Betting Against a
Pension Bailout

The U.S. corporate pension insurer faces criticism as it takes on more risk.


Financial Institutions are fleeing risk these days. Then there’s the Pension Benefit Guaranty Corp., the government agency that insures corporate America’s $2.5 trillion of defined benefit obligations. The institution that some critics think ought to be the most cautious of all decided in February to increase the proportion of riskier assets in its $55 billion portfolio.

After nine months of study, the PBGC chose to junk a 2004 policy that aimed to closely match assets and liabilities by dedicating 75 to 85 percent of its portfolio to bonds, with the rest in equities. Now the PBGC will sharply cut bond holdings to 45 percent, earmarking another 45 percent of its portfolio for stocks and 5 percent each for private equity and real estate. It expects to reach these targets by December. “The new policy is neither more aggressive nor more conservative,” says PBGC director Charles Millard. “It’s safer and better.”

Millard’s plan has sparked strong opposition. Critics say the change in direction is unwise for an entity that acts as an insurer — especially one that faces a $14 billion funding deficit. The new allocation, they say, increases the chances that this shortfall could widen, forcing the agency to seek a government bailout.

“With an investment policy with stocks, the severity of the deficit can grow. And for an insurance company, that should be the dominant concern unless they’re figuring the taxpayer is going to pick up the pieces,” says Zvi Bodie, a Boston University School of Management finance professor and pension economics expert who helped craft the 2004 policy.

Further, he and others worry that the PBGC’s new strategy could accelerate the demise of traditional pensions. Poor results could lead to the PBGC’s charging the companies whose plans it insures higher premiums, prompting more companies to exit the system.

Companies have been ditching their defined benefit plans for two decades — shutting them down entirely, in some cases, or closing them to new employees. Even employee-friendly and financially healthy IBM Corp. in 2006 closed its overfunded plan to new and existing employees. The number of plans insured by the PBGC has fallen from 115,000 in 1985 to about 30,000 today, chiefly because small companies have closed their plans. And although the total number of beneficiaries has risen marginally, to approximately 44 million, the fraction who are active employees has plunged from more than three quarters in 1980 to fewer than half. Today only one in five private sector workers has a defined benefit plan, a statistic that leaves some experts worried about an impending crisis as more employees retire with inadequate savings. The outlook is better for workers in the public sector, where more than four in five enjoy access to guaranteed retirement benefits, according to the Bureau of Labor Statistics.

Millard’s gambit comes as the health of corporate defined benefit plans has begun to decline, reversing five years of improvement. Through 2007 an uptick in interest rates, which allows companies to assume higher rates of return, and gains in stock prices pushed the ratio of assets to liabilities to 106 percent from 99 percent a year earlier. That’s according to benefits consulting firm Milliman’s analysis of the 100 largest corporate plans, which make up more than half of the total liabilities insured by the PBGC. Yet almost all of these gains were wiped out in first-quarter 2008, leaving the overall funding ratio just below 100.

The onset of a bear market for stocks bodes ill, especially with a slumping economy and a surge in oil prices that is hitting some already troubled industries especially hard, notably airlines and automakers. Many of these offer traditional pensions that could wind up in the PBGC’s care.

Millard counters that the new strategy is the best way to close the PBGC’s funding gap and reduce the risk that it will wind up being a burden on taxpayers down the line. “We’re making a significant shift, but doing so in a very sensitive, prudent and responsible way,” he says. Millard adds that according to Rocaton’s projections, the new allocation gives the PBGC a 57 percent chance of achieving full funding in ten years, compared with 19 percent with the current mix, he notes.

Established by the Employee Retirement Income Security Act of 1974, the PBGC aims to promote the health of private sector defined benefit pensions. When a company goes belly-up and is unable to fund its pension obligations, the PBGC steps in to cover promised benefits, up to a maximum of $51,750 a year per person as of 2008. That’s a threshold high enough to cover 84 percent of all beneficiaries. To pay its way the PBGC charges the companies it covers premiums — single-employer plans pay a basic flat-rate premium of $33 per participant annually, and underfunded plans pay an additional $9 per $1,000 of unfunded vested benefits — which totaled some $1.6 billion last year. Like other creditors, the PBGC goes to court to extract as much as possible from failing firms; it generally gets assets equal to about 70 percent of the pension liabilities it inherits. The PBGC is an independent, self-financing government agency that is not backed by the full faith and credit of the U.S. government. Yet Congress has it on a tight leash. The PBGC is free to invest trusteed assets inherited from failed firms as it chooses, but premium income must be kept in a “revolving account” that may hold only securities issued or backed by the U.S. government. All gains must be reinvested the same way. A board consisting of the secretaries of Labor, Commerce and Treasury has authority over asset allocation policy. The agency relies exclusively on external managers and in recent years has put all of its equities into index, or enhanced-index, strategies. Bonds are actively managed.

The PBGC director is appointed by the president, but Millard has made sure that the next administration, whether it be under John McCain or Barack Obama, will not alter his investment policy anytime soon. In May he won board approval to lengthen the period between investment strategy reviews to four years from two. The next change can occur no earlier than 2012.

Millard, a New York attorney, knew next to nothing about the PBGC when he was offered the presidential appointment early last year. “My first reaction was, ‘What’s that?’” he says. In May 2007 he moved into an apartment a few blocks from the agency’s offices on Washington’s K Street, returning home to New York on weekends to spend time with his wife and nine children. “When Charlie takes on something, he puts forth 100 percent of his effort to do it well,” says Paul Atkins, a commissioner of the Securities and Exchange Commission who worked alongside Millard in the late 1980s as an associate at New York law firm Davis Polk & Wardwell. (Atkins recently announced his intention to resign from the SEC.) Millard, 51, joined the firm in 1986 after earning a law degree from Columbia University in New York. (His bachelor’s degree, with a major in religious studies, is from the College of the Holy Cross in Worcester, Massachusetts.)

Although no expert on pensions, Millard had a background in investment and politics. He left Davis Polk in 1991 after winning a seat on the New York City Council as a Republican in an upset against an incumbent who had represented the city’s Upper East Side for 22 years. A fiscal conservative, Millard was one of just two out of 51 council members to vote against a budget that increased the city payroll. “The speaker threatened to cut funds to [Millard’s] district, but Charlie shot the steel up his spine, stood on principle and was reelected overwhelmingly in 1993,” says Lisa Linden, a friend and former press aide. Millard had no such luck when he ran for Congress the following year, losing handily to Democrat Carolyn Maloney. The defeat, though, led to what Millard calls the most satisfying period of his career. He quit the City Council in 1995, when then-mayor Rudolph Giuliani asked him to run the nonprofit New York City Economic Development Corp. Over the next three years, Millard built on work he had begun while with the council to change zoning laws to help rid the city of topless bars and porn shops. He focused on cleaning up Times Square and attracting businesses like Nasdaq and publisher Condé Nast, among others, to the neighborhood. “He knew how to lead, and during challenging times he knew how to get things done,” Giuliani says in an e-mail.

In 1999, Millard moved to Wall Street. After a brief stint as a dot-com investment banker at Prudential Securities, in 2001 he joined Lehman Brothers, where he gave investment advice to wealthy families and foundations. In 2004 he took a job at Broadway Partners, a New York commercial real estate investment and management firm. Millard’s entrée to the White House came from several sources, Giuliani among them, he says, declining to elaborate. (Millard was an early supporter of Giuliani’s presidential campaign, donating $2,100 in December 2006, according to Federal Election Commission records. He also cohosted a fundraiser for the candidate in New York City in spring 2007.) Millard was named interim director of the PBGC in May 2007, and he served in that capacity until December 2007, when he won Senate confirmation. His term is open-ended; he serves at the pleasure of the president.

While interim director, Millard reached out to executives at investment banks and insurance companies for advice. He had to get up to speed on institutional investment strategies and how they might affect the agency’s various goals and the interests of its major stakeholders, namely, the companies paying premiums for insurance, plan participants and, implicitly, taxpayers. Millard held lengthy meetings with the seven members of the PBGC’s presidentially appointed advisory committee. From these talks he concluded that the agency’s top priority should be to avoid a federal bailout. Leopoldo Guzman, president of Guzman & Co., a Coral Gables, Florida, investment banking firm, and a member of the advisory committee through February 2008, tagged this goal the “North Star.”

The details of the new strategy began taking shape in October, when the PBGC hired Rocaton Investment Advisors. Norwalk, Connecticut–based Rocaton is a leading pension investing adviser whose reputation was bruised after it encouraged some of its clients to invest in Amaranth Advisors, a multistrategy hedge fund that collapsed in September 2006 after losing about $6 billion in a single week. By the end of October, Rocaton had written a series of four white papers examining such basic concepts as investment horizon, diversification and cash needs as they applied to the PBGC’s funding status and the North Star goal. “Everything seemed to point to focusing on a long time horizon as opposed to managing volatility and funded status on a year-to-year basis,” says Joseph Nankof, a Rocaton co-founder who led the project.

To find the optimal asset mix, Rocaton ran thousands of simulations of more than a dozen possible portfolios. The models ranged from all bonds to a 75-25 mix of stocks and bonds and included alternatives such as hedge funds and commodities. This process produced the new allocation: 45 percent to fixed income (including 2 percent to high-yield bonds and 3 percent to emerging-markets debt); 45 percent to stocks (including 19 percent to non-U.S. developed markets and 6 percent to emerging markets); and 5 percent each to private real estate and private equity, both buyout and venture capital.

According to Rocaton’s projections, the new asset approach offers both higher return and lower risk. Stocks will be managed either passively or according to enhanced indexing strategies. Bonds will be actively managed. The strategy is expected to deliver an annual return of 7.7 percent, 200 basis points more than the current mix, with a standard deviation of 8.2 percent, compared with the current 9.9 percent. Rocaton projects that an all-bond portfolio would return an annualized 5.2 percent with a standard deviation of 8.8 percent.

Taking the midpoint among thousands of modeled scenarios, Rocaton calculates that the PBGC’s deficit after ten years of using the new strategy will narrow to $5.2 billion, versus $13.1 billion with the current strategy. The new mix should even outperform in a worst-case scenario, defined as the lowest 1 percent of outcomes, with a shortfall of $63.4 billion after ten years compared with $72.6 billion with the old portfolio. An all-bond portfolio does even worse: After ten years the median scenario foresees a gap of $15.5 billion, a figure that swells to $75.4 billion in the worst-case projection.

Critics call Rocaton’s analysis flawed. BU’s Bodie and others point out that although the average annual risk of a stock portfolio diminishes over time, the range of possible outcomes increases. “Risk doesn’t diminish with the time horizon, it grows,” Bodie notes. Bodie has advised three PBGC directors, but not Millard, and he argues that the agency can’t do anything about companies going bust or loading their pension portfolios with risky assets. What it can do is manage its own balance sheet by matching assets with liabilities, holding a portfolio of bonds tailored to deliver cash when obligations come due. In 2004, Bodie convinced then–executive director Steven Kandarian and the board to adopt this approach, despite objections from the majority of the advisory committee.

Adds John Ralfe, a pension consultant in the U.K., where liability-driven investing is more common: “If what Millard is saying is true, then he should be calling [Treasury Secretary Henry] Paulson and saying, ‘Hank, I’ve got the way of closing the budget deficit, a way of digging everybody out of the hole. Issue a trillion dollars worth of Treasuries and put that in the equity market, and sooner or later it’ll come good.’”

The data supporting Rocaton’s projections are insufficiently robust, argues Jeremy Gold of Jeremy Gold Pensions, a New York actuarial and pension consulting firm. “They’re using data for the country which survived the Depression, won World War II, put a man on the moon, won the Cold War and that has been the most successful economic engine in the history of the world. They’re not considering, as risk managers must, other places, other times when things didn’t go so well, such as Japan after 1989.” Nankof counters that Rocaton modeled many scenarios, including ones that assumed no return on equities over 20 years.

Gold also thinks the PBGC is naive to believe that the new strategy will increase to 57 percent from 19 percent the probability of investment returns leading to full funding in ten years. “Probability doesn’t tell you about the risks, about how bad things might be if you fail,” he notes. The extreme sensitivity of the PBGC to equity values is a result of its double-trigger guarantee: It assumes new liabilities only when a company goes bankrupt and its pension fund is underfunded. “Their balance sheet, if you do it accurately, shows that their liabilities are a negative equity position,” says Gold. “The closest thing to what they need is long positions in equity puts.”

Concerns such as these have guided the investment strategy of the British version of the PBGC, the Pension Protection Fund, which became operational in 2005. “We want to have an investment strategy that doesn’t mimic the strategies of the pension schemes we’re covering, but one that offers a buffer against the events we’re seeking to protect against,” says Martin Clarke, the fund’s executive director of financial risk. The fund keeps 70 percent of its assets in bonds and cash, with the balance in equities and property. It does not take short positions in stocks of companies whose pensions it insures, largely for political reasons, he notes.

“It seems pretty clear Rocaton was told what the bottom line conclusion had to be, and the report was designed to produce that result,” asserts Bodie. Although Millard denies this, he does concede that probability estimates reveal nothing about the extent of any possible downturn. But he argues that the new, more diverse asset mix provides better downside protection and lower volatility. “I challenge someone to tell me why that’s not better,” he says. “Theological critics who have a dogmatic point of view based on theory and logic deserve to be listened to, but in the end, if you’re putting people’s retirements at stake, I’d rather look at the numbers.” Millard adds that a long-term investment horizon is optimal for the PBGC because liquidity is not a concern. The agency’s total assets, including shares of companies it has acquired through bankruptcy proceedings, are $68.4 billion.

What’s more, the PBGC’s contingent liabilities — the unfunded pension obligations that may be foisted on it when a company goes under — can be neither fully predicted nor hedged against, argues Rocaton’s Nankof. The number of companies going bankrupt correlates with the strength of the economy, and the timing of the biggest corporate pension plan failures has been idiosyncratic. Just two industries, steel and airlines, are responsible for 76 percent of the PBGC’s current obligations. And the bankruptcies in those sectors had less to do with broad economic cycles than with industry restructurings. “The analysis clearly demonstrated to us that the risk of the deficit growing significantly is much more a function of potential new claims that don’t correlate to any financial instrument that you can buy,” says Nankof. “So you shouldn’t abandon liability-driven investing, but manage assets prudently to get more competitive returns in the long run.”

Of course, the previous strategy also had an element of market illogic. If the PBGC inherited an underfunded plan when the stock market and the economy were weak, it would have had to sell equities at low levels to buy bonds that were expensive because of low interest rates. Laurence Fink, CEO of bond manager BlackRock Financial Management, argues against investing in Treasuries today. “Treasuries at these levels are more of a fear security than a rock-solid investment,” he says. (Millard says he discussed the new policy with Fink over dinner earlier this year. The two men have been acquainted for years.)

The equities the PBGC plans to invest in, moreover, should be less closely correlated with the agency’s liabilities than many critics believe, Millard insists. Slightly more than half will be invested in non-U.S. stocks. The PBGC says it will also ask its active equity managers to avoid the stocks of companies with low credit ratings or underfunded pension plans (although it won’t share the confidential information it has on companies). The new policy will shift about $15 billion from bonds to stocks and will take several years to implement. “We will have fully deployed, with indexes or existing managers, by the end of the year, and over the next couple of years, we’ll add more active managers,” says Millard.

The main challenge now for the PBGC is adding financial professionals. The current investment staff has little experience overseeing external managers in emerging markets, private equity, real estate and alternatives (for alternative assets the PBGC plans initially to invest through funds of funds). So far this year, Millard has increased the investment staff to 14 from ten, and he plans to hire an additional four or five professionals, including a CIO.

Millard would like to remain at the PBGC if McCain wins the White House, informed sources say, and he won’t comment on what he’d like to do if shown the door. Either way, with the next investment policy review not coming until 2012, Millard’s legacy will live on.