shrinkages in market values as interest rates increased secularly. (If interest rates go up, bond prices must go down – and if the bonds are long-term and the rates rise sharply, prices go into a power dive.)
I can’t predict the future but just based on the observation of asset mix, I would prefer Ford’s pension plan manager over GM’s pension plan manager. If you are a GM shareholder, you should worry about the potential double whammy from GM’s pension manager’s increase in equity allocation as the market keeps rising along with the risk and the inevitable rise in yield and decline in value of the fixed income investment.
Now that we have walked through the most important things with regards to GM’s 2012 pension disclosure, what is the conclusion? As with most important questions in investing, there are no definitive answers. The knowables are:
- GM’s pension plan had a deficit of almost $28 billion in 2012.
- GM paid a hefty 10% premium or $2.5 billion to Prudential for the transfer of 25% of its pension obligations.
- GM’s management seems to be more conservative in making pension-related assumptions.
- GM’s pension managers are very likely to be mediocre.
It seems to me that a prudent GM shareholder should revisit the following reminder from Mr. Buffett:
In no other managerial area can such huge aggregate liabilities – which will be reflected in progressively increasing annual costs and cash requirements – be created so quickly and with so little immediate financial pain. Like pressroom labor practices, small errors will compound. Care and caution are in order.