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Markets: Manufacturing Meltdown ?
New York: November 28, 2005
By John R. Stephenson

"A painful cycle of restructuring, waning profitability and further restructuring is likely to characterize GM's future."

--Goldman Sachs Analyst Robert Barry

"We acknowledge that a journey of a thousand miles starts with a single step, but at this rate GM will never get to the land of milk, honey, fat, EBITDA, and bonds that trade at par."

--Shelly Lombard - Senior Research Analyst, Gimme Credit

Could it get much worse for General Motors? Apparently so! The reaction by investors to the recent announcement of the layoffs of some 30,000 General Motors employees seemed ho-hum at best. Buy why? Because GM is a bloated relic of its former self, hobbling rather than sprinting into old age in an increasingly competitive and global market for the production of automobiles. But it isn't just GM that is struggling these days, legions of North American companies are struggling under the weight of increased competition, bloated workforces and uninspired leadership.

Whether it is GM, Delphi or the airlines, one thing seems clear — costs are out of control. With people living longer and companies facing both increased competition and faster product development cycles the result for many is strained profitability particularly for the more traditional manufacturing-oriented companies. Adding to the woes of these firms is a pension system introduced in the good times when workers were many and retirees few.

With some 77 million Americans set to retire by 2030, the stage has been set for increased problems on the business and pension plan front. With more of us hurtling toward old age and family size growing smaller rather than larger, the problems can only get worse for North American companies that have promised their workers a defined benefit in retirement (defined pension plans). With large numbers of American workers retiring over the next several years and huge shortfalls (assets minus obligations) in their pension plans, the stage is set for further layoffs and increased pension follies in the years to come.

Back in the golden age of General Motors, a defined pension plan was just part of good corporate citizenship. After all, your workers were part of your success and, as such, deserved to have full-funded pension plans which looked after their economic needs in retirement. Naturally, they had to be indexed to inflation to protect the earning power of the benefit to retirees.

But all of that occurred at a time when America was the unchallenged superpower and when Germany and Japan were still on their knees from the Second World War and before the Japanese and the Germans produced the best cars in the world. These plans were established before China became the second largest producer of automobiles in the world and on track (2015) to become the largest manufacturer of automobiles. Not only that, but back then there were 10 or more workers for every retiree and most people weren't expected to live much beyond sixty-five years of age.

Figure 1: The Elderly Dependency Ratio Continues to Increase!


But today things are different. We are not alone in the world and the structural changes in our society are bumping up against the promises we made in the past. Promises we can't keep. In the last three years, some 600 companies (21 for obligations of $100 million or more) have reneged on pension obligations. The worst being United Airlines which stuck the government with a bill for $9.8 billion when it decided to walk from its problems. But not far behind are other airlines such as Delta and Northwest who have already announced to Congress that their plans would be in default unless their deadline for funding was extended. Rounding out the group are none other than the automakers whose own pension plans are falling short (assets less than liabilities or obligations to shareholders) by some $55 to $60 billion.

Across the board, promises and pension plans are increasingly likely to be broken as executives realize that the cost of living up to these promises to future retirees is just too tough a pill to swallow. The reason? The assumptions underlying these plans are just plain wrong. Back in the 1980s, there were some 112,000 defined pension plans (promises to pay specific benefits in the future) when times were good and the stock market buoyant. But today, the number has dwindled to a mere 31,000 as managements have realized that making promises to future retirees 40 or 50 years in the future is tantamount to corporate suicide.

While the problem is bad now, it is likely to get a whole lot worse. The reason? The idea behind a pension plan is to invest money today to fund the obligations of pensioners in the future. While the obligations (benefits to retirees) are known today, it is uncertain how much money will be available in the future. In order to calculate the under or over funding that is currently the situation, the pension plans calculate the difference between their future obligations and their current assets assuming a certain rate of return on those assets. The problem? The rates of return being assumed for these pension plan assets is way too high.

Most pension plans are assuming that they can get somewhere between 8 and 9 percent return on their assets each and every year. For a while, they were doing a little bit better. According to Whilshire Associates, last year the average plan recorded returns of 10.8 percent. But that was when the stock market was doing a whole lot better than it is today. With the rates of return on long-term bonds no more than 5 percent and the typical pension plan holding 40 percent bonds and 60 percent stocks, it works out that the equity portion would need to return at least 10 percent for the pension plan to show 8 percent overall returns. But since the stock market tends to grow at just GDP plus inflation over long periods of time, this assumption of 10 percent growth rate in equities might be very optimistic. Roughly speaking, if the Dow Jones Index (30 large blue chip stocks) were to compound at 10% a year, we would be looking at a Dow Jones Index of 22,000 by 2015 - up from 10,615 today. This is highly unlikely.

But just how bad is it? Pretty bad by most accounts. Roger Lowenstein recently wrote in the New York Times that the problem of underfunded pension plans is far larger than anyone imagines. " The amount of underfunding in corporate pension plans totals a staggering $450 billion. Given that pension promises do not come due for years, it is hardly surprising that corporate executives and state legislators have found it easier to pay off unions with benefits tomorrow rather than with wages today. Since the benefits were insured, union leaders did not much care if the obligations proved excessive....".

Roger Lowenstein points out the problem with corporate pension plans but the problem exists with government pension plans as well. According to Business Week magazine, the problems could be much worse than originally thought. "As much as states are throwing into pensions, they may owe even more. Despite a 2004 stock market rise that should narrow some of the gap, pension experts at Barclays Global Investors say that if public plans calculated their obligations using the more conservative math that private funds do, they would not be $278 billion under, but more than $700 billion in the red. It's just ruining the financial picture for states and municipalities," says Mathew H. Scanlan, managing director of Barclays, one of the largest pension-fund investment managers. "You're looking at a taxpayer bailout of this pension crisis at some point."

So with markets poised to deliver weaker returns over the next several years and with more and more of us set to retire, the stage has been set for massive government bailouts of corporate and state pension plans in decades to come. With government forced to dig deeper to fund a looming crisis and fewer workers to call upon to shoulder the burden, is a taxpayer revolt imminent?

Perhaps. But just as likely is taxpayer flight. We already have seen the perverse scenario of American corporations locating to tax havens such as Bermuda. Strangely enough the Carribean Islands have surpassed on occasion the financial centers of London, Tokyo and New York as buyers of U.S. Treasuries. The reason? Hedge Funds and the large pools of capital they control have moved there to take advantage of favorable tax treatment.

With corporations and capital already moving offshore can young people be far behind? Who knows? But the promises we have made in the form of social security and pension plans are promises that we can't keep. Soon, our children will be faced with a bill they cannot pay. And they won't. Pretty soon, we'll be re-writing the social contract that binds us together.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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