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Short thinking

The PBGC, the federal agency entrusted with bailing out corporate pension plans, has rethought its asset allocation yet again -- this time it will all but shun stocks. Does that make any sense?

Henry Ford founded the Rouge Steel Co. to supply his fast-growing car company, and for 80 years the Dearborn, Michigan, steel mill has been rolling out flat carbon sheets. But like many of its U.S. rivals, Rouge began to experience tough competition from lower-cost foreign producers in the 1970s. After struggling for decades the company filed for Chapter 11 bankruptcy protection in October. Two months later, however, Russia's Severstal, a steelmaker dating back to the Stalin era, agreed to acquire Rouge, and a Delaware bankruptcy court judge approved the $285.5 million deal.

But there was a catch: The Russian company refused to assume responsibility for Rouge's four defined benefit pension plans, which cover 5,400 workers and retirees. The plans' $140 million in assets were no match for liabilities of almost twice that.

Enter the Pension Benefit Guaranty Corp. The PBGC will assume trusteeship of the Rouge plans, and their assets will go into the agency's $35 billion portfolio, which consists of funds salvaged from some 3,240 other failed pension plans as well as the premiums paid by healthy companies as a kind of pension insurance. As a result, Rouge's current and retired workers will collect their pensions after all, or at least a significant proportion of them.

The PBGC, as the government agency that protects the retirement plans of 44 million Americans, is a powerful presence in the pension world. Now, at time when so many U.S. companies are experiencing pension-funding crises, the agency has come under intense scrutiny for a controversial approach to managing its own assets: dramatically increasing its reliance on bonds. Newly departed PBGC executive director Steven Kandarian, an appointee of President George W. Bush, decided to up the agency's allotment to bonds from 63 percent of its overall portfolio to as much as 85 percent. This seismic shift will be implemented over the next 18 months.

Critics worry that the PBGC's disproportionate dependence on fixed-income investments will jeopardize future returns and could force the agency -- which is running an $11 billion deficit -- to ask Congress to let it hike its premiums in order to stave off its own solvency crisis. In turn, that could cause corporations that already feel overburdened by the PBGC's pension premiums to close their defined benefit plans to new members.

"Most people understand that the best way to grow a nest egg over the long term does not involve just buying Treasury bonds," says David John, a senior economist at the Heritage Foundation. Adds Mark Ugoretz, president of the ERISA Industry Committee, a Washington-based lobby organization for corporate pension funds, "The PBGC's investment strategy is the plan sponsor's equivalent of stuffing the cash under a mattress."

Other experts counter that the bondcentric strategy is in fact the best way to assure Rouge retirees and other pensioners that they will receive their future payments. Jared Gross, the PBGC's top investment policy official, argues that the agency should view itself as a form of insurer. "This is about better matching our assets with our liabilities," he explains. "The goal is to outperform liabilities without taking undue risk. Downside protection is vital. With a more fixed-income-driven approach, we aim to grind out nominal gains year over year." The fixed-income-heavy strategy, he adds, will enable the PBGC to better match its assets with its liabilities -- by, say, buying bonds with a duration of nine years to cover benefits due in nine years.

The PBGC's three-person board, made up of Secretary of Labor Elaine Chao, Treasury Secretary John Snow and Commerce Secretary Donald Evans, approved Kandarian's strategy in early January. However, Kandarian, now 52, resigned the following month, saying that he wanted to spend more time with his family, and he has yet to be replaced. In the meantime, Vincent Snowbarger, a former Kansas congressman and assistant executive director of the PBGC since July 2002, has been installed as acting executive director.

The bonds-versus-stocks debate is as ancient as securities markets and as fresh as tactical asset allocation. But it has taken on a special resonance at the PBGC, not only because of the sheer size of the assets at stake but also because the agency's recourse to a bond-tilted portfolio comes just as the Bush administration is proposing that workers be allowed to invest some of their Social Security contributions in stocks. At the same time, the Treasury Department is championing broad reforms that would compel corporate pension plans to invest a larger share of their assets in fixed income.

All this takes place, of course, as many struggling corporate pension plans are adopting more aggressive investment strategies that mostly revolve around stocks, notably hedge funds. Observes Scott Macey, head of Chicago-based benefits consulting firm Aon Consulting: "Corporate plan sponsors would rather see the PBGC invest more like a pension fund, if only to show its faith in our industry's most basic concept -- having a balanced portfolio. What message are they sending?"

To be sure, the PBGC's position is not an enviable one. The agency, which turns 30 in September, receives not one jot of federal funding to keep its pension safety net in good repair. Instead, it is empowered to collect annual levies from healthy corporations with defined benefit plans. The formula varies, but employers with fully funded plans pay an annual premium of $19 per participant, while those deemed to be underfunded pay $9 for every $1,000 that they are underfunded. In addition, the agency has the authority to seize the assets of terminated pension funds. When the PBGC takes over a plan, it assumes some, but not all, of the plan's benefit obligations. Its annual cap for a single beneficiary: $43,000.

In theory, the PBGC's combination of annual premiums and investment income should cover the benefits it doles out to retirees. But if the agency's cash flow turns out to be negative, it can draw on its accumulated assets to cover a shortfall. By law the PBGC cannot reduce the benefits it has promised to retirees when it takes over a plan. Of course, the agency can raise the premiums it charges corporations, provided Congress goes along.

What if all these remedies fall short? Then, because the PBGC is a government entity, the U.S. Treasury (read: taxpayers) must step in to make good on the pension agency's pledges. That gives the bonds-versus-stocks debate an extra zing.

One of he PBGC's own former chief actuaries, Ron Gebhardtsbauer, voices doubts about the bond shift. "Many actuaries would suggest that the PBGC has a long enough time horizon that it can handle the risk involved with equities and get the higher return [of stocks] over the long term," says Gebhardtsbauer, who is the senior pension fellow with the American Academy of Actuaries in Washington. Moreover, he argues, if the PBGC increases its fixed-income stake now, when interest rates are at a 45-year low, just to match up assets with liabilities, it will prevent the agency from ever getting its head above water. Explains Gebhardtsbauer: "Duration matching will keep the PBGC's deficit from increasing when interest rates fall, and it will keep the deficit from decreasing when interest rates increase. The bottom line? The PBGC is locking in its existing $11 billion deficit."

Some PBGC pension math is in order. Interest rate hikes cut two ways for the agency: They have the negative effect of reducing the PBGC's fixed-income assets, but they also have the salutary effect of lowering its nominal liabilities while increasing its portfolio income. Interest rate reductions work in reverse.

The PBGC's Gross staunchly defends the agency's decision to approach portfolio management as more of an insurer than a long-term investor. "Broadly speaking, we are trying to better match duration of liabilities with assets," he says, "but we aim to use active managers to outperform our liabilities in rising rate environments."

To a significant extent, the PBGC's hands are tied. Under 1974's ERISA, which created the agency, it can invest the annual premiums -- pooled in so-called revolving funds -- only in fixed-income securities. Although the law doesn't mandate it, the PBGC invests exclusively in Treasuries. Revolving funds held $16.4 billion, or about 48 percent of the PBGC's total assets, as of September 30, 2003.

The agency does have free rein over investments seized from terminated plans, known as trust fund assets, and this is where the bond strategy comes into play. At the end of September, these assets were 72 percent invested in equity: 80 percent in stock index funds and 20 percent in actively managed portfolios.

Managers of corporate pension plans had better pay close attention to the PBGC's tactics. The Treasury has proposed changing the way corporate plans calculate discount rates -- the interest rate assumptions that go into determining the present-day value of their of future benefit obligations. The proposed methodology, conceived by former Treasury undersecretary Peter Fisher (now a managing director responsible for risk management at BlackRock), works this way: Instead of the current approach of one discount rate for an entire plan, the Treasury would impose a sliding-scale system; higher discounts would apply to younger workers, while lower rates would govern older workers. Compelled to more closely fund older workers' nearer-term liabilities, plans would have no choice but to increase their fixed-income allocations. "Institutional investors would be forced to move out of equities and into bonds in huge numbers," explains James Delaplane Jr., a pension attorney with Washington-based law firm Davis & Harman.

The proposal is not incorporated into a bill currently before Congress that is designed to give employers temporary pension relief. That measure, the Pension Funding Equity Act of 2004, pegs the discount rate for two years to relatively high-yielding long-term corporate bonds; for the past two years, plans have had to use a formula of 120 percent of the four-year average of 30-year Treasuries. This esoteric calculation was devised to make things easier for corporations after interest rates on 30-year Treasury bonds dropped to artificial lows when the government stopped issuing the long bonds. The corporate bond benchmark, which is currently about 1 percentage point higher than the Treasury version, would sharply raise the discount rate, lowering future pension liabilities and therefore funding requirements. The bill would save companies an estimated $80 billion in pension contributions over the next couple of years. (Hard-pressed airline and steel companies would get an additional funding break).

The legislation, which has passed the House of Representatives but faces strong opposition in the Senate -- Democratic Senator Edward Kennedy of Massachusetts objects that it favors a few large corporations over many small, unionized businesses -- may well fail. If so, plans would have to revert to using the straight four-year average of the 30-year Treasury. They argue that this is far too low and unfairly raises their pension liabilities. Treasury sources suggest that, under the circumstances, Fisher's ingenious sliding-scale approach may well surface in future pension bills.

THE PBGC OPENED ITS DOORS in October 1974, one month after then-president Gerald Ford signed ERISA into law. The agency addressed an urgent need: Until then workers and retirees were left empty-handed if a troubled company dropped its retirement plan. Within the PBGC's first 12 months -- which happened to coincide with the 1974­'75 recession -- nearly 4,000 orphaned retirement plans were placed on its doorstep. (Some healthy companies saw it as a way to duck their pension responsibilities.)

From its inception the agency's investment policy was as complicated as it was controversial. Former Salomon Brothers partner William Simon, Treasury secretary during the Ford administration, insisted that the PBGC's premiums constituted government revenue and thus were subject to the Office of Management and Budget's standard policies regarding government accounts. That is, the money would have to be invested in Treasuries known as nonmarketable book-entry securities. The PBGC's first executive director, Steven Schanes, had no choice but to defer to Simon and put the premiums into Treasuries. But with the support of the PBGC's overseer, the Department of Labor, Schanes, who had spent much of his career as head of the New Jersey State Division of Pensions, lobbied the PBGC board to permit the agency to invest the trust fund assets seized from plans as it saw fit -- in stocks, bonds or both.

Schanes turned for counsel to an outside investment advisory panel consisting of the late Roger Murray, a finance professor at Columbia Business School, and Eugene Burroughs, a former investment director for the International Brotherhood of Teamsters. Murray didn't go in for fashionable academic ambivalence: Invest 100 percent of PBGC assets in stocks, he declared, because that was by far the most effective way to generate sound long-term returns. The PBGC agreed to do precisely that with the trust fund assets, and in 1976 it began to look for money managers.

This show of faith in the power of stocks reflected an emerging consensus among institutional investors and academics that shares outperform bonds over time, no matter what. Buttressing the case for equity was the landmark study "Stocks, Bonds, Bills and Inflation," by Yale University finance professor Roger Ibbotson and money manager Rex Sinquefeld, published about the time ERISA was signed.

However, Treasury secretary Simon, who had headed Salomon's bond department, stated very publicly in the summer of 1976 that the PBGC should not buy any security other than a federal obligation with any of its assets. Simon believed that for a government agency like the PBGC to buy private sector bonds or stocks posed a conflict of interest.

When Jimmy Carter defeated Ford in the election that November, Simon became a lame duck, and the PBGC kept buying equities. By the end of 1976, it had amassed $11 million in assets from failed plans, all of which it invested in stocks. Throughout the 1980s the PBGC continued to invest the bulk of its trust fund assets in stocks.

The agency embarked on a critical review of its strategy in 1989 when president George H.W. Bush appointed a new PBGC executive director, James Lockhart III. The former treasurer of New York­based insurance conglomerate Alexander & Alexander Services, Lockhart had been a classmate of Bush's son George at Andover and Yale. Lockhart, not surprisingly, felt that the PBGC should match its assets and liabilities insurer-style to minimize volatility -- an approach akin to the one the agency has just adopted.

In mid-1990 Lockhart called in renowned economist Fischer Black, then at Goldman, Sachs & Co., to conduct an independent analysis. Black concluded that the agency should invest heavily in fixed-income securities to, as he put it, "immunize" itself -- match the maturity of its bonds to the due dates of its liabilities. By 1991, Lockhart had increased fixed income's share of the PBGC's total portfolio from 59 percent to 75 percent.

That approach didn't last long. In 1993 president Bill Clinton named Martin Slate, a former Yale Law School classmate of Hillary Clinton's, as the PBGC's executive director, and Slate ordered yet another investment policy review. Led by Wilshire Associates, this study rejected the notion that the PBGC should act as an insurer and contended that, like any long-term investor, the agency should overweight stocks. Slate moved decisively, allocating 100 percent of the trust fund assets to stocks and increasing equity's share of the portfolio from 17 percent in September 1993 to 30 percent a year later.

During this same period interest rates spiked: 30-year Treasury yields jumped from 6.75 percent to 8 percent, sparking the worst bond market rout in decades. With a 70 percent stake in bonds, the PBGC's then­$8.3 billion asset pool suffered a $426 million, or 6 percent, loss. In the counterintuitive world of pension math, however, the interest rate hikes reduced the agency's long-term liabilities, from $11.5 billion to $9.5 billion. As a result, the PBGC, which at the time was not facing an onslaught of failed plans, saw its deficit shrink for the first time, from a $2.9 billion shortfall on $8.4 billion in assets in September 1993 to a $1.2 billion gap on $8.3 billion in assets in September 1994.

The agency's 30 percent stake in stocks enhanced its returns when the late 1990s bull market roared. For the five years ended September 1999, the PBGC's portfolio returned 14 percent a year -- 10 percent for the fixed-income-fixated revolving funds and 21 percent for the equity-happy trust funds. That compares with 15.6 percent for the median of corporate pension funds as measured by the Wilshire Trust Universe Comparison Service (TUCS) index. The PBGC also benefited during this boom period from a decline in corporate bankruptcies and their consequent busted pension plans. As a result, its funding status steadily improved, going from a modest $860 million surplus -- its first -- in 1996 to a hefty $7 billion excess in 1999. By the time the stock market bubble burst in March 2000, the agency had an impressive $10 billion surplus.

A drop in interest rates (which raised the agency's projected liabilities), a flood of plan terminations and the market crash all combined to chop back the surplus to $7.7 billion by November 2001, when Kandarian took over. A longtime venture capitalist, he had been the pick of Labor Secretary Chao, who knew him through a network of Harvard Business School alumni and valued his financial expertise. Though highly intelligent and a quick study, Kandarian knew very little about pensions. To educate himself, he called on a well-known pension expert, Zvi Bodie, a finance professor at Boston University who had conferred with earlier PBGC administrations.

During a meeting at Bodie's cramped BU office just before Christmas 2001, Kandarian listened intently as the professor argued the case for investing 100 percent of the PBGC's pension assets in fixed-income securities. Essentially, Bodie said, stock market returns are unpredictable, and pension liabilities are predictable. For that reason, he explained, fixed-income investments are the only reliable way to match assets against liabilities. "I think I get it," Kandarian told the professor toward the end of their chat. Says Bodie: "The people running the PBGC before Kandarian thought of me as a sort of heretic and never paid me much attention. But with Kandarian there was a meeting of the minds."

That would become clear in Kandarian's strategy. When he took charge, the PBGC's overall asset allocation was 72 percent fixed income and 28 percent equity. Of its $22 billion in assets, $14.4 billion was in revolving funds and $7.6 billion in trust fund assets. The revolving funds, restricted as they are to Treasury bonds, buoyed the PBGC's portfolio during the bear market: The agency's ­3.3 percent return for 2001 compares favorably with the median corporate pension plan's ­12.9 percent; in 2002 it returned 2.1 percent, compared with a 9.3 percent loss for the median plan. Nonetheless, the PBGC's nearly $8 billion surplus was reduced one year later to a $3.6 billion deficit.

This staggering swing was brought about not by poor investment perfor-mance but by a dramatic increase in the number and size of the failed plans dumped in the PBGC's lap -- 144 pension schemes with $9.3 billion in unfunded liabilities in 2002. Steel companies alone accounted for $7.6 billion.

Kandarian recruited Gross as his right-hand man for investment policy. A former bond trader with Crédit Lyonnais, Gross had spent several years as senior adviser to Treasury undersecretary Fisher, who recommended him for the PBGC job. With Gross on board, Kandarian began to lean even more toward the fixed-income option. But first, to more broadly air the issue, Kandarian arranged for Bodie and Princeton University economist Burton Malkiel to address some of the PBGC staff in October 2002. Bodie made his case for a 100 percent investment in bonds. Malkiel remarked that he understood the logic behind the argument but questioned its timing. Says Malkiel: "I suppose I was right and wrong. Rates haven't moved, but had they put more in equity, the PBGC would be in better shape."

After further consulting with Bodie as well as with Michael Peskin, head of Morgan Stanley's global asset liabilities strategies group, and Wayne Angell, former chief economist at Bear, Stearns & Co. (and a onetime Federal Reserve Board governor), Kandarian and Gross concluded that the bond-heavy approach made the most sense for the PBGC.

The board endorsed the strategic shift. Although they recognized that a more equity-driven allocation offered a better chance of boosting returns and thus reducing the long-term deficit, Kandarian and Gross were convinced that a fixed-income portfolio was the safer bet. And if that protection came at the cost of locking in the current deficit, so be it. "I'd agree that fixed income might delay our ability to get out of deficit by a couple of years," Gross says, "but it offers downside protection, and our board decided that they would rather have the downside protection and be a little more patient."

Although finance experts continue to argue the merits of bonds versus stocks, no investment strategy can eliminate the PBGC's vulnerability to a flood of failed and woefully underfunded pension plans. Last year it had to take in 152 plans with a combined deficit of $5.4 billion. "There is only so much that asset allocation can do," warns Gross. "If underfunded plans keep terminating at this pace, there is no allocation that can get us out of the hole."