Funding OPEB Liabilities: A Proposal for the Automotive Industry

By B. Anthony Billings and Randolph Paschke

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“The state of OPEB is extremely unsettling,” wrote S&P analyst Howard Silverblatt in a December 2005 press release. Unlike pensions, which are regulated, there exists no legal requirement to create a trust entity to fund current or future OPEB costs, S&P pointed out. The ratings agency also observed that tax treatments and credits set up specifically to encourage pension funding do not exist for OPEB costs. S&P further noted that 88% of pension obligations are set aside in trusts, compared with only 22% for OPEB obligations.

The OPEB debate has so far focused on trying to reduce retiree benefits or increase retiree contributions. Obviously, neither of these options is politically popular. Dealing with the OPEB liability may also force companies to reduce investment in important, but discretionary, programs. The most notable example is investment in alternative-energy vehicles that can be more competitive in a market of rising oil prices and political appeals for energy independence. For the U.S. economy as a whole, one concern is that any reduction in healthcare coverage will place further burdens on the Medicare system. What is clear is that the combination of addressing the OPEB obligation and the need for more competitive automobiles with energy-efficient designs may be the most significant challenge the industry has encountered. It is worth asking if it is a challenge that U.S. automakers cannot solve without help.

One option for funding OPEB liabilities, advanced funding, uses an entity for employers to build an asset base to offset the accrued liabilities and thus provide payment of the benefits as they come due in future years. As the asset base builds up and the funding ratio increases, a larger share of the plan’s revenues derives from investment income, while contributions decline. This has been the result of pension trusts in the U.S. over the last century. S&P reports that reasonably well funded defined-benefit pension plans receive 60% to 70% of total revenues from investment income.

How can companies like GM and Ford advance-fund their OPEB liabilities and at the same time continue to invest additional resources into developing new energy-saving automobiles? The authors propose the use of government-guaranteed bonds as a means of stopping the financial hemorrhaging of American automakers that are burdened by OPEB liabilities.

Use of Federal Guarantee Programs

Many national governments, including the United States, support a wide range of activities through credit guarantee programs. Although used sparingly in the private sector, the most notable loan guarantee program to date was the bailout of the Chrysler Corporation in 1980. The U.S. government provided Chrysler with $1.5 billion in government-guaranteed debt (GGD) instruments to help the firm achieve financial stability. By 1983, Chrysler paid off the loan with a return of approximately $350 million to the U.S. government. More recently, GGD instruments have been used to subsidize the airline industry after September 11, 2001. Other notable objectives have included the financing of rural cable television, electrification, rural utilities, and similar types of public infrastructure. Other programs include the Small Business Administration, the Small Business Investment Companies program, and the Export-Import Bank program.

Loan guarantees lower the default risk to lenders by shifting credit risks to the government, thereby lowering the interest cost for the borrower. Funds obtained through GGD loans often would not have been approved by lenders or would have been made at higher interest rates. Because lenders charge higher interest rates for riskier loans, the differences in the market rate of interest and the subsidized interest rate provide an arbitrage opportunity for the borrower. The arbitrage opportunity arises because the federal government can borrow funds and absorb risks more cheaply than most private entities. From 2002 to 2006, the federal government guaranteed approximately $495.6 billion in loans annually. Moreover, subsidized loans generally have more flexible regulations than alternative lending institutions and are exempt from state and local taxes.

Considering that federal guarantees of bonds have been used successfully to fund a variety of activities at minimal costs to the Treasury, the authors propose that qualified companies be allowed to use GGD to fund legacy costs, as well as for the development of advanced technology for fuel-efficient vehicles and certain of their components. The obvious benefit from this approach would be enhanced liquidity, less expensive financing to produce fuel-saving technologies, and more cost certainty for retirement benefits. Such a program would allow companies to use the arbitrage benefit from such loans to compete with foreign competitors without resorting to direct subsidies from the U.S. government.

The subsidy cost of GGD normally depends on the probability of default on proceeds from any related collateral and the fees paid by debtors. For GGD, the risk of default is negligible and the securities trade in a narrow spread to Treasury bonds. The evidence shows that the default risk of existing loan guarantee programs varies widely. Most programs have default rates of less than 2%, while others are as high as 20%. The challenge is to structure the loan guarantee program in a way to provide as much flexibility as possible for the debtor so that the arbitrage benefit is sufficient to earn a rate of return at least equal to the entity’s internal rate of return. Qualified programs should demonstrate social benefits in the form of helping to preserve and extend employment (and, hence, enhance employment tax receipts) and reduce the risk of pension-fund defaults. GGD instruments offer flexibility with respect to size, fixed or callable maturities, as well as floating or fixed interest rates.

Estimation of Arbitrage Opportunity

For purposes of analysis, companies’ arbitrage is measured as the excess of a firm’s cost of debt compared to the AAA bond rate. Cost of debt is derived by dividing interest expenses for financial reporting purposes by outstanding debt (see the Sidebar for details). Data for several original equipment manufacturers (OEM) over the 2000–2004 period are extracted from several sources. The authors used the AAA interest rates on corporate bonds as a proxy for the subsidized cost of GGD instruments, based on the assumption that the implicit government guarantee reduces the risk of default for such bonds to a risk equivalent to AAA bonds. Lawrence J. White (“Fannie Mae, Freddie Mac, and Housing Finance: Why True Privatization Is Good Public Policy,” Policy Analysis: No. 528) provides support for the notion that AAA rates are good indicators of GGD instrument costs. W. Scott Frame and Lawrence J. White (“Regulating Housing GSEs: Thoughts on Institutional Structure and Authorities,” Federal Reserve Bank of Atlanta Economic Review, Second Quarter 2004) also note that without the implicit government guarantee, GGD instrument ratings would fall within the range of A and AA bonds.

To account for seasonality, the two-year moving average of interest expense was divided by the two-year moving average of outstanding debt to obtain companies’ interest cost. As shown in the Exhibits, the companies examined were automobile manufacturers and automobile parts suppliers. Data points used in the estimation were extracted from SEC filings during 2000–2004 and were supplemented by bond yield data from several sources (missing data points are designated as “na”). Exhibit 1 presents estimates of the arbitrage opportunity amounts, based on the replacement of existing debt only. Column H, however, shows the additional arbitrage amount that could be earned by increasing debt levels to the industry average debt-to-asset ratio. Column E shows the annual arbitrage amount and Column F shows the amounts accumulated over the ensuing five years, based on the internal rate of return on voluntary employee beneficiary association (VEBA) assets.

The annual amounts in Column F are derived by adding the computed arbitrage amount in each year to the time value of the prior year’s Column F amount. For this purpose, the average internal rate of return for firms with VEBA information was used for nonpublic companies. Unlike Exhibit 1, Exhibit 2 presents arbitrage opportunity amounts based on the excess of interest costs tied to each firm’s bond rating over the yield of the applicable 30-year Treasury bond. Both the Exhibit 1 and Exhibit 2 amounts are calculated based on total outstanding debt. As shown, some companies would not benefit under the proposed policy, because their interest costs are lower than the interest cost on the applicable agency debt.

Implications

The computed arbitrage amounts would provide enhanced liquidity from which the automotive companies can fund a variety of programs without adding significant risk to their balance sheet. These available funds could be used to partially offset the OPEB amounts, and the remaining amount could be earmarked to fund programs with public benefits, such as research and development into alternative energy sources.

The authors propose that any GGD for U.S. automotive companies be tied to key activities like funding new investments in advanced technology for fuel-efficient vehicles and alternative-fuel vehicles for domestic energy independence. New investments could be defined in a way to ensure the related research—or production would take place in the United States and generate American jobs. The use of available funds for the development and production of advanced-technology vehicles and technology to lower domestic demand for foreign oil would go a long way in achieving energy security and in financially stabilizing the auto industry. Such activities would have secondary benefits in the form of helping to preserve and extend employment (and hence enhance employment tax receipts), along with reducing the risk of pension-fund defaults.

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