GM's pension gamble: like many other companies, General Motors has a huge pension problem. But are "co-cos" the way to solve it? The answer is: "it depends.".

Baby boomers are thinking about their golden years, but American CEOs are wrestling with the soaring and potentially lethal pension liabilities that go along with that. U.S. corporate pension plans have pledged to pay out $1.5 trillion to retirees, but their assets are valued at only $1.1 trillion in today's market conditions, leaving a $400 billion shortfall.

So when General Motors floated an innovative $17.6 billion bond issue--including a $4 billion chunk of so-called contingent convertible bonds that will reinforce its pension plan--guys in the green eyeshades asked themselves: Is this a way to slay the pension monster?

The answer is that GM took advantage of extraordinarily low interest rates and a run-up in the equity markets, both of which may prove short-lived. And the company has such a large market capitalization that it can tolerate the dilutive effect that will occur when the holders of the so-called co-co bonds convert them to GM shares.

GM, which faces the largest pension fund shortfall of any U.S. company--$25 billion--was the first to use such a financial instrument to help fund its pension shortfall. Because the co-co bonds can be converted to shares after 15 years, GM was able to lock in a 6.25 percent interest rate, much lower than the 8.5 percent it pays on other debt.

GM trumpeted its bond issue as a tidy way for it to deal with the liabilities, but the three major rating agencies felt differently. Moody's Investors Service, Standard & Poor's and Fitch Ratings remained unmoved. S&P still rates GM debt BBB, two levels above junk, and Moody's rates it Baal, three levels above junk. "We gave (the issue) a mild negative," says Mark Oline, managing director at Fitch's Chicago office, which covers the auto industry. "I don't see a lot of other companies doing this."

Instead, he predicts they will rely on the old-fashioned method of generating cash from earnings. "GM is pre-funding and locking in the amounts, but they have significant financing costs," Oline notes, estimating the financing cost for the issue at around $1 billion annually.

Craig Farr, managing director and head of U.S. convertible origination at Citigroup in New York, expects more companies will use convertibles to fund their pension liabilities. But he sees a "trickling, not a flood--not hundreds, but five to 10 companies over the next six months." Citigroup was one of the three main under-writers on the GM bond issue, along with Morgan Stanley and Merrill Lynch.

How many companies play copycat could depend on the success of GM's issue. Edward Eberle, president of Seizert Hershey & Co., in Bloomfield Hills, Mich., says the key is how GM invests the funds obtained from the bond issue. If GM gets a higher return on the money reaped from the bond issue than what it costs, it's a winner. If not, it's a loser, says Eberle, whose firm owns GM shares in its $500 million portfolio.

Obviously, GM wouldn't take the money from a bond issue and put it back into the bond market unless it could lock in a great return, hardly likely with interest rates so low. The equity market is obviously subject to volatility. Other investment choices include private placements, real estate or hedge funds. The question becomes: How much risk does GM want to take?

GM didn't consider it a risk when it decided on the convertible approach because the stock market had rebounded. "We did a convertible bond issue because the thinking was that the capital markets are very attractive," says Sanjiv Khattri, GM's assistant treasurer in Detroit. "We wanted to know how in one single swoop we could take the pension issue off the table."

The co-co's are convertible into GM stock first at 15 years and then 20, 25 and 30 years. For every $25 in bonds, the bondholder will receive 1 2/3 shares of GM at the prevailing price. "We have no material problems at all with the convertible issue. We built in enough protection," Khattri says. GM now has 550 million shares outstanding, so Khattri doesn't expect any dilution problems when the bondholders do convert.

As to whether other companies will use GM as a template, Khattri says that "if you have a clear-cut use for the bond issue, the capital markets are saying they have an appetite for this."

A convertible issue hinges in part on ratings. A company with good ratings from agencies like S&P will find it easier to float an issue because the interest cost won't be too high. But it's a double-edged sword. "The disadvantages are potential diluting," Farr says. Normally, a convertible issue is 2 to 3 percent dilutive to earnings. "It's a question of whether a company is willing to incur dilution to reduce its interest burden," he says. That could discourage some companies from following GM's lead.

Or, a company might have a high dividend and low stock volatility. If this hypothetical company did a convertible, it could spell disaster. Investors buying a convertible want the stock price to move up, but if the price goes nowhere, so will the bond issue.

The worst-case scenario for any company using a co-co is two-fold. First, a serious stock dilution and, secondly, imprudent investments from the bond proceeds that widen, not close the pension liability gap.

Despite all the complexities, the most obvious candidate to emulate GM's bond issue is the airline industry. Bashed by both 9/11 and a weak economy, airlines have tumbled into Chapter 11 reorganization or teetered on the edge. One giant problem remains pension fund liabilities.

The major airlines are loathe to talk about such a sensitive subject, but they will have to do something. Earlier this year, Northwest said it had a $223 million shortfall in pension payments for 2002 and needed a new financial maneuver to fill the gap. In August, the Labor Department allowed Northwest to contribute privately held stock of its regional affiliate, Pinnacle Airlines Corp., to three pension plans covering 73,000 employees and retirees. Since the stock contribution requires Labor Department approval, and that isn't easy to obtain, the next step for airlines could be convertible bonds.

The message to companies in all industries seems to be: If your company has a large pension liability, you can consider a co-co if you have a good bond rating, a low dividend and a stock with some volatility. Avoid it if your company has a big dividend, minimal stock volatility and low bond ratings. Not everyone will follow the GM strategy. But clearly the day of reckoning is drawing nigh.

Shortfall Leaders

The industries with the most significantly underfunded pension plans:

Auto: $60 billion Airline: $26 billion

Source: Pension Benefit Guaranty Corp.