Despite plowing billions in borrowed funds into its pension plan, General Motors Corp.'s (GM ) worldwide retirement schemes still had a shortfall of $7.5 billion at the end of 2004. On top of that, the auto maker had a $57 billion gap in its retiree health-care plans. Investors must delve deep into GM's 196-page annual report, to footnote 16, to learn all this. It's certainly not clearly laid out on the balance sheet, where much of GM's retiree obligations are not accounted for at all.
But if accounting rulemakers have their way, GM's $65 billion in unfunded retiree promises -- $20 billion more than its cash and investments -- will be front and center on its balance sheet as soon as next year. Encouraged by the Securities & Exchange Commission, the Financial Accounting Standards Board is moving to bring more transparency to pension and health-care benefit accounting. "The degree of underfunding in these plans has become more and more visible over the years," says Robert H. Herz, chairman of FASB. "We thought we needed to do something quickly to get these numbers on the balance sheet."
Once that's done, FASB will undertake a more ambitious reconfiguring of the way pension and health-care promises are tallied. This second phase could take several years, FASB says. Executives worry it could eventually result in companies having to reflect volatile swings in such liabilities in their earnings reports.
Herz may face a big backlash from business. Standard & Poor's (MHP ) calculates that companies in its 500-stock index owe $442 billion more in retiree benefits than they have put aside. Of that amount, some two-thirds, or almost $300 billion, isn't reflected on balance sheets, according to Morgan Stanley (MWD ). Indeed, Morgan Stanley calculates that if companies put their full pension and other retiree obligations on their balance sheets, reported debt would soar 40%, to $1 trillion. As a result, says Howard J. Silverblatt, S&P's senior index analyst, FASB's move "is going to make [the controversy over expensing] options look like nothing."
GM isn't going to have to stump up $65 billion all at once. Its pensions conform with Employee Retirement Income Security Act (ERISA) funding requirements. Legally, health-care promises don't have to be prefunded. Nor would a big downgrade of debt come into play, as debt rating agencies already factor these obligations into their ratings. GM Vice-Chairman and Chief Financial Officer Frederick A. "Fritz" Henderson say the proposed new rules are very complex, and GM doesn't yet know what the impact will be. But GM's shortfalls could shrink this year, given its pension plan's strong performance. GM Chairman and CEO G. Richard Wagoner Jr. would not comment on FASB's proposed changes. But he noted during an analyst meeting on Jan. 13 that GM's plan is now overfunded by $6 billion after earning a 13% return on its investments in 2005, a $3.5 billion gain over 2004. A health-care deal recently signed with the United Auto Workers will cut that liability by $15 billion, according to GM.
Still, the initial change in FASB rules could have a significant impact on how companies employ surplus cash. It will also reset a host of financial ratios, such as debt-to-equity and debt-to-book value, that loan officers, investment bankers, and investors use to evaluate companies. "Anything that affects the balance sheet in this magnitude is important," says Henry McVey, Morgan Stanley's chief U.S. investment strategist.
Companies most affected will be older ones that are often unionized and have large pension plans and substantial retiree health-care commitments. For example, Boeing Co. (BA ) could see $18.6 billion in obligations added to its balance sheet under the proposed rules. Its health and pension plans are still open to new employees. But even companies that moved to freeze their plans, most recently IBM (IBM ), will add a lot of red to their balance sheets if they are underfunded.
The logic of putting these shortfalls on company tabs is simple. Companies have to make good on any underfunding that isn't compensated for by better-than-expected investment returns. And that won't be easy. S&P calculates that seven companies in its 500 index have unfunded retirement liabilities exceeding 25% of their total assets. At the top of the list: appliance giant Maytag (MYG ) (47%), Goodyear Tire & Rubber (GT ) (38%), and Navistar International (NAV ) (35%), maker of trucks and engines. For Lucent Technologies Inc. (LU ), which has $17 billion in assets on its corporate books and pension plan assets of $28 billion, "you can argue that the pension plan is as important as the operating company itself," says Credit Suisse First Boston (CSR ) accounting analyst David Zion.
For many, it's not the pension that hurts them the most. S&P figures retiree health plans are only 22% covered by assets, vs. 88% for pensions. The reason: Besides not being legally required to fund health-care costs, companies don't get the same tax credit for them as they do for pensions. An analysis by accounting expert Jack T. Ciesielski, publisher of the Analyst's Accounting Observer, shows that more and more liabilities are being hidden off balance sheets. He found that for 276 S&P 500 companies such underfunding rose 30%, to $318 billion, from 2001 to 2004, while the amount making it onto balance sheets barely budged, at around $200 billion.
Since many plans are being frozen these days, critics of change argue the accounting issue is fast becoming moot. "It's a dinosaur," says Colleen Cunningham, president and CEO of Financial Executives International, an association of corporate finance officers. "Shouldn't [FASB] be spending time on other things that might make a bigger difference?"
Executives seem especially concerned about the second stage of FASB's overhaul of the rules. Moving unfunded liabilities from a footnote onto the balance sheet is little more than a "geography question," says Gregory J. Hayes, accounting and controls vice-president for United Technologies Corp. (UT ), which has a pension underfunding of $3.1 billion and an estimated $4.5 billion in off-balance-sheet retiree liabilities. "We don't like it, but it's no new news." More worrisome to Hayes is the possibility that FASB might require liabilities and assets to be adjusted to reflect current market values. For his $15 billion fund, a 1% change could add (or subtract) $150 million in income.
Such volatility frightens financial executives, and many would prefer to stick with today's convoluted accounting. "Our concern is that the constant state of change at FASB makes it harder to understand the financial statements," says Hayes. "Our goal is to make [them] more transparent." Which is just what FASB hopes its changes will do.
By Nanette Byrnes, with David Welch in Detroit