A free lunch can be the most expensive meal in the world. For living
proof, look at General Motors. A big reason that GM has gotten into
such trouble is that the pension and health care commitments it made to
employees decades ago seemed to be a free lunch.
The United Autoworkers placed a high value on these benefits, but the
accounting rules of the time placed no cost on GM's risk of providing
them. So the UAW and GM made deals that were heavy on benefits,
relatively light on wages.
Lower salaries meant that GM reported higher profits, which translated
into higher stock prices -- and higher bonuses for executives.
Commitments for pensions and "other post-employment benefits" -- known
as OPEB in the accounting biz -- had little initial impact on GM's
profit statement and didn't count as obligations on its balance sheet.
So why not keep employees happy with generous benefits? It was a free
lunch. Besides, GM's only major competitors at the time, Ford and
Chrysler, were making similar deals.
Now, as we all can see, pension and health care obligations are eating
GM alive. The bill for the "free" lunch has come in -- and GM is having
trouble paying the tab. In the past two years, GM has put almost $30
billion into its pension funds and a trust to cover its OPEB
obligations. Yet these accounts are still a combined $54 billion
"Any market economist would tell you that things that are 'free' are
overconsumed," says Greg Taxin, chief executive of Glass, Lewis & Co.
"That's true of pensions, it's true of OPEB, and it's true of stock
options in the '90s." That's a lesson the SEC seems to have ignored,
given last week's decision to let companies delay counting the value of
options as an expense. But that's a topic for another day.
GM began its slide down the slippery slope in 1950, when it began
picking up costs for medical insurance, pensions and retiree benefits.
There was huge risk to GM in taking on these obligations -- but that
didn't show up as a cost or balance-sheet liability. By 1973, the UAW
says, GM was paying the entire health insurance bill for its employees,
survivors and retirees, and had agreed to "30 and out" early retirement
that granted workers full pensions after 30 years on the job,
regardless of age.
These problems began to surface about 15 years ago because regulators
changed the accounting rules. In 1992, GM says, it took a $20 billion
non-cash charge to recognize pension obligations. Evolving rules then
put OPEB on the balance sheet. Now, these obligations -- call it a
combined $170 billion for U.S. operations -- are fully visible. And
out-of-pocket costs for health care are eating GM alive.
GM spokesman Jerry Dubrowski says the company expects to pay $5.6
billion in health care costs this year for 1.1 million people covered
by its plans. That's up from the $3.9 billion it shelled out in 2001 to
cover 1.2 million people.
"At the time GM began offering these benefits, no one had any idea that
the costs for prescription drugs and medical services would explode the
way they have," Dubrowski said. True. But the UAW was astute (or lucky)
enough to push the risk of covering these costs onto GM.
GM's pension funds are in pretty good shape, thanks to an $18.5 billion
infusion two years ago. GM got this cash by selling bonds at relatively
low rates, hoping to resolve its pension problems once and for all.
This maneuver has been successful so far, but funding the pension plans
has consumed much of GM's borrowing power and strained its balance
At the end of last year, GM says, its U.S. pension funds showed a $3
billion surplus. GM's pension accounting, which assumes that the funds
will earn an average of 9 percent a year on their assets, is highly
optimistic. But things are under control -- as long as GM stays
By contrast, OPEB is out of control. At year-end, OPEB was $57 billion
in the hole, even though GM threw $9 billion into an OPEB trust in
2004. The company has no legal obligation to pre-fund these costs, but
it's trying to show the financial markets and its workers that it's
dealing with them. The OPEB trust has a hefty $20 billion of assets --
but GM calculates its obligations at a staggering $77 billion.
What's more, GM says they're rising at 10.5 percent a year. Thus, even
though President Bush's Medicare prescription drug benefit whacked $4
billion off GM's OPEB obligation last year -- thanks, George -- it
covered barely half the year's increase in the liability.
If GM were making lots of money selling vehicles, this would all be
manageable, sort of. GM could buy enough time for demographics to bail
it out, as more retirees begin getting Social Security and Medicare,
reducing GM's costs, and other retirees die off. Its ratio of retirees
to workers, currently 2.5 to 1, would shrink. Alas, GM's vehicle
business is in the tank. Unless GM starts making money on vehicles or
gets a break from the UAW or the federal government, things are going
to get really ugly. I hope that doesn't happen, but it easily could.
The bottom line: Whenever you offer someone a free lunch, make sure
that you'll be able to pay the bill when it comes in.