Ford To Fund Its Pension Fully By Mid-Decade

| About: Ford Motor (F)

Ford (NYSE:F) is one of the most popular stocks covered by analysts, journalists and online contributors. Much of the research conducted on Ford is overly simplistic and rarely talks about important points beyond looking at the company's P/E ratio. There are many articles that look at Ford and try to determine whether the company is buy, hold or sell by using only at its P/E ratio. This is why I decided to write this series on the company to cover many aspects of it. In this article, I'll talk about one of the most important items in Ford's balance sheet: its pension obligations.

Those interested can find the previous six articles here: 1) When Will People Understand Ford's Debt?, 2) The Ford Story Continues In Europe, 3) Ford: Opportunities Exist In South America, Asia And Africa, 4) Ford Credit Is An Important Part Of Ford, 5) Digging Deeper Into Ford Credit and 6) So How Can Ford Steal Market Share From Competitors? (Bonus: Connectivity Is The Next Big Thing For Cars).

So, what's going on with Ford's pension plan and why is it so important for the investors? As of the end of last year, Ford had an outstanding pension obligation to its retirees totaling $83 billion. The company spent $3.4 billion during 2012 in order to fund some of the obligations and there is a shortfall of $18.7 billion. The company plans to meet all its obligations by the mid-decade. As you can see, the pension obligations are one of the biggest items in Ford's balance sheet and they eat a big chunk of Ford's earnings right now. On a positive note, when the company is done with paying these obligations off, its balance sheet will be very healthy and it will be able to spend this money on its investors in shape of dividends and buybacks.

Currently, the policies of the Fed have created a low-interest environment which is hurting pension funds across the world. Pensions can't put all their money in stocks because it would be too risky. After all, millions of retirees and their families will have to rely on pension funds to support a living. When the interest rates are low, companies have to make larger contributions to their pension funds in order to close the gap.

In 2012, Ford's pension plan's asset return was $7.0 billion and its obligation growth was $5.2 billion, resulting in a net return of $1.8 billion. The contributions totaled $3.8 billion, which added $5.6 billion to the funds when combined with the net return. Unfortunately, the lower discount rate was $8.9 billion, which increased the funding gap by $3.3 billion ($8.9 billion minus $5.6 billion). The discount rate is a direct function of interest rates.

According to the company's calculations, if the interest rates were higher by 1%, the funding gap would have narrowed by $2.3 billion in 2012. Similarly, if the interest rates were lower by 1%, this would have widened the funding gap by another $2.8 billion. As you can see, the funding status of Ford's pension plan will be heavily dependent on the interest rates. In fact this is true for most companies with pension plans. The good thing is that the interest rates will be almost always higher than how they are right now because they are artificially pulled back by the policies of the Fed until the economy improves.

In January of this year, Ford issued new debt of $2 billion with a yield of 4.75%. Part of this debt (i.e., $600 million) was used to retire an older debt that used to yield 7.50% and the rest of this amount ($1.4 billion) will be used to make pension payments. This debt will mature in 30 years.

Ford is funding its pension plans at a higher rate each year. In 2011, the contribution was $2.3 billion, followed by $3.4 billion in 2012. This year, the plan is to contribute $5.4 billion to the plan, which will be the largest payment in a long time. Of this, $5 billion will go to funded plans and $400 million will go to unfunded plans. The number is large enough to worry some investors and eat a large portion of Ford's income; however, keep in mind that once the program is funded, Ford won't have to worry about this anymore, which means it can focus on other things such as further growth, higher dividends and stock buybacks. Once the pension plan is fully funded, Ford's balance sheet will start get significantly stronger. Currently, Ford's balance sheet is one of Alan Mulally's biggest priorities because he understands the importance of a strong balance sheet for both operations and investors of a company. Strong balance sheets support strong dividends and buybacks in addition to future growth initiatives.

The future contributions to the pension plans will depend on several factors. These factors are discount rates (dependent on yield of high-quality bonds in a given country), expected long-term rate of return on assets (focuses on historical long term trends rather than short term fluctuations), salary growth (a function of inflation), inflation (based on GDP growth and central bank inflation targets), expected or planned contributions (based on cash availability), retirement rates and mortality rates. Due to the strong stock market in the US last year, the return on assets was as high as 14.2%. In the long term, the expected return on assets is 7.5% per annum. This is because the pension plan is heavily invested in high quality bonds and the stock exposure of the pension plan is limited in order to limit the risk.

In addition to the pension plans, the company also offered to pay a lump-sum to many current or former employees that were either close to or in retirement. A number of these employees voluntarily took the payouts, which resulted in a one-time payment of $1.2 billion. Ford is pretty much done with making payments to those who accepted the lump-sum payment. The offer is good through 2013, so there might be more people who accept to take the payment and be done with it.

In conclusion, under the leadership of Mr. Mulally, Ford is working on improving itself in every way including its balance sheet. Currently, the company is making large contributions to its pension plan, but once the plan is fully funded, the company will be able to put its cash in other uses such as dividends, stock buybacks and future growth initiatives.

Disclosure: I am long F. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.