Features : Borrowing From Peter To Pay Paul?

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 deals size was the aim of neutralizing GMs $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 terma financially stressful option disliked by stockholdersor 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 issuancewith $13.2 billion of the pro-ceeds channeled to its pension planappears to have made sense. To avoid paying risk premiums to the PBGC, we needed to contribute $15 billion in cash be-tween 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 GMs 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 flexi-ble 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 pen-sion 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-of- funding point of view is largely immaterial. Its what they do with the money that matters.

Dubrowski says that GM is transparent in revealing as-set allocations.These new funds will dovetail with ex-isting allocations, but its a lot of money and we may make allocation changes. GMs pension plan is current-ly invested 30% in US equity, 20% in international equi-ty, and 30% in fixed income, with the remainder in pri-vate equity, real estate, hedge funds and other assets.

Bianco believes allocation changes are likely.Aggres-sive investment in equities might make up the remain-der of the deficit. If investment is largely in fixed in-come, its hard to see the point of the fundraising. Most bonds would pay less than GMs cost of funding.

The timing of GMs bond issue to fund the deficit was controversial for two reasons.While GM cites low inter-est rates as a motivation for the issue, the consensus view is that rates will fall again this year.Thats a tough bet to make, says GMs Dubrowski.We wanted to re-move 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 Bush 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 proba-bly become law by the end of the year.

The change will not alter the amount to be paid, sim-ply 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.

GM, along with many other firms, estimates a return of 9% from its pension assetsa figure that would delight many retail investors. Its the average return over the past 15 years, says Jerry Dubrowski, spokesperson for GM, by way of explanation. In the first six months of 2003 we have earned our 9%. It is attainable in the long term.

But David Bianco, head of the US valuation and accounting group at UBS, believes that the returns assumed by many S&P500; firms pose a problem. The real concern in the pension arena is not just the size of the deficits but the quality of earnings implications for many of these companies, says Bianco. Because of the financial expectations implied by many pension funds, such as 13% returns from equity investments, this is an ongoing problem that will erode the quality of earnings.

With equity markets unlikely to show such growth in the medium term, pension plan sustainability may be predicated on figures that are unachievable. If that is the case, corporates may find themselves forced to contribute to plans again in future years.


Gambling on the Markets

Changing the discount rate from 30-year treasuries to corporate bond yield makes sensenot least because they are no longer issued. But Phillip Gainey, an analyst in the US valuation and accounting group at Smith Bar-ney, 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.Its 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 dis-count rates and therefore higher obligations.

With such uncertainties there are considerable doubts over whether companies should be replenishing their pension plans now and if debt really is the answer to the reputed $300 billion underfunding of pension li-abilities by US companies.

Ideally companies should make contributions from cash on their books,says Gainey.Ford Motor Group has taken this option. The company contributed $1 billion earlier this year out of operating incomehaving ini-tially said it would contribute half that in both 2003 and 2004.We decided not to spread the contributions be-cause of Fords strong performance and success in low-ering costs, says Marcey Evans, a spokesperson for the company at its headquarters in Detroit. There are also tax benefits to early contributions, notes Gainey. Evans says that Ford now has no further legal funding obliga-tions until 2007.

If funding from current free cash is not possible, cor-porates should try to reduce capital expenditurewith-out damaging their businessto generate more free cash.Only if none of these options are possible should a company consider debt or equity issues, says Gainey.

GM opted for debt primarily because it could not comfortably pay its large deficit from cashflow. But GM is a rare example of an infrequent, but attractive, issuer seeking to raise funds from the debt markets to fund its pension deficit.As Gainey notes,Most of the companies that want to issue debt as a last resort to fund pension deficits are not in a position to issue debt at all.

Laurence Neville