High stakes move: to fulfill its enormous pension fund obligations, General Motors turns to riskier investments.

On the 16th floor of the General Motors Building in midtown Manhattan, W. Allen Reed is fixed on the number nine, as in 9 percent. That's the annual return he must make when investing GM's pension fund to meet the company's daunting obligations. Facing the largest pension fund shortfall of any U.S. corporation--$25 billion--GM last year floated an extraordinary $17.6 billion bond issue. That relieved the immediate financial pressure, but now comes the hard part of continuing to keep the pension fund afloat.

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As CEO of GM's Asset Management, the largest corporate pension fund in the nation, Reed has $86 billion to invest. Even with that kind of financial muscle, not to mention the clout of the General Motors name, he will have to perform like Lance Armstrong to achieve his goal.

Consider the following: The bond market is at historic lows; the stock market has failed to fully recover from the dot-com bust and continues to be choppy; six-month Treasury bills are yielding just 1.73 percent; and six-month certificates of deposit 1.32 percent. So how does Reed expect to pull it off?

He's mapped out an investment strategy that carries a remarkable degree of risk for a company as conservative as GM. Given the current state of the markets, Reed has reduced the company's reliance on stocks and corporate bonds in favor of less conventional and riskier alternatives such as junk bonds, emerging markets, real estate investment trusts and the slick science of arbitrage. It's not the first time GM has made such bets, but the stakes have never been this high.

Due to the size of its work force, General Motors has colossal pension obligations. Its pension plan covers 452,000 retirees and their spouses, plus 195,000 active employees in the United States. The company pays $6 billion in annual benefits, as GM employees are living longer and using up more of the pension funds.

At least one expert questions the logic of the company's strategy. "It's troubling to hear that the way GM thinks of dealing with underfunding is by taking more risk," says Jeffrey R. Brown, a professor at the University of Illinois business school and a former senior economist at the Council of Economic Advisers under President George W. Bush. He says that while the risks under GM's plan involve different markets and therefore don't move in tandem, they also may not bring the expected high returns. "Maybe," says Brown, "GM should re-examine the appropriateness of a 9 percent return."

General Motors officials staunchly defend the pension-fund investment strategy and say they have solid ways of managing the risks. "The strategy is designed to reduce volatility," says Jerry Dubrowski, a GM spokesman. He notes that GM's pension fund has made a 9-to 10-percent return for the past 15 years in good markets and bad, and that GM sees no need to lower its investment goals.

Pension underfunding, of course, is a national problem. At midyear, U.S. corporate pension plans were underfunded by a total of $278.6 billion, according to the Pension Benefit Guaranty Corp., a government agency that insures benefits for 44 million Americans enrolled in roughly 30,000 plans. The agency faced a $9.7 billion deficit from covering failing plans. United Airlines shocked both the pension agency and its own employees in late July when it deferred a required quarterly payment of $72 million to its pension fund and planned no further payments while it remained in bankruptcy proceedings.

The problem of pension underfunding stems from a confluence of forces: the nation's rising number of retirees, a drop in stock prices and historically low interest rates. Corporate America long relied on stock-market gains to offset soaring pension liabilities, but, given the current stock and bond markets, that is no longer an option. Interest rates are used in pension calculations as a proxy for the rate at which a pension fund must grow to pay future benefits. Low rates make pension obligations look much bigger today.

Beyond Stocks and Bonds

Last year's convertible bond issue, as well as GM's sale of Hughes Electronics and Hughes stock, gave Reed $18.5 billion in cash without oncrous terms that would have hurt the pension's investment portfolio. This boosted the pension fund to $86 billion and gave the company "a blank sheet of paper to think through a new risk and return profile," Reed says. "The wisdom of that decision depends on how well the investment portfolio does."

In devising his strategy, Reed "went to all the smart people we do business with," which includes heavyweights like Morgan Stanley, Citigroup and Goldman Sachs. The pension fund has the outside firms managing 85 percent of its investments, and GM manages the other 15 percent. The fact that different managers make investments means that their portfolios do not mirror each other, adding a measure of protection against volatility. In each of these markets, Reed says, "active managers have been historically able to generate a meaningful amount of excess return."

But greater return also means greater risk, especially with junk bonds, where the risk of default is relatively high. Reed says that GM has invested in high-yield bonds for many years. While he acknowledges the inherent risk, he insists that it's manageable. "Some issuers are going to default," he says, adding, "Our portfolio has never experienced more than a 2 percent default rate. We pick out the best."

Emerging markets are often economically and politically volatile, and therefore pose significant risks. GM invests in Asia, particularly China, as well as in Latin America, Eastern Europe and Russia.

Yet another calculated risk GM is taking is in real estate investment trusts, or securities invested in real estate, which serve as an alternative to direct ownership. Previously, it was predominantly individuals who bought REITs, but now institutional investors have taken over and changed the manager's compensation from a fee for investing in real estate to compensation depending on how well the assets perform. REITs can be risky because the underlying real estate assets can fall precipitously in value. For instance, gentrification of a certain area could fail, causing buildings to become vacant.

Finally, to get that last bit of incremental return, Reed is relying on the most fragile factor of all--human skill. Among other things, GM is turning to arbitrage, or buying and selling simultaneously in the same markets. This is a financial maneuver only for the brave and the wise. Arbitrageurs routinely pour billions into the market to squeeze out a "plus." A "plus" is a manager's ability to have his or her "long" investments perform better than "short" investments.

GM launched its pension-fund investment strategy in late 2003. Thus far, says Reed, "the numbers are a little bit better than our expectations." The 650,000 GM workers who are depending on the company's pension fund can only hope that Reed continues to deliver such an ambitious rate of return.