2 Big Automakers Threatened By Pension Obligations

| About: General Motors (GM)
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An interesting tidbit to come from the transportation legislation headed to President Obama for signing has nothing to do with roads. Instead, it deals with pension income issues that could have a major impact on several companies, especially General Motors (NYSE:GM) and Ford (NYSE:F). That's because of the large pension obligations that both of these companies are trying to fund. If these obligations are not tended to, they will threaten the profits of these companies. All of the gains that they have reported over the past year, including increases from car sales, could be wiped out if the costs associated with their pension obligations are not reined in.

While the legislation is important, investors should note that GM and Ford have been proactive in dealing with their pension obligations. Already this year, they both introduced buy back plans to get a hold of their liabilities. This is just another indicator that these two giant automakers understand the financial pressures that threaten their bottom lines. Over the next 12 to 18 months, I expect the stocks of these companies to strengthen mainly due to strong sales of new vehicles. For June, Ford's vehicle sales were up 7% from last year to 207,759. GM's vehicle sales were up a 16% to 248,750, and the company reported that the month represents its highest sales since September 2008.

The main goal of the legislation, Moving Ahead for Progress in the 21st Century (MAP-21) Act (S. 1813), is to fund major transportation projects, such as those for highways and bridges, throughout the country. Most of the measure is financed by extending federal taxes on gasoline and diesel fuel for two more years. Those levies have been stuck at 18.4 cents a gallon for gasoline and 24.4 cents for diesel for 20 years. Now they fall well short of the amount needed to fully finance highway programs, which they were designed to do.

The architects of the transportation bill, which President Obama signed into law over the weekend, set out to fund the transportation program through a two-year extension of federal taxes on gas and diesel fuel. However, after recognizing this would not be enough to fund the transportation projects called for in the bill, lawmakers had to find a funding source. They were able to agree to fund the program through unconventional means.

The plan they devised basically works like this. Tax deductions for company pension contributions will be reduced, while fees they pay to federally insure their plans will be raised. This will basically let companies spend fewer dollars on their pensions. Estimates indicate that $20 billion will be raised over the next 10 years.

The measure received considerable support, including from the American Benefits Council. It found that the measure represents good pension policy, in addition to helping to raise revenue.

There is no question that companies throughout the country are struggling to meet their pension obligations and at the head of that list are GM and Ford. JPMorgan Chase (NYSE:JPM) found that GM's underfunded assets totaled $25 billion, while Ford's totaled $15.4 billion. That amounts to 74% of GM's market cap and 40% of Ford's.

Part of the reason GM, Ford and other corporations are having problems covering their pension liabilities stems from the current low interest rate environment. Companies park their assets in pension funds. They look to long-term interest rates as a way to determine the growth of those assets. When interest rates are high, the pension funds grow. However, in low interest rate environments, like the one we are currently in, the funds don't grow as much, which causes pension liabilities to grow.

To deal with their pension liabilities, General Motors and Ford have proposed buyout plans to their employees. At the beginning of June, General Motors announced a retirement plan that it hopes leads to a $26 billion in its U.S. pension obligation. It entails offering a one-time, lump-sum payment to about 42,000 salaried retirees and surviving beneficiaries. GM plans to purchase a group annuity contract from Prudential (NYSE:PRU), under which Prudential will pay and administer future benefit payments to most of the remaining U.S. salaried retirees, according to a statement from GM. The transactions are expected to be completed by the end of the year. Prudential is expected to start making the benefit payments in January.

During the spring, Ford announced it will offer its 98,000 U.S. salaried retirees and former employees lump-sum payments as part of its buyout plan. Its plan could reduce its pension obligations by $49 billion, or about 33%.

For both General Motors and Ford, the success of the plans depends on how many people will take them up on the offers.

Ford and General Motors are part of what is referred to as The Big Three. Chrysler is the third part of the group. In June, it said that it had no plans to offer buyout plans to its retirees to help shore up its pension obligations. Chrysler had about $32 billion in pension obligations at the end of 2011, and they were underfunded by $6.5 billion.

The situation will only be aggravated as they deal with declining sales of their products in Europe and Asia. Last week, Ford announced that its losses for the second quarter of 2012 could reach $600 million. Ford, General Motors and other automakers will report their sales totals for June on Tuesday. All eyes will be on the report to see if they will report sales in line with economist's expectations of an annual rate of 13.9 million automobiles, which would be higher than May's annual rate of 13.7 million.

Automakers report the month's U.S. sales totals Tuesday, with economists expecting an annual rate of 13.9 million cars. That would beat last month's disappointing 13.7 million rate, but be shy of the 14.5 million average for the first four months of the year.

As an investor, I think it is very important that these companies get a hold of their pension obligations. At this point, any help, including through the federal government's legislative assistance like the transportation bill, should be very much appreciated. This is especially true considering that the low interest rate environment will likely span through 2014 now that the Federal Reserve has said it will likely not raise rates until after 2014. This means that these obligations will likely continue to grow, and will affect the finances of these automakers.

Auto manufacturer's stocks are finally recovering from years of being under pressure because of the economic slowdown. While I don't count them out now because of their mounting pension obligations, I think the liabilities pose viable threats if not addressed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.