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Pension Fund Magic


Much (but not enough in my opinion) has been written about the pension funding problems of U.S. companies. Recently, the House of Representatives approved a bill to "alleviate" the magnitude of the problem. Notice I used the word "alleviate" (to lesson the pain, decrease) and not "solve". Let's look at why.

A company's actuaries make three basic assumptions in determining how much to put into a pension fund in order to honor their obligation to the company's employees upon retirement.

First, a company determines the future values (nominal values they need in the future) of what they will owe based on the number of employees, salaries, attrition rates, death rates, etc. Although this is somewhat nebulous, calculations are done using standard actuary probability curves much as an insurance company would use.

The next two assumptions are where all the controversy lies and deals in the present values of those future liabilities. Normally there is only one interest rate assumption in discounting a future value back to get a present value. Pension fund accounting is a little different.

A company first must make an assumption as to what the assets of the fund will earn as investments. During the 1990's this number was continually increased as investments were making higher and higher returns. As of late those numbers have been coming down, although perhaps not fast enough. Intl Bus. Machines(IBM:NYSE) recently lowered their assumed rate of return from 9.5% to 8%. The lower this rate, the more money the fund must invest now to match the future liabilities. If they do not put more money into the fund, the pension runs a deficit.

Not many people realize how much of the earnings generated by large companies for the five years between 1995 and 2000 was due to taking pension fund "profits" out of the fund asset-liability mix and bringing them to the bottom line. There are no hard figures, but our work shows that this number could be as large as 25-30% of earnings for large companies. This occurred when the companies earned (credited) larger than expected returns on pension fund assets during the heyday of the stock market. Now that those assumed rates are coming down, all those differentials that were booked as "profits" are now causing problems.

Enter Congress to "alleviate" the problem. The final assumption a company makes in pension fund accounting is the rate at which it discounts back its future liabilities to arrive at a present value. (I know this is confusing for those used to using only one rate, but it is difficult for me to reason as to why there are two rates. The only thing I can come up with is that the "earn" rate allowed is discretionary and much higher than any "discount" rate acceptable by FASB). The House has approved the use of a corporate rate instead of the lower government rate in discounting the liabilities back. This sounds innocuous, but let's see what it means in dollars and cents.

General Motors Corp.(GM:NYSE) is a company with a pension fund deficit. The company's own 10-K indicates that a 25 basis point drop in the discount rate for its pension fund liabilities would reduce its obligation by $1.9 billion. The current government 30 year-rate of 5.25% is 95 basis points lower than the 6.2% average Moody's corporate rate. By using the higher corporate rate, the present value of the company's overall pension obligation is reduced by $7.22 billion ($12.90 per share).

This does not mean that the future value has changed: the company still owes that in the future. It means instead that the company is being allowed to be less conservative in its assumptions in meeting that obligation.

It may very well be that the company will in the future meet these obligations, but the risk that it won't has increased.

The problem has been "alleviated".
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Position in GM and IBM

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