Automakers’ Pension Shortfall Puts More Pressure on Suppliers

Auto Focus: Automakers’ Pension Shortfall Puts More Pressure on Suppliers
MiBizWest • November 4, 2002
by Jim Gillette

Look out suppliers! You are about to be hit once again for price concessions to help pay for retirement benefits at GM and Ford.

The effects of a declining stock market are proving to be more far reaching than the depression you feel after looking at your 401(k) statements. Losses at both Ford and General Motors’ investment portfolios that underpin their pension plans are forcing the companies to ante up real cash to meet legally mandated fund­ing requirements. That’s cash that would otherwise be spent to develop and launch new prod­ucts.

Moody’s, the credit rating agency, has warned that GM’s unfunded pension liabilities could end 2002 at more than $20 billion if falling stock prices reduce the invested portfolio by 10 percent. Fitch, another agency, expects GM to end the, year $17 billion underfunded while Ford will have a shortfall exceeding $5 billion.

Defined-benefit VS. defined-contribution

The two most common types of pension plans are “defined-contribution” and “de­fined-benefit.” With defined-contribution plans, employers contribute a certain amount cash to employees’ pension investment port­ folios each year without committing that a specified amount of income will be avail­ able to each employee at retirement.

In contrast, defined-benefit plans promise to pay a given dollar amount to retirees on a monthly basis for as long as they live following retirement. With the defined-con­tribution plan, the retiree is at risk based upon how well his or her retirement investment portfolio performs. With the defined­ benefit plan, the employer has committed to a future stream of payments and, therefore, must make sure it has an investment portfolio of sufficient size to honor the commitment.

A number of factors determine the present value of the future liability of the plan in­cluding:

  1. The number of employees covered.
  2. The amount promised to each employee. This is usually based on years of service and salary level.
  3. The number of years the average employee is expected to live beyond retirement. The longer the life expectancy, the greater the liability.
  4. The expected rate of re­ turn on pension assets. The higher the expected return, the lower the value of assets needed to fully fund the future liability.

As of this writing, the S&P500 stock index is down about 24 percent for the year. Since Ford’s target investment allocation is 70 percent equities and 30 per­ cent fixed income securities (bonds), you know the market’s free fall has got to hurt. The company’s pension return assumption go­ing into 2002 was 7.25 percent, very typical from a historical perspective. The actual return for the first six months was a negative 6.7 percent. Since stock performance subsequent to June 30 has been even worse than before, we can assume the total return has worsened. Thus the shortfall of maybe $5 billion. Ford will need to come up with the cash over the next few years or pay penalties required by federal law. GM is facing the same requirement.

Another round of cost cuts

GM’s CFO John Devine sees no way out for 2003 except to make “very aggressive North American cost cuts” in order to raise cash flow sufficiently to cover the estimated $1 billion needed to add to the plan next year. Ford has also forewarned of draconian cuts needed in 2003 to keep the company afloat. While both companies are looking to slash overhead expenses, their suppliers have learned the hard lesson from the last decade that they will be asked to give until it hurts. (Most suppliers we know would tell you they would rather have an annual root canal compared to another cost­ down mandate.)

It’s hard to imagine that the automakers and UAW could have foreseen the ulti­mate cost of the defined-benefit programs when they were first put in place after World War II. I’m sure the executives at GM during the 1950s believed their com­pany would dominate the North American market forever. Intense competition has shrunk GM’s market position and reduced its workforce to the point where there are approximately 2.5 retirees for every active worker.

The first defined-benefit plan was intro­duced in 1949 when the United Steelworkers negotiated retirement benefits for their members at several steel companies. Nu­merous companies including the automakers soon followed suit. In response to the high cost and risk of defined benefit plans, corpo­rations establishing new plans over the past several years have shifted to defined-contri­bution plans or other alternatives.

Some bizarre manipulations

Back in 1989, then GM Chairman Roger Smith was faced with an accounting earn­ings shortfall for the previous year primarily due to an especially steep decline in the company’s North American market share. Smith decided to take advantage of the flex­ibility in pension accounting assumptions to lower the required contribution to the plan that year.

Without solid rationale or economic jus­tification, he raised the rate of return expec­tation of the pension investment portfolio by two full percentage points. This had the effect of lowering GM’s immediate funding requirements because the investment port­ folio was expected to be larger in the future.

The really bizarre move, however, was that Smith decided that retired GM employ­ees would in fact live two years less than was previously estimated. While this cut GM’s ultimate pension liability by a significant amount, I wondered at the time if Smith had consulted with his retirees before he made the decision. The conversation may have gone a little like, “The company’s been loyal to you. Now you should be loyal to the company. Help us out and cash in two years early.”

Of course, there was little or no hope that the plan would achieve such unrealistic re­sults. Smith was just delaying the required cash infusion until later. The day of reckoning did come in 1993 when GM’s underfunded liability hit $22.3 billion and the company had to contribute an extra $18 billion in cash and securities.

No one currently at the automakers or UAW is to blame for the fact this got out of hand. We’ve seen estimates that GM’s post­ retirement costs (including medical ben­efits) amount to $1,000 or more per vehicle. The reality is that the transplant automakers with their younger workforces and no legacy retirees are not faced with this competitive disadvantage.

It is also reality that suppliers are weary of shouldering the burden and are more and more targeting customers who are willing to pay market prices for their components without crying about structural cost disadvantages that have nothing to do with the suppliers.