It’s a problem that Jeffrey Immelt largely ignored as he tried to appease General Electric’s most vocal shareholders.
But it might end up being one of the costliest for John Flannery, GE’s newly anointed CEO, to fix.
At $31 billion, GE’s pension shortfall is the biggest among S&P 500 companies and 50% greater than any other corporation’s in the U.S. It’s a deficit that has swelled in recent years as Immelt spent more than $45 billion on share buybacks to win over Wall Street and pacify activists like Nelson Peltz.
Part of it has to do with the paltry returns that have plagued pensions across corporate America as ultra-low interest rates prevailed in the aftermath of the financial crisis. But perhaps more importantly, GE’s dilemma underscores deeper concerns about modern capitalism’s all-consuming focus on immediate results, which some suggest is short-sighted and could ultimately leave everyone — including shareholders themselves — worse off.
“It’s a clear tension,” said Olivia Mitchell, a professor at the University of Pennsylvania’s Wharton School and executive director of the Pension Research Council. “Buybacks clearly use assets available not to fund the pension promise but to make shareholders happy.”
In GE’s case, lavish shareholder rewards failed to deliver outsize returns and leave Flannery with less room to maneuver. Not only must he boost profits, shore up its cash flow and contend with its flagging oil services and transportation businesses, but the 30-year GE veteran also needs to pay close to $50 billion in pension obligations that come due in the next decade.
“Given the significant decline in interest rates and volatile financial markets that resulted in lower asset returns from 2008 to 2009, the company has been actively managing the pension liability,” said GE spokeswoman Jennifer Erickson. She added that in 2017 and 2018, the Boston-based company plans to contribute a total of $3 billion to its pension. GE’s primary plan covers about 467,000 people and is one of the biggest in the U.S.
Nobody is suggesting that GE is in imminent danger of defaulting on its pension obligations and many analysts say the company still has years to address the bulk of its shortfall. What’s more, a rising rate environment helps GE winnow its pension deficit by boosting its expected return.
But if nothing else, balancing the competing interests of its shareholders and employees has proven to be especially hard for GE. Immelt began ramping up GE’s buybacks in 2015, shortly after Peltz’s Trian Fund Management took a stake in the industrial giant and recommended the company step up the repurchases to boost its stock price. GE bought back about $23 billion that year and then $22 billion in 2016. Last year’s total was more than double the amount GE spent in 2013, data compiled by Bloomberg show.
‘Living in Fear’
Yet in those same two years, GE spent little more than $2 billion on total pension contributions, which hasn’t been nearly enough to keep the overall shortfall from widening. (The company also curtailed capital investments.) At the end of 2016, its pension had $94 billion in obligations but only $63 billion in assets — a funding ratio of 67%.
“GE has the tension between financial-ization and innovation,” said William Lazonick, a professor of economics at the University of Massachusetts Lowell. “People at the top are living in fear of hedge fund activists and worry about their share price rather than what is going on with the company.”
To make matters worse, GE shares have still underperformed even with the buybacks — though they did help Immelt meet one of the goals used in determining his bonus last year. Since October 2015, when Peltz first disclosed his position in GE, the stock has returned 20%, less than half the gain for industrial companies in the S&P 500.
The financial consequences of GE’s short-termism have been considerable. In addition to the “anemic” free cash flow from its industrial businesses, GE’s pension hole and its indebtedness helped subtract roughly $8 per share from its equity value, based on a sum-of-the-parts analysis by Cowen & Co. That’s equal to $70 billion in market capitalization. To put it another way, the discount amounts to eight years of per-share earnings based on 2016 results.
Those problems “prevent Mr. Immelt or his successor Mr. Flannery from dramatically transforming the portfolio,” according to Cowen, which put out its report on June 12, the day that GE announced Flannery would succeed Immelt as chief executive officer.
When it comes to dealing with GE’s pension, Flannery may have few good options. While many other companies, including General Motors Co., have offloaded some of their obligations to insurers, it could come at a considerable cost because of how big and underfunded GE’s pension has become. The company has the largest projected benefit obligation of any S&P 500 member, and among the top 10, no one has a lower funding ratio.
And the longer its pension remains underfunded, the costlier it becomes. The Pension Benefit Guaranty Corp., a government agency that acts as a backstop when plans fail, has more than tripled its rates for companies with funding deficits, and they’re set to rise even more in the next two years.
“Those premiums have gone significantly higher,” said Michael Moran, chief pension strategist at Goldman Sachs Group Inc.’s asset manager. Depending on the circumstances, “it may be more advantageous to lower what you pay for the premiums than buy back stock.”
Because interest rates are still relatively low, it’s possible for GE to borrow money it needs to cover its shortfall. Both Verizon Communications Inc. and FedEx Corp. sold bonds this year to do just that. But according to Cowen, GE may be constrained in how much more debt it can take on because it’s already on the hook for about $130 billion.
And even if GE is able to fully fund its pension with debt, there’s no guarantee it won’t fall behind again. Investing in safe, low-yielding bonds might not be enough for GE to earn the 7.5% return that it expects for its pension assets each year and pay for the debt that it incurs. Taking on more risk could leave its pension vulnerable to another market downturn.
“This would be quite a risky strategy,” Mitchell said. “Any unpleasant investment surprises would leave the pension even worse-funded than now.”
Earning enough will be crucial. Even though GE ended its defined benefit plans for new hires in 2012, the company still needs to pay out roughly $47 billion in pension benefits to its retired employees and their beneficiaries over the next 10 years, a regulatory filing showed. That’s half its total obligations.
It wasn’t supposed to be this way. According to Dennis Rocheleau, a 36-year GE veteran who was its chief labor negotiator until 2004, the company considered its pension well prepared and thought its investing prowess could help keep the plan in shape. No one could foresee the financial crisis or the rock-bottom rates that followed.
We were “smug about our position,” said Rocheleau, who has spearheaded an effort opposing GE’s decision to reduce some health benefits for retirees.
What Flannery will do now is anyone’s guess. And truth be told, GE’s employees have a stake in seeing the company’s stock rise because the pension trust itself owned about 32.9 million GE shares at the end of 2016, according to data compiled by Bloomberg.
During a conference call to discuss the CEO transition and his priorities, Flannery said that “it is important that we’re always mindful of the impact on all of our stakeholders.”
“So, obviously, our customers, our employees,” he explained before adding, “but I’d say, especially our shareholders.”