Risk or Return? Risk Management and PBGC
Risk or Return?
Risk Management and PBGC
By Gordon Enderle, Evan Inglis and Joseph N. McDonald
THE AUTHORS OF THIS ARTICLE provide commentary on the PBGC's asset reallocation plan. This article was written before the capital market downturn that began in Sept./Oct. 2008. Recent events do not change the questions posed or perspectives offered herein.
The Pension Benefit Guaranty Corporation (PBGC) announced a significant change in policy with respect to the asset allocation of its pension assets in February 2008. The changes are highlighted by a shift from a conservative, liability matching strategy to a portfolio with a higher allocation to non–matching assets such as equities. Also included in the change is an increase in the allocation to alternative return–seeking assets. Specifically, the PBGC shifted its target asset allocation from 15 percent to 25 percent equity with the remainder in long–duration bonds, to a portfolio consisting of 45 percent equity, 45 percent fixed income and 10 percent alternatives.
Referencing the long–term nature of its obligations, the PBGC asserts that the new policy is designed to take advantage of its long–term investment horizon. Analysis conducted by the PBGC suggests that the new portfolio is expected to increase the likelihood of meeting their obligations over a 10–year period. The strategy also increases the expected return on assets and decreases the expected volatility of return on assets, considering invested assets independent of liabilities.
In its 2008 annual report, the PBGC reports that it is underfunded by $11 billion, with roughly $74 billion in liabilities and $63 billion in assets. Since the cost of any current or future deficit will be borne by surviving defined benefit plan sponsors, or perhaps taxpayers, the way the PBGC manages its funded position is a critical issue for the private pension system. The PBGC's funded position will ultimately affect PBGC premium levels, which contribute to the overall cost of running a plan and influence the decision organizations make as to whether to continue to sponsor such plans.
In this brief article we examine the PBGC's change in policy from a risk management perspective, starting with a review of the role of the PBGC in the U.S. pension system. We then outline the PBGC's rationale for the policy change, present an approach for managing risk within a pension plan context and consider the implications of the new policy on the various stakeholders of the PBGC.
THE PBGC AND ITS ROLE IN THE U.S. PENSION SYSTEM
A pension plan is an entity through which employers provide for accumulation and distribution of pension benefits to plan participants. The promised pensions will only be paid to the extent the plan remains solvent (assets are sufficient to pay benefits) or the sponsoring employer remains solvent to fund any shortfall that may develop in the plan. The PBGC then serves as an insurer that will assume responsibility for pension payments if the sponsoring corporation is no longer able to fund the obligations of the plan.
As an insurer of the pension system, the PBGC is exposed to three primary sources of risk:
- Risks associated with the assets and liabilities of the pension plans already assumed by the PBGC.
- Risks associated with the pension plans that have not yet been assumed by the PBGC.
- Risks associated with the sponsors of those plans.
Relevant to this discussion is an understanding of the premium structure and authority of the PBGC under the current regulatory framework. The PBGC collects premiums from surviving pension plan sponsors. The PBGC has no authority to adjust its premium structure nor is there any institution with the ability to generate revenue standing behind the PBGC in the event it cannot meet its obligations. In its recent study, the PBGC notes that it has no revenue raising capability and does not consider a taxpayer bailout in its decision making. As a practical matter, many observers do feel that taxpayers will be called upon to fund any PBGC deficit. In its letter to U.S. Rep. George Miller, chairman, Committee on Education and Labor, the Congressional Budget Office states:
"Although the Employee Retirement Income Security Act of 1974 (ERISA) explicitly states that the federal government does not stand behind PBGC's obligations, an implicit expectation exists among many market participants and policymakers that taxpayers will ultimately pay for benefits should PBGC be unable to meet those obligations."Additional background information on the decision made by the PBGC and the potential implications are effectively summarized in the CBO letter to Chairman Miller. The complete CBO letter can be found on the CBO's Web site (CBO.gov ).
SUPPORT FOR CHANGES CITED BY PBGC
The PBGC conducted a thorough review before concluding changes to its investment policy were appropriate. These conclusions are based on thinking that will undoubtedly sound familiar to most pension practitioners, some of which are noted below:
- The long–term time horizon of the PBGC allows it to accept volatility over the short term in exchange for higher expected returns over the long term.
- The new asset allocation increases the likelihood of having sufficient assets to meet its obligations under expected conditions. The anticipated benefits are presumed to outweigh the added exposure to tail risk. The PBGC notes that the new portfolio is expected to outperform the current portfolio over 20–year rolling periods 98 percent of the time.
- The market value measurement of the funded position of the PBGC at any point in time has little meaning when setting its investment strategy due to the perpetual nature of the PBGC, as it can outlast any period of poor investment performance or low interest rates.
- Since the PBGC cannot assume a taxpayer bailout or a law change when formulating an investment strategy, the only way to increase the likelihood of having assets to pay benefits promised is to seek additional investment return (even if this means a greater mismatch with the liabilities). The PBGC noted that the new portfolio increases the likelihood of reaching full funding over a 10–year period to 57 percent, from 19 percent.
- The risk associated with equities and other risky assets can be greatly diminished by holding a sufficiently diversified portfolio of such assets.
In 2008, the PBGC took steps toward implementing the new investment policy. According to its 2008 Annual Report, the PBGC appointed a chief investment officer, added technical staff resources, selected fixed–income and equity managers and initiated a search for strategic partners to assist with its private equity and real estate investments.
MODELING RISK WITHIN THE PENSION PLAN CONTEXT
Risk management is fundamental to any policy change considered by the PBGC. Properly assessing risk within a pension plan framework is especially challenging for the PBGC as it has characteristics of both a plan sponsor and an insurer of other plan sponsors.
The traditional process for determining the appropriate asset allocation for a pension plan is fairly well defined. Typically a handful of efficient portfolios are considered. An analysis is conducted, often including a Monte–Carlo stochastic simulation process, the results of which are used to compare the risk and return profile of the various portfolios under study, with the plan sponsor selecting the portfolio with the risk and return profile with which it is most comfortable. Risk is often measured by considering metrics such as the funded status of the plan at the end of the projection period or the present value of contributions in the worst case outcomes or tails, often defined as the 95th or 99th percentile events. Return is often measured by looking at similar metrics, as well as the actual rate of return on plan assets, in the expected case or median outcome.
This type of plan–centric analysis may not show the full picture because:
- Viewing the plan as a stand–alone entity ignores the conditions outside of the plan which may exacerbate the impact of downside scenarios on stakeholders.
- Some practitioners believe standard modeling assumptions do not accurately depict what happens in the tails.
- Modeling over a long–term time horizon often shows the very painful worst–case events to happen so infrequently that these scenarios are not given enough consideration.
It is this intense focus on the tails that defines risk management. Plan sponsors must ask themselves, "What is happening to our organization when these worst–case scenarios are playing out? What is happening in the broader economy?" Only after having seriously considered the answers to those questions will plan sponsors be able to properly assess the level of risk they are able to assume.
The PBGC does acknowledge that most plan sponsors are invested in a manner similar to the new PBGC policy, with a significant amount of equity investment. At the very time poor economic conditions are deteriorating the funding position of the PBGC, so too are they wreaking havoc on the funded status of many of the pension plans the PBGC insures. Taken further, the poor economic conditions may be indicative of a depressed economy, meaning that many plan sponsors are more likely to default, increasing the likelihood that the PBGC will have to assume additional unfunded pension liabilities at the same time its own funded position is declining.
In the tail scenarios, we need to look at the PBGC's role in the overall pension system as well as the PBGC's individual funded status to evaluate the benefit gained from the risk taken. The PBGC's funded status is an important bellwether in the U.S. pension system. One major purpose of the PBGC is to provide stability for pensioners when conditions get rough in the individual plan sponsor world. A weak PBGC causes concern among both plan sponsors and policymakers. Viewed as a self–standing entity, the long–term benefit from equity investing is a risk that may be worth taking. Viewed as a stabilizing entity in the pension system, the short–term and intermediate risk involved with equity investing can create problems (real and perceived) that cause stakeholders to lose confidence in the overall system and force regulatory action.
It is noteworthy that the recently created pension insurance fund in the United Kingdom has an investment policy more like the prior PBGC policy, with a heavy emphasis on duration matching fixed–income investments.
Like any pension plan sponsor facing a deficit, the PBGC has limited options for eliminating the deficit:
- Fund the deficit by making additional contributions (i.e., higher premiums from surviving plan sponsors or taxpayer dollars).
- Invest to get to full funding by seeking extra return (which may involve additional investment risk).
- Adjust benefits.
The PBGC has elected to attempt to eliminate the deficit by taking on investment risk, as its authority limits its ability to raise funds (through increased premiums, in this case) or to adjust benefits, as noted previously. This choice was influenced by, and will likely have an impact on a variety of stakeholders. For an investment policy to be assessed it must be clear who the investors in fact are. Who stands to gain if the risks pay off, and who stands to lose if they do not? We will consider this issue from the standpoint of a number of relevant stakeholders.
The PBGC's decision is likely to have direct and lasting implications on those organizations that continue to sponsor defined benefit plans. On the one hand, plan sponsors may benefit from lower premiums if the expected higher returns materialize. However, as outlined earlier, the actions taken by the PBGC increase the risk profile of the PBGC as an insurer. To the extent the new investment policy does not pay off as expected, plan sponsors will likely be asked to fund some or all of the resulting deficit, which will increase the cost of sponsoring pension plans and may motivate some organizations to move away from pension plans altogether. If plan sponsors view the PBGC as providing insurance that secures participants' benefits, it is questionable that if given the choice, plan sponsors would choose an entity so heavily invested in equities.
According to its Web site (PBGC.gov), the PBGC currently pays monthly retirement benefits to about 640,000 retirees in 3,860 pension plans that have come under PBGC protection. Including those who have not yet retired and participants in multi–employer plans receiving financial assistance, the PBGC is responsible for the current and future pensions of about 1,305,000 people.
Participants whose benefits are paid, or will be paid, by the PBGC are essentially creditors of the PBGC, as they are due to receive a series of fixed payments from the PBGC over a number of years. The PBGC has opted to take the investments supporting those payments out of matching fixed income assets and put them into equities and other diversified return–seeking assets. It is doubtful that these participants, if given the choice, would purchase an annuity from an insurer that needed or wanted to invest a significant portion of premium proceeds in the stock market to meet its annuity payment obligation.
On the other hand, in discussing its investment policy change, the PBGC notes that based on its current funded status and investment policy, there is a high likelihood that PBGC will not have sufficient assets to pay all future benefits due current beneficiaries. This crystallizes the unique situation the PBGC finds itself in. Just as it is generally imprudent for an insurance company to mismatch its assets and liabilities, it is also doubtful that individual retirees would purchase an annuity from an insurance company that projects a significant chance of ruin.
Thus, the beneficiaries face risk in the status quo and risk with the new investment policy. Certainly, beneficiaries expect that their benefit will be paid. If the PBGC cannot make its payments, the beneficiaries will likely look to the legislators and policymakers for remedies.
The actions and motives of policymakers are very difficult to analyze and predict. However, it is worth noting that other possible choices for addressing the PBGC's deficit exist: Funding the deficit either through government funds or increased premiums levied on plan sponsors, or adjusting retiree benefits downward. Both choices carry severe political consequences. The PBGC's choice to fix the deficit via investment returns over an extended time period may have favorable short–term political repercussions, as this choice will either solve the problem or defer it to a future period.
The PBGC is not funded by general tax revenues. However, given that the PBGC has no other means to generate revenue, many speculate that a taxpayer bailout could occur in the event the PBGC becomes insolvent. If taxpayers are ultimately on the hook for some portion of any deficit that may exist at the PBGC, then the PBGC investment policy decision impacts taxpayers as well. If the downside risk lies with taxpayers, taxpayers would only be comfortable taking on this additional risk if the upside resides with them as well. If the new investment policy does result in higher returns, the possibility for a future bailout may be lessened. But, is it advisable for the PBGC to take on investment risk on behalf of the U.S. taxpayer? Does it make sense for the government to simultaneously incur debt and invest proceeds from that debt in equities? Taxpayers would likely object to this type of activity; severe economic consequences would result if the strategy did not work. Risks taken by the PBGC need to take into account any potential impact on taxpayers.
In order to improve its expected ability to pay benefits to pensioners, the PBGC changed its asset allocation policy to one that increases expected returns while creating a larger mismatch between assets and liabilities. There are other ways to address the PBGC's funding deficit. For example, the PBGC deficit could be addressed via a funding solution instead of an investment solution. This article provides some perspectives that may help actuaries to view the decision made by the PBGC from a risk management framework in addition to the more traditional asset liability management framework.
Given the unique nature of the PBGC and the potential consequences of various strategies for different stakeholders, there are no easy answers. However, current market conditions provide evidence of the potential downside of taking on risk in the financial world. Any change by which the PBGC assumes significant amounts of additional risk should be carefully considered and monitored by all parties interested in the well–being of the PBGC and the defined benefit pension system.
As noted at the beginning, this article was written before the capital market downturn that began in September/October 2008. Perhaps the timing of the latest economic trouble will help interested parties focus on the risk management aspects of the PBGC's investment policy and consider the value secure financial institutions provide to the workers of the United States—the constituency the PBGC was created to protect. It is our understanding the implementation of the new investment policy is still a work in progress.
Sidebar: THE PENSION BENEFIT GUARANTY CORPORATION
The Pension Benefit Guaranty Corporation (PBGC) was created by the Employee Retirement Income Security Act of 1974 to prevent workers from losing pension benefits due to employer financial failure or plan insolvency. PBGC provides uninterrupted payment of pension benefits to participants in defined benefit pension plans that terminate without sufficient assets to meet plan obligations. PBGC currently pays pension benefits to over 600,000 retirees.
Defined benefit pension plans promise to pay a specified monthly benefit at retirement, commonly based on salary and years on the job. PBGC support does not apply to benefits from 401(k) plans, profit–sharing plans or other defined contribution plans. Additionally, PBGC support does not usually apply to church plans or federal, state or local government plans.
PBGC is not funded by general tax revenues. PBGC collects premiums from employers that sponsor covered pension plans.
Gordon Enderle, FSA, EA, MAAA, is a consulting actuary with Watson Wyatt Worldwide. He can be contacted at email@example.com.
Evan Inglis, FSA, EA, FCA, MAAA, is chief actuary with The Vanguard Group. He can be contacted at firstname.lastname@example.org.
Joseph N. McDonald, FSA, MAAA, is a consulting actuary with Hewitt Associates LLC. He can be contacted at email@example.com.
The views and opinions in this article are those of the authors and not their employers.