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Report to Congressional Requesters:
United States Government Accountability Office:
GAO:
July 2008:
PBGC Assets:
Implementation of New Investment Policy Will Need Stronger Board
Oversight:
GAO-08-667:
GAO Highlights:
Highlights of GAO-08-667, a report to congressional requesters.
Why GAO Did This Study:
The Pension Benefit Guaranty Corporation (PBGC) insures the retirement
future of over 44 million people. As a federal guarantor of private
defined benefit plans, PBGC finances its operations through insurance
premiums, investment income, and funds from terminated pension plans.
PBGC is governed by a board of directors comprised of the Secretaries
of Commerce, Labor, and Treasury, who are responsible for providing
policy direction and oversight but often rely on board representatives.
In 2004, PBGC began reviewing its investment policy biennially and
recently decided to broaden the range of asset classes in which it
invests.
GAO reviewed PBGC’s procedures for developing and implementing its
investment policies, and examined PBGC’s most recent investment policy.
To address these issues, GAO reviewed and analyzed PBGC policies and
data, assessed the analysis informing the recent policy change, and
interviewed agency officials and other experts.
What GAO Found:
PBGC’s directors collaborated with board representatives to reach
consensus on a board-approved investment policy for each of the recent
biennial reviews; however, it is not clear to what extent the board
oversaw PBGC’s efforts to implement its policy. Three different PBGC
directors managed the policy reviews, which culminated in board
ratification of the 2004, 2006, and 2008 policies. In 2004, the board
instructed PBGC to limit its exposure to financial risk by reducing
equity holdings to a range of 15 to 25 percent of its total
investments; the board made the same requirements in 2006. The board
has assigned responsibility to PBGC staff for implementing the
investment program, monitoring investment managers, and reporting on
investment performance. However, by 2008, the board’s policy goal had
not been attained. PBGC staff told us that high equity returns and low
fixed-income returns made it difficult to reach the target allocation
and that flexibilities built into the policy had allowed them to
maintain a higher ratio, particularly since equity returns helped
improve PBGC’s overall financial condition. While PBGC’s director and
staff kept the board apprised of its investment performance and asset
allocation, GAO found no indication that the board had approved the
deviation from its established policy or expected PBGC to continue to
reduce the proportion of equities to meet the policy objectives.
Figure: Proportion of Equities in PBGC’s Total Portfolio, December 31,
2003, through March 31, 2008:
[See PDF for image]
This figure is a plotted point graph depicting the following data:
Target equity allocation range is 10-25%.
Date: December 31, 2003;
Percent: 30%.
Date: March 31, 2004;
Percent: 29%.
Date: May 31, 2004;
Percent: 30%.
Date: August 31, 2004;
Percent: 29%.
Date: September 30, 2004;
Percent: 29%.
Date: October 31, 2004;
Percent: 29%.
Date: December 31, 2004;
Percent: 31%.
Date: March 31, 2005;
Percent: 30%.
Date: June 30, 2005;
Percent: 31%.
Date: September 30, 2005;
Percent: 28%.
Date: February 28, 2006;
Percent: 27%.
Date: March 31, 2006;
Percent: 29%.
Date: June 30, 2006;
Percent: 29%.
Date: August 31, 2006;
Percent: 28%.
Date: October 31, 2006;
Percent: 29%.
Date: November 30, 2006;
Percent: 30%.
Date: January 31, 2007;
Percent: 31%.
Date: March 31, 2007;
Percent: 30%.
Date: April 30, 2007;
Percent: 31%.
Date: June 30, 2007;
Percent: 32%.
Date: August 31, 2007;
Percent: 31%.
Date: December 31, 2007;
Percent: 29%.
Date: March 31, 2008;
Percent: 2&%.
Note: Data represent certain points in time and are not comprehensive.
Source: GAO’s analysis of PBGC data.
[End of figure]
While the investment policy adopted in 2008 aims to reduce PBGC’s $14
billion deficit by investing in assets with a greater expected return,
GAO found that the new allocation will likely carry more risk than
acknowledged by PBGC’s analysis. According to PBGC officials, the new
allocation will be sufficiently diversified to mitigate the expected
risks associated with the higher expected return. They also asserted
that it should involve less risk than the previous policy. However,
GAO’s assessment demonstrates that the risks are likely higher in the
new allocation. Although it is important that the PBGC consider ways to
optimize its portfolio, including higher return and diversification
strategies, the agency faces unique challenges, such as PBGC’s need for
access to cash in the short-term to pay benefits, which could further
increase the risks it faces with any investment strategy that allocates
significant portions of the portfolio to volatile or illiquid assets.
What GAO Recommends:
GAO recommends (1) improvements to the way that PBGC’s board monitors
progress in achieving investment policy goals, and (2) additional
analyses on the new investment policy. In response, PBGC’s board stated
its informal guidance is appropriate oversight. GAO states this type of
guidance is not strong enough for investing $68 billion. Further, PBGC
is conducting additional analysis on the new policy.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-667]. For more
information, contact Barbara Bovbjerg at (bovbjergb@gao.gov), (202) 512-
7215, or Thomas J. McCool at (mccoolt@gao.gov), (202) 512-2642.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Board Representatives Collaborated with PBGC Directors to Develop
Investment Policies, but Board Oversight of Implementation Efforts Is
Not Clear:
PBGC's New Investment Policy Aims to Achieve Greater Returns, but PBGC
Has Likely Understated the Risks:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Description of GAO's Sensitivity Analysis:
Appendix III: Comments from the Pension Benefit Guaranty Corporation
Board of Directors:
Appendix IV: Comments from the Pension Benefit Guaranty Corporation:
Appendix V: GAO Contacts and Staff Acknowledgments:
Related GAO Products:
Tables:
Table 1: PBGC's Investment Policy Objectives and Target Allocations,
1975 to February 2008:
Table 2: Estimated Average Asset Allocation Percentage for Life and
Property and Casualty Insurance Companies, 2006:
Table 3: Average Asset Allocation Percentages for the Top 200 Public
and Private Defined Benefit Plans, September 30, 2007:
Table 4: PBGC Consultant Assumptions, Returns and Risk:
Table 5: PBGC Consultant Assumptions, Correlations:
Table 6: Sensitivity Analysis of Portfolio Expected Returns:
Table 7: Sensitivity Analysis of Portfolio Risk:
Table 8: JPMorgan Asset Management Long-term Capital Market
Assumptions, Returns and Risk for Select Assets:
Table 9: JPMorgan Asset Management Long-term Capital Market
Assumptions, Select Correlations:
Figures:
Figure 1: Amount of Assets in Revolving and Trust Funds, Fiscal Years
1991 through 2007:
Figure 2: Total Investment Performance and Performance by Revolving and
Trust Funds, Fiscal Years 1991 through 2007:
Figure 3: PBGC Asset and Liabilities, Fiscal Years 1991 through 2007:
Figure 4: Proportion of Equities in PBGC's Total Portfolio, December
31, 2003, through March 31, 2008:
Figure 5: Comparison of PBGC's Previous and New Asset Allocation
Policies:
Figure 6: Degree to Which the New Allocation Holds More or Less Risk
than the Previous Allocation under Different Asset Assumptions:
Abbreviations:
ERISA: Employee Retirement Income Security Act of 1974:
PBGC: Pension Benefit Guaranty Corporation:
PPA: Pension Protection Act of 2006:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
July 17, 2008:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
The Honorable Edward M. Kennedy:
Chairman:
The Honorable Michael B. Enzi:
Ranking Member:
Committee on Health, Education, Labor and Pensions:
United States Senate:
The Pension Benefit Guaranty Corporation (PBGC) insures the pensions of
more than 44 million private sector workers and retirees who
participate in approximately 30,000 employer-sponsored pension plans.
Created in 1974 as a federal guarantor of private defined benefit
plans, PBGC finances its operations through insurance premiums paid by
the plan sponsors, money earned from investments, and funds received
from terminated pension plans. PBGC shares many traits with both
insurance companies and pension plans--it was established to insure the
pension benefits of participants in qualified plans and to pay
participants' benefits when plans could not. However, unlike insurance
companies, it cannot set premiums and, unlike pension plans, it cannot
adjust plan terms; it must also take on new beneficiaries regardless of
the level of funding accompanying terminated plans.
PBGC holds approximately $68 billion in assets, making it, by that
measure, one of the largest federal government corporations. PBGC also
holds approximately $82 billion in liabilities from underfunded pension
plans--many of which have been terminated in the past decade. As a
result, PBGC has an accumulated deficit that currently stands at about
$14 billion. Recognizing the long-term vulnerabilities facing PBGC's
insurance program, its single-employer program[Footnote 1] is on GAO's
high-risk list of federal programs needing attention and congressional
action.[Footnote 2]
PBGC is governed by a three-member board of directors that is
ultimately responsible for providing policy direction and oversight of
PBGC's finances and operations, but often relies on board
representatives to conduct much of the work on their behalf.[Footnote
3] The board approves the Corporation's investment policy and is
responsible for overseeing its implementation. After years of limited
investment policy review, the board began reviewing the policy
biennially in 2004. As a part of the 2004 and 2006 reviews, the board
instructed PBGC to limit its exposure to financial risk by reducing
equity holdings to a range of 15 to 25 percent of its total
investments--and maintaining the rest of PBGC's assets mostly in fixed
income investments. In February 2008, the board lifted these
limitations and approved investments in a broader range of asset
classes, including more international equities and other asset classes,
such as private equity and emerging market debt. In response to the
changes in PBGC's investment policy, you asked us to assess (1) PBGC's
procedures for developing and implementing its investment policies and
(2) PBGC's most recent investment policy for its potential risks and
benefits.
To conduct our work, we reviewed PBGC's recent investment policies and
supporting documentation, paying particular attention to the process
used during recent biennial reviews (2004, 2006, and 2008). We reviewed
policy statements that outlined PBGC's goals, minutes from board and
advisory committee meetings, and memos discussing the rationale and
process used to implement strategies. In addition, we reviewed PBGC's
published annual reports, investment performance reports, and other
related documents. For the 2008 policy, we assessed the study that
informed PBGC's new investment policy and discussed the outcomes of the
study with PBGC staff and the consultant hired to conduct the study. As
a part of our assessment, we tested some of the consultant's
assumptions on asset risks and returns to determine how sensitive
outcomes were to changes in the assumptions. We did not review the
process to implement the 2008 policy because it was approved by the
board in February and PBGC had not yet devised its strategy for
implementing the changes. In addition, we attended an advisory
committee meeting where investment options for the recent policy change
were presented. We also interviewed current and former officials from
PBGC; the Departments of Commerce, Labor, and Treasury; and the PBGC
advisory committee. To gain the perspective of the board, we
interviewed the board representatives and their staffs. We also
interviewed PBGC's current investment managers to discuss their role in
implementing the investment strategy and managing PBGC's assets. In
addition, we reviewed relevant literature, statutes, and data and
interviewed experts knowledgeable of PBGC and investment approaches.
We conducted this performance audit between November 2007 and July
2008, in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit
to obtain sufficient, appropriate evidence to provide a reasonable
basis for our findings and conclusions based on our audit objectives.
We believe that the evidence obtained provides a reasonable basis for
our findings and conclusions based on our audit objectives. For
additional discussion of our scope and methodology, see appendix I.
Results in Brief:
PBGC's directors collaborated with board representatives to reach
consensus on a board-approved investment policy for each of the recent
biennial reviews; however, it is not clear to what extent the board
oversaw PBGC's efforts to implement its policy. Three different PBGC
directors managed the policy reviews, which culminated in board
ratification of the 2004, 2006, and 2008 policies. In 2004, the board
instructed PBGC to limit its exposure to financial risk by reducing
equity holdings to a range of 15 to 25 percent of its total
investments, and repeated these expectations in 2006. The board has
assigned responsibility to PBGC staff for implementing the investment
program, monitoring investment managers, and reporting on investment
performance. However, by 2008, the board's policy goal had not been
attained. PBGC staff told us that high equity returns and low fixed-
income returns made it difficult to reach the target allocation and
that flexibilities built into the policy had allowed them to maintain a
higher ratio, particularly since equity returns helped improve PBGC's
overall financial condition. While PBGC's director and staff kept the
board apprised of its funds' investment performance and asset
allocation, we found no indication that the board had approved the
deviation from its established policy or expected PBGC to continue to
reduce the proportion of equities to meet the policy objectives.
While the new investment policy aims to reduce PBGC's $14 billion
deficit by investing in assets with a greater expected return, we found
that the new allocation will likely also carry more risk than
acknowledged by PBGC's analysis. According to PBGC officials, the new
allocation will be sufficiently diversified to mitigate the expected
risks associated with the higher expected return. They also asserted
that it should involve less risk than the previous policy. Based on our
analysis that tested the sensitivity of the PBGC's results to the
underlying assumptions, we found that the expected returns could be
higher than the previous allocation, but the risks may also be higher.
Although it is important that the PBGC consider ways to optimize its
portfolio, including higher return and diversification strategies, the
agency faces unique challenges, such as PBGC's need for access to cash
in the short term to pay benefits, which could further increase the
risks it faces with any investment strategy that allocates significant
portions of the portfolio to volatile or illiquid assets.
To ensure accountability for the full implementation of the board's new
investment policy decisions and its appropriate oversight of an
investment policy that carries more risk, we are recommending that the
PBGC board require the director to formally submit PBGC's plan for
implementing its new investment policy, develop accountability measures
to monitor progress in achieving the policy goals, and request periodic
reports on the status of implementation. In addition, to gain a better
understanding of the risks involved in the new investment policy, we
are recommending that PBGC conduct sensitivity analyses before
implementing the new investment policy.
In response to our draft report, the PBGC board of directors emphasized
the board's commitment to providing strong oversight of the PBGC
investment policy to ensure that the policies are implemented
appropriately. During the implementation of the previous investment
policy, board members received reports on PBGC's efforts and determined
that PBGC had taken prudent measures to comply with the investment
policies. The chair of the PBGC board did not specifically address our
recommendations, but stated that the current combination of
presentations by PBGC, verbal agreements, and informal guidance
provided from the board and its representatives offered an appropriate
level of oversight. In addition, the chair reported that PBGC had
submitted a preliminary implementation plan for the new policy and
reported that PBGC had planned to provide a more complete
implementation briefing in early July. We do not believe that a system
of verbal agreement and informal guidance is strong enough oversight
for investing $68 billion. The successful implementation of this
policy, which invests in a broader range of assets, will require close
monitoring and consistent oversight.
In responding to the draft report, the PBGC director stated that the
process that supported the adoption of the new policy was complete and
robust. He said the process included a thorough assessment of PBGC's
long-term obligations to plan participants and beneficiaries,
exhaustive discussion among numerous constituents, and in-depth
analysis by leading industry experts, including PBGC's investment
consultant. In response to our recommendation, the director agreed that
sensitivity analyses are important, and that PBGC will continue to
perform them going forward. PBGC took initial steps to conduct an
analysis on the new policy. However, we believe that more analysis
should be conducted, including an analysis that incorporates assets,
liabilities, and funded position. PBGC's board of directors and PBGC's
director's comments are reproduced in appendixes III and IV,
respectively.
Background:
PBGC was established to insure the pension benefits of participants in
qualified defined benefit plans and pay participants when plans could
not. PBGC takes over the assets of underfunded terminated plans and is
responsible for paying benefits to participants who are entitled to
receive them. The Employee Retirement Income Security Act of 1974
(ERISA) established PBGC as a self-financing entity. Its assets
originate from multiple sources including insurance premiums from
sponsors of insured private sector defined benefit plans, assets
acquired from terminated plans, and investment income earned on these
assets; PBGC receives no tax revenue and its liabilities are not backed
by the U.S. government. The premium rate and the maximum benefit level
are set by statute.[Footnote 4]
PBGC holds its assets in two categories of funds: the trust funds and
the revolving funds. The trust funds hold assets acquired from
terminated plans; the revolving funds consist of premium receipts.
While ERISA requires certain revolving funds to be invested in
obligations issued or guaranteed by the United States, PBGC has more
flexibility to invest the trust fund assets in other investments.
[Footnote 5] As shown in figure 1, the trust funds grew significantly
over the past 16 years to become the larger of the two funds, with most
of the growth occurring after the record number of sizable terminations
started in 2001. Because the terminated plans were underfunded, PBGC's
deficit increased significantly.
Figure 1: Amount of Assets in Revolving and Trust Funds, Fiscal Years
1991 through 2007:
[See PDF for image]
This figure is a stacked vertical bar graph depicting the following
data:
Year: 1991;
Trust funds: $2.3 billion;
Revolving funds: $2.5 billion.
Year: 1992;
Trust funds: $3 billion;
Revolving funds: $3.2 billion.
Year: 1993;
Trust funds: $3.3 billion;
Revolving funds: $5 billion.
Year: 1994;
Trust funds: $3.3 billion;
Revolving funds: $4.9 billion.
Year: 1995;
Trust funds: $4.1 billion;
Revolving funds: $6.4 billion.
Year: 1996;
Trust funds: $5 billion;
Revolving funds: $7.2 billion.
Year: 1997;
Trust funds: $6.6 billion;
Revolving funds: $9 billion.
Year: 1998;
Trust funds: $6.5 billion;
Revolving funds: $11.6 billion.
Year: 1999;
Trust funds: $7.8 billion;
Revolving funds: $10.8 billion.
Year: 2000;
Trust funds: $8.9 billion;
Revolving funds: $12.1 billion.
Year: 2001;
Trust funds: $7.6 billion;
Revolving funds: $14.4 billion.
Year: 2002;
Trust funds: $9 billion;
Revolving funds: $17 billion.
Year: 2003;
Trust funds: $18.1 billion;
Revolving funds: $16.4 billion.
Year: 2004;
Trust funds: $21.3 billion;
Revolving funds: $16.2 billion.
Year: 2005;
Trust funds: $32.6 billion;
Revolving funds: $16.4 billion.
Year: 2006;
Trust funds: $44 billion;
Revolving funds: $15.2 billion.
Year: 2007;
Trust funds: $48.1 billion;
Revolving funds: $14.5 billion.
Source: GAO’s analysis of PBGC annual report data.
[End of figure]
The investment performance of the revolving and trust funds has varied
over time (see fig. 2). However, PBGC's investments in fixed income and
equities have generally followed major indexes, such as Lehman Brothers
long Treasury index for the fixed income and the Wilshire 5000 and
Standard and Poor's 500 indexes for the equity investments.
Figure 2: Total Investment Performance and Performance by Revolving and
Trust Funds, Fiscal Years 1991 through 2007:
[See PDF for image]
This figure is a combination vertical bar and line graph depicting the
following data:
Year: 1991;
Trust funds: 29.8%;
Revolving funds: 21.1%;
Total: 24.4%.
Year: 1992;
Trust funds: 11.2%;
Revolving funds: 11.2%;
Total: 11.2%.
Year: 1993;
Trust funds: 15.7%;
Revolving funds: 37.7%;
Total: 27.7%.
Year: 1994;
Trust funds: 1.6%;
Revolving funds: -11.2%;
Total: -6.4%.
Year: 1995;
Trust funds: 26.8%;
Revolving funds: 22.5%;
Total: 24.1%.
Year: 1996;
18.6 2.3
Trust funds: 18.6%;
Revolving funds: 2.3%;
Total: 8.5%.
Year: 1997;
Trust funds: 35.6%;
Revolving funds: 13.3%;
Total: 21.9%.
Year: 1998;
Trust funds: 2.1%;
Revolving funds: 22.4%;
Total: 14.4%.
Year: 1999;
Trust funds: 24.3%;
Revolving funds: -7.7%;
Total: 3.6%.
Year: 2000;
Trust funds: 18.1%;
Revolving funds: 9.7%;
Total: 13.2%.
Year: 2001;
Trust funds: -26.1%;
Revolving funds: 13.8%;
Total: -3.3%.
Year: 2002;
-15.5 14.4
Trust funds: -15.5%;
Revolving funds: 14.4%;
Total: 2.1%.
Year: 2003;
Trust funds: 22.9%;
Revolving funds: 3.8%;
Total: 10.3%.
Year: 2004;
Trust funds: 11.5%;
Revolving funds: 5.4%;
Total: 8%.
Year: 2005;
Trust funds: 10.3%
Revolving funds: 7%;
Total: 8.9%
Year: 2006;
Trust funds: 6.2%;
Revolving funds: 0.6%;
Total: 4.2%.
Year: 2007;
Trust funds: 9.5%;
Revolving funds: 2%;
Total: 7.2%.
Source: GAO analysis of PBGC annual report data.
[End of figure]
In July 2003, GAO designated PBGC's single-employer pension insurance
program--its largest insurance program--as "high-risk," including it on
GAO's list of major programs that need urgent attention and
transformation due to the financial risks that it faces. The program
remains on the list today.[Footnote 6] PBGC projected its financial
deficit at nearly $14 billion as of September 2007 (see fig. 3).
Figure 3: PBGC Asset and Liabilities, Fiscal Years 1991 through 2007:
[See PDF for image]
This figure is a combination vertical bar and line graph depicting the
following data:
Year: 1991;
Assets: $5,918 million;
Liabilities: $8,241 million.
Year: 1992;
Assets: $6,602 million;
Liabilities: $9,050 million.
Year: 1993;
Assets: $8,828 million;
Liabilities: $11,449 million.
Year: 1994;
Assets: $8,659 million;
Liabilities: $9,702 million.
Year: 1995;
Assets: $10,848 million;
Liabilities: $10,971 million.
Year: 1996;
Assets: $12,548 million;
Liabilities: $11,555 million.
Year: 1997;
Assets: $15,910 million;
Liabilities: $12,210 million.
Year: 1998;
Assets: $18,376 million;
Liabilities: $13,023 million.
Year: 1999;
Assets: $19,123 million;
Liabilities: $11,886 million.
Year: 2000;
Assets: $21,524 million;
Liabilities: $11,438 million.
Year: 2001;
Assets: $22,575 million;
Liabilities: $14,727 million.
Year: 2002;
Assets: $26,374 million;
Liabilities: $29,854 million.
Year: 2003;
Assets: $35,016 million;
Liabilities: $46,515 million.
Year: 2004;
Assets: $40,063 million;
Liabilities: $63,604 million.
Year: 2005;
Assets: $57,630 million;
Liabilities: $80,741 million.
Year: 2006;
Assets: $61,138 million;
Liabilities: $80,019 million.
Year: 2007;
Assets: $68,438 million;
Liabilities: $82,504 million.
Source: GAO analysis of PBGC annual report data.
[End of figure]
We previously reported that pension funding rules and PBGC's structure
have contributed to its poor fiscal position.[Footnote 7] The pension
funding rules were not designed to ensure that plans had the means to
meet their benefit obligations in the event that plan sponsors
experienced financial distress. Meanwhile, in the aggregate, premiums
paid by plan sponsors have not adequately reflected the financial risk
to which PBGC is exposed. Accordingly, defined benefit plan sponsors
have been able to turn significantly underfunded plans over to the
PBGC, thus creating the current deficit. PBGC has become responsible
for a number of large terminated pension plans, which have brought it
large numbers of claims from plan participants. Between fiscal years
2000 and 2005, the number of participants to whom PBGC has paid
benefits increased from around 243,000 to almost 700,000, with another
half million expected to receive benefits from PBGC when they become
eligible to retire.
To strengthen pension plan funding, Congress passed the Pension
Protection Act of 2006 (PPA) and included provisions to shore up
defined benefit plan funding. These provisions included raising the
funding targets that defined benefit plans must meet, reducing the
period over which sponsors can "smooth," or average, reported plan
assets and liabilities, and restricting sponsors' ability to substitute
"credit balances" for cash contributions.[Footnote 8] Other provisions
of the act may increase PBGC revenues by raising flat-rate premiums,
expanding variable-rate premiums, and introducing a termination premium
for some bankrupt sponsors, while limiting PBGC's guarantee to pay
certain benefits.
Characteristics of PBGC Investment Policies:
PBGC has typically invested primarily in fixed income and domestic
equities. However, the proportion of assets allocated to each class has
shifted according to changes in investment policy. PBGC has
responsibilities and liabilities as both an insurer and a payer of
pension benefits. PBGC's investment policy, as established by its board
of directors, has alternated between a philosophy characteristic of
insurance companies (immunizing against potential interest rate risk
exposure by investing in fixed income assets of appropriate duration)
[Footnote 9] and an investment philosophy more characteristic of
pension plans (optimizing investment returns) since its establishment
(see table 1).
Table 1: PBGC's Investment Policy Objectives and Target Allocations,
1975 to February 2008:
Objectives[A];
1975-1990: Optimize investment return within acceptable levels of risk;
1990-1994: Immunize assets against potential risk exposure by limiting
deficit volatility;
1994-2004: Optimize investment return within acceptable levels of risk;
2004-2008: Immunize assets against potential risk exposure by limiting
deficit volatility.
Fixed-income investments target[B];
1975-1990: No set limit;
1990-1994: 75% or greater;
1994-2004: No set limit;
2004-2008: 75-85%.
Equity investments target;
1975-1990: No set limit;
1990-1994: No more than 25%;
1994-2004: No set limit;
2004-2008: 15-25%.
Source: GAO analysis of PBGC documents.
[A] Each investment policy included additional objectives, such as to
maintain low premium levels and to provide benefits to participants and
beneficiaries.
[B] Each investment policy statement indicates that the revolving fund
will be invested only in Treasury bonds although PBGC did not set a
limit of fixed income investments at times.
[End of table]
When the strategy called for optimizing returns, PBGC generally
invested much of the trust fund assets in equities, leaving the
revolving fund as the primary source for fixed-income securities. PBGC
changed its investment policy in both 1990 and 2004 in an effort to
limit the volatility of the financial performance and reduce the
overall risk including interest rate risk. During these periods, PBGC's
investment policies set a cap of 25 percent on the proportion of total
assets that PBGC could invest in equities. The policies called for PBGC
to increase its investments in fixed-income securities to closely match
the duration of its liabilities. The purpose of this strategy was to
offset changes in the value of PBGC's liabilities with corresponding
changes in the value of the fixed-income assets, in order to reduce the
risk of an increase in PBGC's deficit as a result of interest rate
changes.
Like the policies that PBGC adopted in 1975 and 1994 that optimized
returns, PBGC's board recently approved investments in a broader range
of asset classes. The new policy includes more international equities
and other asset classes, such as private equity and emerging market
debt. The policy's target allocation includes 40 percent to fixed-
income, 39 percent to equities, 10 percent to real estate and private
equity, 6 percent to alternative equities, and 5 percent to alternative
fixed-income.
While PBGC functions as both an insurer of defined benefit plans and a
trustee of the plans it takes over, it has unique attributes that set
it apart from operating exclusively as either entity. PBGC has been
compared to both life and property and casualty insurers. As with life
insurers, PBGC has a long-term investment horizon for some of its
liabilities; like property and casualty insurers, PBGC has
unpredictable liabilities that require a degree of liquidity in the
assets it holds. Both insurers allocate assets to a number of different
classes, but predominately invest in fixed income assets--on average 75
percent in bonds for life insurers and 67 percent for property and
casualty insurers (see table 2). However, unlike an insurance company,
under current law, PBGC does not have the authority to adjust the
premium it charges to reflect the potential risk of a policyholder, nor
does it have the ability to control its risks by choosing which defined
benefit plans it will insure or the terms under which it will insure
them. In addition, insurers cannot carry a deficit at the magnitude
that PBGC currently faces.
Table 2: Estimated Average Asset Allocation Percentage for Life and
Property and Casualty Insurance Companies, 2006:
Equities:
Life insurance[A]: 3.6;
Property and casualty insurance: 18.8.
Equities: Common;
Life insurance[A]: 1.4;
Property and casualty insurance: 17.5.
Equities: Preferred;
Life insurance[A]: 2.1;
Property and casualty insurance: 1.3.
Fixed income:
Life insurance[A]: 78.0;
Property and casualty insurance: 75.1.
Fixed income: Bonds;
Life insurance[A]: 75.2;
Property and casualty insurance: 67.2.
Fixed income: Cash;
Life insurance[A]: 2.8;
Property and casualty insurance: 7.9.
Real estate and mortgages:
Life insurance[A]: 11.0;
Property and casualty insurance: 1.1.
Real estate and mortgages: Real estate;
Life insurance[A]: 0.7;
Property and casualty insurance: 0.8.
Real estate and mortgages:
Mortgages; Life insurance[A]: 10.4;
Property and casualty insurance: 0.3.
Other[B]:
Life insurance[A]: 7.4;
Property and casualty insurance: 5.0.
Total:
Life insurance[A]: 100.0;
Property and casualty insurance: 100.0.
Source: GAO analysis of data from the National Association of Insurance
Commissioners.
[A] Data on life insurance allocations represent only the assets held
in general accounts. A general account is usually an insurer's largest
account and is where insurers record their guaranteed contracts. Life
insurers also maintain other accounts, called "separate accounts,"
where they hold assets such as equities and real estate. A separate
account is maintained independently from the insurer's general
investment account and used primarily for variable annuity and variable
life products. They are beyond the scope of this presentation.
[B] Other includes contract loans, other invested assets, and
receivables from securities.
[End of table]
Much like a defined benefit plan sponsor, PBGC is responsible for
paying benefits to participants of plans it has taken over. The
investment strategies of pension funds typically center on equities and
other investments, such as real estate and private equity. The fixed
income investments averaged just over one-quarter of pension plan
assets (see table 3). Unlike employers that sponsor defined benefit
plans, PBGC does not have business revenue that can be tapped to make
up funding shortfalls, nor can it appeal to a state legislature for
additional funds as public plans can. PBGC's new investment policy
matches closely with the investment philosophy of pension plans.
[Footnote 10]
Table 3: Average Asset Allocation Percentages for the Top 200 Public
and Private Defined Benefit Plans, September 30, 2007:
Equities:
Private Defined Benefit Plans: 56.3;
Public Defined Benefit Plans: 60.4.
Equities: Domestic;
Private Defined Benefit Plans: 35.8;
Public Defined Benefit Plans: 40.5.
Equities: International;
Private Defined Benefit Plans: 20.5;
Public Defined Benefit Plans: 19.9.
Fixed income:
Private Defined Benefit Plans: 30.6;
Public Defined Benefit Plans: 25.9.
Fixed income: Domestic;
Private Defined Benefit Plans: 25.7;
Public Defined Benefit Plans: 23.3.
Fixed income: International;
Private Defined Benefit Plans: 3.7;
Public Defined Benefit Plans: 1.1.
Fixed income: Cash;
Private Defined Benefit Plans: 1.2;
Public Defined Benefit Plans: 1.5.
Real estate and Mortgages:
Private Defined Benefit Plans: 3.8;
Public Defined Benefit Plans: 5.8.
Real estate and Mortgages: Real estate equity;
Private Defined Benefit Plans: 3.6;
Public Defined Benefit Plans: 5.2.
Real estate and Mortgages: Mortgages;
Private Defined Benefit Plans: 0.2;
Public Defined Benefit Plans: 0.6.
Other:
Private Defined Benefit Plans: 9.3;
Public Defined Benefit Plans: 7.9.
Other: Private equity;
Private Defined Benefit Plans: 5.3;
Public Defined Benefit Plans: 5.2.
Other: Other;
Private Defined Benefit Plans: 4.0;
Public Defined Benefit Plans: 2.7.
Total:
Private Defined Benefit Plans: 100.0;
Public Defined Benefit Plans: 100.0.
Source: Pensions & Investments.
[End of table]
PBGC Governance:
ERISA established a governance structure for PBGC consisting of a board
of directors, with the Secretary of Labor as the Chair of the Board and
the Secretaries of Commerce and Treasury as members. The board sets the
parameters for PBGC's investments through the development of an
investment policy statement. Prior to 2004, the board reviewed its
investment policy on a limited basis. In 2004, the board formalized the
investment policy decision making by requiring a review of PBGC's
investment policy no less than once every 2 years. PBGC's board
recently revised its bylaws specifying that the board review PBGC's
investment policy statement every 2 years and approve the statement
every 4 years. The purpose of this periodic review was to ensure that
(1) the investment policy objectives and operational objectives were
properly aligned, (2) the implemented investment strategies were
consistent with the investment objectives, and (3) the investment
policy was conducted in a manner consistent with ERISA. The board
sought to give PBGC sufficient flexibility in managing implementation
while establishing parameters to ensure that investments are executed
in a manner consistent with the stated objectives.
In 2007, we reported that PBGC's board had limited time and resources
to provide policy direction and oversight and had not established
comprehensive written procedures and mechanisms to monitor PBGC's
operations.[Footnote 11] In that report, we concluded that because the
Secretary of Labor has historically had the authority to administer
PBGC, the Department of Labor (Labor) has, in some ways, filled the
void in accountability. Board representatives from the Departments of
Treasury and Commerce often deferred to Labor on administrative matters
and did not generally question Labor on its actions. However, we noted
that it is essential that the board members exercise their authority to
oversee PBGC and coordinate with Labor and each other not only on major
policy issues, but also on the oversight of PBGC's activities. In
addition, we noted that PBGC's management should work with the board to
ensure that all significant matters are formally elevated to the
board's attention. In addition to our recommendation regarding board
oversight, we advised Congress to consider expanding board membership
with additional suggestions that these members have diverse backgrounds
as well as knowledge and expertise useful to PBGC's responsibilities.
Further, if Congress were to expand the board, we suggested that
dedicated staff be assigned who are independent of PBGC's executive
management and have pension and financial expertise.
Board Representatives Collaborated with PBGC Directors to Develop
Investment Policies, but Board Oversight of Implementation Efforts Is
Not Clear:
For each of the biennial reviews since 2004, the PBGC board
representatives collaborated with the PBGC directors to reach consensus
on a board-approved investment policy, but it is unclear to what extent
the board oversaw efforts to implement the 2004 and 2006 policies,
which were intended to limit PBGC's exposure to financial risk. Three
different PBGC directors managed the investment policy reviews in 2004,
2006, and 2008 and PBGC staff took steps to implement changes resulting
from the 2004 and 2006 investment policies. Despite these efforts, by
2008, PBGC had not met the 2004 and 2006 policy objective of reducing
PBGC's equity holdings down to within a board-approved range. Although
PBGC kept the board apprised of its asset allocation and returns, we
found no indication that the board had approved the deviation from its
established policy or expected PBGC to continue to reduce the
proportion of equities to meet the target allocation.
PBGC's Directors Determined Scope of the Investment Policy Reviews and
Made Recommendations to the Board:
Three different PBGC directors managed the reviews that led to the
2004, 2006, and 2008 investment policies and followed a similar process
in developing their respective investment policy recommendations to the
board. For each of these reviews, the PBGC directors determined the
scope of the review, consulted with a range of industry experts, and
hired third-party financial consultants to perform the review of PBGC's
investment policies and asset allocation strategies. The consultants
provided detailed analyses and recommendations on PBGC's long-term
asset allocation strategy. The advisory committee meetings served as a
venue for sharing information during each investment policy review
process. These meetings were regularly attended by advisory committee
members; representatives of the board; and PBGC's director, staff, and
consultants. The meetings provided a forum to discuss PBGC's investment
strategy and hear presentations from PBGC's consultants, investment
managers, and industry experts. The advisory committee provided its
investment policy recommendation to the director, who then collaborated
with the board representatives to prepare a consensus recommendation
for the board's approval.
While each of the biennial policy reviews followed similar patterns,
they had some distinctions. In managing the review that led to the 2004
investment policy, the PBGC director sought to better position PBGC to
weather future volatility in the fixed income securities markets and
the defined benefit pension system. As part of this review, the
director presented three different asset allocation scenarios to the
PBGC advisory committee members based on information gathered from
academic professionals and industry experts. The director then
presented his recommendation and the advisory committee's
recommendation to the board and outlined the pros and cons of each. The
board's representatives and the PBGC director worked together to reach
consensus on a draft board resolution on investment issues, which the
board later ratified as PBGC's new investment policy.
As part of the 2006 investment policy review, a new PBGC director
conducted a review that was limited in scope; he considered it
premature to make substantial changes to the 2004 investment policy as
PBGC staff had just begun to implement the policy and had not yet
reached the objective of limiting its equity risk exposure. To arrive
at a recommendation, PBGC hired a consultant that provided a range of
asset allocation options for PBGC to consider. In addition, the
advisory committee convened panels comprised of representatives from
state public pension funds and private corporations. As a result of
this process, the PBGC director recommended and the board approved one
substantive change to the existing policy--to allow PBGC to diversify
its holdings to include international fixed income and equity
securities.
In managing the review that led to the 2008 investment policy, a new
PBGC director called for a comprehensive review of PBGC's investment
policy to improve the likelihood that PBGC would meet its current and
future obligations. To assist in this process, PBGC again hired a
consultant to analyze a range of asset allocation alternatives to
improve PBGC's financial condition. At the advisory committee meetings,
presentations were made by PBGC's investment managers as well as by
experts and the consultant who discussed liability-driven investing and
alternative asset investments. The consultant also briefed the advisory
committee on the scope and timeline of its review, presented a range of
alternative allocation scenarios and risk assessments, and recommended
its preferred asset allocation to improve the probability PBGC would be
able to meet its statutory obligations with its current resources.
In the 2008 review, the advisory committee and the PBGC director relied
on the consultant's analyses in developing their respective investment
policy recommendations. The advisory committee considered the
consultant's study along with PBGC's projections of future
contributions and plan failures, and recommended to the PBGC director
an investment allocation option that the committee believed best met
the needs of the PBGC. PBGC staff told us that the director took the
consultant's recommendation to the board representatives and worked
with their respective staffs to customize a recommendation to the board
itself. This process led them to alter the weights of certain asset
classes, remove some asset classes altogether, and have the consultant
run further analysis on the revised asset allocation formula. The board
representatives told us that the goal in developing the recommendation
was to achieve consensus and the board's unanimous vote. Upon reaching
consensus, the director presented a recommendation to the board, which
the board approved as PBGC's 2008 investment policy.
PBGC Staff Were Responsible for Implementing Policy Changes and
Monitoring Investment Performance:
In each investment policy, the board assigned responsibility for
implementing the investment program, monitoring investment managers,
and reporting on investment performance to PBGC staff. To address
changes made in the 2004 and 2006 investment policies,[Footnote 12]
PBGC's staff told us that they worked with a consultant to determine
the number and type of investment managers to hire. For example, in
2004, they said that PBGC determined that it needed additional fixed-
income investment managers that focused on asset-liability matching. In
2006, PBGC staff said that they chose to hire no new managers but
instead instructed their existing managers to add international
securities as an investment option in their portfolios. According to
PBGC officials, when PBGC has hired new investment managers, it has
used the competitive federal procurement process.[Footnote 13] As part
of this process, they explained that PBGC took steps to identify the
appropriate managers, held oversight meetings on the premises of
investment firms; reviewed historical reports and systems; and
evaluated the managers' implementation strategies, financial ties, and
management capacity. PBGC officials told us that they selected managers
based upon their demonstrated performance, expertise, and cost. PBGC
then let most contracts to the investment managers for one base year
plus six option years and gave the investment managers discretion to
manage investments within PBGC's policy guidelines.
PBGC staff monitored the managers' performance against negotiated
investment benchmarks and guidelines. For example, PBGC staff told us
that they monitored the managers' monthly investment reports--which
provided a full accounting of all transactions, commentary on the
status of investments, and projections of future returns--and followed
up with the portfolio managers to clarify issues that emerged. Several
investment managers told us that they had frequent conversations with
PBGC staff and that the frequency of the contact would increase if they
did not meet their benchmarks. In addition, PBGC produced detailed
quarterly investment performance reports for the board that among other
things compared managers' performance against benchmarks and listed the
risk characteristics associated with the portfolio.
PBGC staff told us that they ensured that investment managers complied
with the terms of their contracts by conducting quarterly compliance
reviews of its investment managers and annual on-site compliance
reviews during which staff would review the managers' systems,
financial disclosure forms, and annual reports. In addition, PBGC
officials said that they evaluated each manager's annual financial
disclosure form required by the Securities and Exchange Commission, and
sought clarification for any anomalies they found. PBGC officials said
that these due diligence procedures provided additional assurance that
its investment managers would follow PBGC's policies and guidelines on
managing the assets entrusted to them. Moreover, they told us that they
used the annual contract renewal to monitor the investment manager
contracts closely, negotiate fees, or seek termination as necessary.
Between 2004 and 2008 PBGC terminated several of its investment manager
contracts, at least one because of poor performance.
Board Oversight of Policy Implementation Efforts Is Unclear:
In the 2004 investment policy, the board called on PBGC to limit its
exposure to risk arising from differences in interest rate sensitivity
between its assets and liabilities. To accomplish this objective, the
board set an expectation for PBGC to decrease its equity investments to
a target range of 15 and 25 percent of total assets within 2 years.
[Footnote 14] The 2006 investment policy--which made one substantive
modification to the 2004 policy--maintained the same objective of
minimizing exposure to interest rate risk and repeated the target
allocation and the 2-year time frame. However, as shown in figure 4,
PBGC did not attain its goal of limiting its exposure to interest rate
risk by reducing its equities down to within the board-approved target
range as required by the 2004 and 2006 investment policies.
Figure 4: Proportion of Equities in PBGC's Total Portfolio, December
31, 2003, through March 31, 2008:
[See PDF for image]
This figure is a plotted point graph depicting the following data:
Target equity allocation range is 10-25%.
Date: December 31, 2003;
Percent: 30%.
Date: March 31, 2004;
Percent: 29%.
Date: May 31, 2004;
Percent: 30%.
Date: August 31, 2004;
Percent: 29%.
Date: September 30, 2004;
Percent: 29%.
Date: October 31, 2004;
Percent: 29%.
Date: December 31, 2004;
Percent: 31%.
Date: March 31, 2005;
Percent: 30%.
Date: June 30, 2005;
Percent: 31%.
Date: September 30, 2005;
Percent: 28%.
Date: February 28, 2006;
Percent: 27%.
Date: March 31, 2006;
Percent: 29%.
Date: June 30, 2006;
Percent: 29%.
Date: August 31, 2006;
Percent: 28%.
Date: October 31, 2006;
Percent: 29%.
Date: November 30, 2006;
Percent: 30%.
Date: January 31, 2007;
Percent: 31%.
Date: March 31, 2007;
Percent: 30%.
Date: April 30, 2007;
Percent: 31%.
Date: June 30, 2007;
Percent: 32%.
Date: August 31, 2007;
Percent: 31%.
Date: December 31, 2007;
Percent: 29%.
Date: March 31, 2008;
Percent: 2&%.
Source: GAO’s analysis of PBGC data.
Note: The data for this figure come from the advisory committee meeting
minutes (2004-2007) and other documents that PBGC provided to us. The
data depict PBGC's financial condition at certain points in time and
are not comprehensive.
[End of figure]
In February 2006, the PBGC director reported to the board that the 2004
policy (which PBGC began implementing in 2005) continued to serve PBGC
well and while PBGC had not met the target range, he expected to do so
shortly.[Footnote 15] The director resigned in May 2006 shortly after
the board approved the 2006 policy, and PBGC made little progress
between May 2006 and March 2008 in reducing its equities below 25
percent. In May 2007, PBGC reported that its equity returns (11.6
percent) had significantly outperformed its bond returns (3.6 percent)
in the previous 3 years, making it difficult to reach the target in a
financially responsible way. PBGC officials told us that although they
had not met the target, they had operated within the policy's
management flexibility to improve PBGC's overall financial condition by
having more equity on the market during a period of high equity
returns. In a 2007 overview of the investment program, PBGC noted that
PBGC staff, the board, and advisory committee understood the dynamic
nature of PBGC's financial environment and that the investment policy
gave PBGC the flexibility to respond quickly and prudently to changes
in market conditions. Our review of the 2004 and 2006 policies found
that the board gave PBGC some flexibility in managing investments, but
expected PBGC to stay within specific parameters set by the board to
ensure successful execution of the investment program in a manner
consistent with the stated policy objectives.
PBGC staff provided the board with information on PBGC's investment
performance and asset allocation at board meetings and in quarterly and
annual reports, but there is no indication whether the board formally
approved PBGC's deviation from the policy or maintained its expectation
that PBGC would meet the target. According to minutes from the board
meetings during this time, board members asked informational questions
periodically, such as inquiring about the basis for PBGC's fixed
income/equity ratio, but did not otherwise discuss PBGC's difficulties
implementing the investment policy. In 2006, PBGC's director notified
the board that PBGC had not met the board-approved target, but
recommended that the board keep the current policy mostly intact. The
board ratified a policy that contained the same target range and same
timetable for PBGC staff to reach it. However, the board did not
require PBGC to establish interim implementation goals against which to
measure PBGC's progress, identify the challenges in meeting the
investment goals, and facilitate discussion about the steps necessary
to ensure that the larger policy objectives were achieved. PBGC
officials told us that the mandates for the 2004 and 2006 policies did
not trigger the need for an in-depth, complex transition plan. However,
PBGC's efforts to reach the policy goal were not successful.
While the board is responsible for establishing and overseeing PBGC's
administration of its investment policies, the board members did not
provide clear direction in the efforts to implement them. In 2007, we
reported that PBGC's board of directors had limited time and resources
to provide policy direction and oversight and lacked established
procedures and mechanisms to monitor PBGC operations. We further noted
that the board members have designated officials and staff within their
respective agencies to conduct much of the work on their behalf and
relied mostly on PBGC's management to inform these board
representatives of pending issues. While board representatives served
as liaisons between PBGC and their respective board members and
reported that they kept the board members apprised of developments in
the investment policy review, it is unclear from our interviews and the
documents that we reviewed what role the board members expected them to
play in monitoring investment policy implementation. The current and
former board representatives that we spoke to provided a variety of
perspectives on the extent to which the board bore responsibility for
investment policy implementation. The board's representatives told us
that they reviewed PBGC's investment performance reports and
participated in regular conference calls. One former board
representative told us that the board representatives served as the de
facto governance of PBGC and another indicated that while it was the
board's responsibility to ensure the implementation of the investment
policy, the board lacked mechanisms to oversee the implementation
process. Current board representatives told us that while they were
aware that PBGC had not met the policy objective, they did not believe
that the board had a role in implementing policy. For example, one
representative stated that it was not the board's role to question
PBGC's management of assets, but rather to ensure that PBGC hired the
right investment firms. Another representative stated that the board
and PBGC did not attempt to tighten the range of investments allowed
under the current policy because they expected that the investment
policy would soon change.
PBGC's New Investment Policy Aims to Achieve Greater Returns, but PBGC
Has Likely Understated the Risks:
PBGC's investment policy objective has shifted from protecting its
deficit from volatility to focusing on optimizing returns;
specifically, the policy aims to eliminate PBGC's current deficit over
the long term by increasing the expected rate of return on assets. The
new policy reduces the proportion of PBGC assets allocated to fixed-
income investments, such as Treasury and corporate bonds; increases its
proportional holdings in international equities; and introduces new
asset classes, such as private equity, emerging market debt and
equities, high-yield fixed income, and private real estate (see fig.
5).[Footnote 16] PBGC officials assert that the new allocation of
assets is diversified enough not only to provide higher expected
returns, but also to lower expected risks when compared to the previous
allocation.[Footnote 17] The consultant hired by PBGC to conduct an
asset allocation review concluded that the previous asset allocation
policy that limited equity investments to a maximum of 25 percent had
lower expected returns and held higher risks. Based on the consultant's
assumptions, the measure of risk for PBGC's newly adopted asset
allocation is about 1 percentage point lower than the risk measure for
the previous allocation.
Figure 5: Comparison of PBGC's Previous and New Asset Allocation
Policies:
[See PDF for image]
This figure is an illustration of a comparison of PBGC's previous and
new asset allocation policies, as follows:
Previous target allocation (percentage):
U.S. equity: 25%;
Long corporate bonds: 30%;
Long treasury bonds: 45%.
New target allocation (percentage):
High yield fixed income: 2%;
Emerging market debt: 3%;
Treasury inflation-protected securities (TIPS): 4%;
Private equity: 5%;
Private real estate: 5%;
Emerging market equity: 6%;
International equity: 19%;
U.S. equity: 20%;
Long corporate bonds: 14%;
Long treasury bonds: 22%.
Source: GAO.
Note: The previous asset allocation target represents PBGC's target of
a maximum of 25 percent of total investments in equities and does not
reflect the actual portfolio that PBGC held. The new asset allocation
is based on PBGC's 2008 Investment Policy.
[End of figure]
Our assessment of PBGC's analysis shows that while the returns may
improve, the risks associated with the new allocation could be higher
than presented. The original analysis was based on a forecasting model,
which is driven by estimates that rely on judgment and a degree of
subjectivity. The consultant conducted a series of simulations to
identify the risks and returns of various asset allocation options and
develop its recommendations to PBGC, but did not test the sensitivity
of its analysis to reasonable changes in the assumptions.[Footnote 18]
The Office of Management and Budget states in guidance to federal
agencies that, because of the uncertainty inherent in modeling, its
effects should be analyzed and reported, and that sensitivity analysis
should be included in such a report.[Footnote 19] Using data from
PBGC's consultant, we conducted several analyses designed to highlight
the sensitivity of the results to the underlying assumptions and found
that the expected returns could be higher than the previous allocation,
but the risks (as measured by standard deviation) may also be higher
(see fig. 6). In our analysis, we varied the consultant's assumptions
using Ibbotson data and JPMorgan's capital market estimates to compare
the risks and returns associated with previous and new target
allocations.[Footnote 20] We did not conduct sensitivity tests
incorporating PBGC's liabilities or funded position because we
encountered difficulty obtaining reliable data to conduct a more
complete analysis.[Footnote 21] For an explanation of our analysis, see
appendix II.
Figure 6: Degree to Which the New Allocation Holds More or Less Risk
than the Previous Allocation under Different Asset Assumptions:
[See PDF for image]
This figure is an illustration of the degree to which the new
allocation holds more or less risk than the previous allocation under
different asset assumptions, as follows:
Percentage point difference between new allocation target and old
allocation target.
New allocation: PBGC estimates;
Less risk: -1.01%;
More risk: 0.
New allocation: GAO Analysis 1;
Less risk: 0;
More risk: 0.18%.
New allocation: GAO Analysis 2;
Less risk: -0.16%;
More risk: 0.
New allocation: GAO Analysis 3;
Less risk: 0;
More risk: 0.61%.
New allocation: GAO Analysis 4;
Less risk: 0;
More risk: 0.82%.
New allocation: GAO Analysis 5;
Less risk: 0;
More risk: 1.61%.
New allocation: GAO Analysis 6;
Less risk: 0;
More risk: 2.57%.
Source: GAO.
Notes: Magnitude is represented as the percentage point difference
between the standard deviations of the old target allocation and the
new target allocations. A negative difference indicates that the
previous target allocation holds more risk than the new allocation.
The New Target Allocation is based on PBGC's investment policy
statement, 2008.
The Previous Target Allocation is based on the allocation used by the
consultant in its analysis and does not represent the assets PBGC was
holding at the time.
[End of figure]
Our analysis focused mostly on how different assumptions about the
volatility of fixed income and equities affected the overall risk of
the new allocation and highlights how sensitive the new allocation is
to small changes in assumptions--demonstrating the uncertainty of the
measures of risk associated with the allocation.[Footnote 22] Our
analysis shows that the consultant's measures of risk associated with
fixed income are particularly sensitive to changes. For example, the
consultant set the assumption of market risk (as measured by the
standard deviation) for long Treasury bonds at 11.2 percent. In
contrast, other sources use a lower risk assumption, such as 7.62
percent in JP Morgan's Capital Market assumptions or roughly 9.3
percent based on Ibbotson historical data.[Footnote 23] When the risk
on high-quality corporate bonds and long Treasury bonds is lowered by
just 2 percent, the new allocation becomes riskier than the previous
allocation. Since the majority of PBGC's previous allocation was in
fixed income investments, the differences in fixed income risk
assumptions significantly affects the outcomes in comparison with the
new allocation. In addition, when we substituted JP Morgan's full set
of capital market assumptions for the consultant's assumptions,
including asset correlations, we found that the new allocation took on
significantly more risk (as shown in GAO analysis 6 in fig. 6).
Since the PBGC has a long-term investment horizon it may be able to
prudently incur greater short term risks to secure higher long term
returns. For example, in analyses 1 through 5 in figure 6, the expected
returns for the new allocation are 1.9 percent higher than the previous
allocation while in analysis 6, it was approximately 1 percent higher-
-although significantly more volatile.[Footnote 24] However,
quantitative measures of risk do not capture the full set of risks
inherent in the new investment strategy. As PBGC's need for cash on a
short-term basis increases to pay the growing number of beneficiaries
over the next decade, liquidity risk becomes an important consideration
in its asset allocation strategy. PBGC had cash obligations of over
$4.5 billion in 2007.[Footnote 25] These obligations included $4.2
billion in benefit payments, $2 million in settlements, and $377
million in administrative expenses. The consultant's analysis indicated
that liquidity risks were considered and that the new asset allocation
policy should allow those risks to be managed, but recommended ongoing
monitoring of liquidity needs.[Footnote 26] Under the new allocation,
PBGC plans to hold 21 percent of its assets in private equity, real
estate, emerging market debt and equity, and high-yield fixed income,
totaling over $11 billion of PBGC's total investments.[Footnote 27]
These assets are generally considered illiquid or volatile and are held
for a long period of time before gaining expected returns. For more
illiquid assets like private equity, recent studies estimate that it
generally takes at least 7 years to return the committed capital.
[Footnote 28]
Further, while strategies that emphasize fixed income run the risk of
preventing PBGC from growing itself out of its deficit, strategies that
de-emphasize fixed income may increase the risk that the PBGC's deficit
will increase in an economic downturn. A downturn could affect the
plans insured by PBGC since large private pension plans hold assets
similar to those in PBGC's new allocation. As a result, PBGC could take
trusteeship of newly terminated plans at the same time that its assets
have declined. A recent letter issued by the Congressional Budget
Office (CBO) on PBGC's new investment strategy further highlights the
additional risks.[Footnote 29] The CBO finds that PBGC's move into new
asset classes may raise the expected rate of return, but it also
entails a greater downside risk--increasing the probability that the
value of PBGC's assets will be below the amount necessary to meet
benefit obligations as they come due.
Conclusions:
PBGC's governance structure is a critical element in ensuring that PBGC
can meet its obligations to U.S. workers and retirees who rely on it
for their retirement income. Last year we reported that the current
board had limited time and resources to provide policy direction and
oversight and suggested that Congress consider expanding the board,
appointing additional board members with knowledge and expertise
beneficial to PBGC.
In a short period of time, the investment policy has changed from one
focused on optimizing returns to limiting PBGC's exposure to interest
rate risk to returns again. While the board formally approved each
policy, it has not taken an active and engaged role in ensuring that
its own policy objectives are met. As a result, the board's lack of
policy direction and oversight may be hindering PBGC's long-term
viability.
Although PBGC's new investment policy was developed in response to its
current deficit, relying solely on investment income to remedy PBGC's
inherently poor financial outlook is likely to introduce additional
risk to PBGC's portfolio. The degree of the risk associated with the
new policy is unclear and may carry more risks than the previous
policy. If the investment strategy is focused on improving the PBGC's
financial condition, a worsening condition could lead to increasingly
risky strategies that may threaten the pension benefits of retirees.
PBGC needs to have a better understanding of the risks associated with
its new policy as it prepares to move a considerable portion of its
assets into investments that it has never held before. A complete
disclosure and understanding of the risks PBGC faces will help the
board and PBGC better plan for implementing the new policy.
Implementing PBGC's new investment policy will require that the board
have accountability measures, such as objectives, milestones, and
completion time frames, to conduct careful, ongoing oversight and to
ensure that PBGC achieves its policy goals and protects the pension
benefits of retirees.
Recommendations for Executive Action:
To ensure accountability for the full implementation of the board's new
investment policy decisions and its appropriate oversight of an
investment policy that carries more risk, we are recommending that the
PBGC board:
* Require the PBGC director to formally submit for board approval a
written implementation plan that outlines accountability measures for
carrying out the new investment policy, such as PBGC's key objectives,
milestones, and completion time frames;
* Require the PBGC director to report periodically on the progress
toward meeting the objectives, milestones, and time frames in the plan
and to provide justification for any deviations in the approved
implementation plan; and:
* Document the board's agreement or disagreement with any deviations
from the policy implementation plan.
To gain a better understanding of the risks involved in the new
investment policy, PBGC should conduct sensitivity analyses before
implementing the new policy. These analyses should use a variety of
assumptions of the risks and returns of the new allocation that
incorporates assets, liabilities, and funded position.
Agency Comments and Our Evaluation:
We obtained written comments on a draft report from the Secretary of
Labor, on behalf of the PBGC board of directors, and from the director
of PBGC. Their comments are reproduced in appendixes III and IV,
respectively. In addition, PBGC provided technical comments, which we
incorporated in the report where appropriate.
In a response to our draft report, the chair of PBGC's board of
directors emphasized the board's commitment to providing strong
oversight of the PBGC investment policy to ensure that the policies are
implemented appropriately. The comments stated that, during
implementation of the previous investment policy, board members
received reports on PBGC's efforts and determined that PBGC had taken
prudent measures to comply with the investment policy. The chair of the
PBGC board did not specifically address our recommendations, but stated
that the current combination of presentations by PBGC, verbal
agreements, and informal guidance provided from the board and its
representatives offered an appropriate level of oversight. In addition,
the chair reported that PBGC had submitted a preliminary implementation
plan for the new policy and that PBGC had planned to provide a more
complete implementation briefing in early July.
We do not believe that a system of verbal agreement and informal
guidance is strong enough oversight for investing $68 billion. The
successful implementation of this policy, which invests in a broader
range of assets, will require close monitoring and consistent
oversight. Documentation of PBGC's progress toward meeting policy
objectives, milestones, and implementation timelines and the board's
agreement or disagreement with any deviations from the policy
implementation plan remains critical for ensuring the accountability of
the funds needed to support millions of retirees. Further, PBGC's
governance structure--which comprises presidentially appointed board
members, board representatives, and the PBGC director--has experienced
frequent turnover in the past, making the need for documentation of key
decisions related to PBGC's investments essential.
In responding to the draft report, the PBGC director stated that the
process that supported the adoption of the new policy was complete and
robust. He said that the process included a thorough assessment of
PBGC's long-term obligations to plan participants and beneficiaries,
exhaustive discussion among numerous constituents, and in-depth
analysis by leading industry experts, including PBGC's investment
consultant. In response to our recommendation, the director agreed that
sensitivity analyses are important and that PBGC will continue to
perform them going forward. PBGC also provided some additional analysis
using alternative assumptions from Goldman Sachs. PBGC noted that our
sensitivity analysis used fixed income assumptions that understated the
risk associated with PBGC's fixed income assets and that assumptions
based on the 15-year duration bond are more accurate. Finally, PBGC
points to the higher Sharpe ratio of the new portfolio as evidence that
the new policy is superior to the old policy in all the alternatives it
considered.[Footnote 30]
We are pleased that PBGC has taken initial steps to conduct a
sensitivity analysis. Since the assumptions used in this analysis are
not disclosed, it is difficult to determine whether PBGC reasonably
captured differing views. Our report emphasized that the quality of
PBGC's forecasts, which used stochastic modeling, depends on the
technique used to model uncertain returns and on the assumed values of
key parameters, including the distribution of returns, means, standard
deviations, and correlations between assets. Therefore, reasonable
variation of these assumptions is needed to better inform the degree of
uncertainty in the results.
We urge PBGC to consider whether the analysis conducted by Goldman
Sachs provides sufficient variation in the alternative assumptions to
those employed by its outside consultant. In addition, the analysis
should incorporate PBGC's assets, liabilities, and funded position as
our recommendation indicates.
With respect to our assumptions on fixed income, we used data that more
closely aligned with PBGC's actual fixed income investments than that
presented by PBGC's consultant.[Footnote 31] While we do not believe
the assumptions we utilized in this report are necessarily superior to
those used by others, we believe that they are reasonable for
sensitivity analysis in that they approximate historical averages and,
in one test, are based on estimates produced by a reputable financial
advisor that differed significantly from PBGC's outside consultant.
PBGC's reliance on the Sharpe ratio is subject to limitations similar
to those of the standard deviation in evaluating alternative
portfolios. Moreover, the Sharpe ratios are based on assumptions about
future asset returns and the volatility of those returns--unknown items
given the uncertainty of future events. We agree with PBGC that the
uncertainties inherent in the Sharpe ratio and the standard deviation
should be identified to highlight that an analysis of quantitative
uncertainty does not fully account for real world uncertainty. Lastly,
a superior Sharpe ratio implies that the new investment policy is
expected to provide better risk-adjusted performance. However, as we
demonstrated in our analyses using our different assumptions, better
risk-adjusted performance should not be interpreted to imply that the
new strategy is less risky than the previous policy.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after today's issuance. At that time, we will send copies of this
report to the Secretaries of Commerce, Labor, and Treasury as well as
the Director of PBGC and other interested parties. We will also make
copies available to others on request. If you or your staff have any
questions concerning this report, please contact Barbara Bovbjerg on
(202) 512-7215 or Tom McCool on (202) 512-2642. Contact points for our
Office of Congressional Relations and Office of Public Affairs can be
found on the last page of this report. Key contributors are listed in
appendix V.
Signed by:
Barbara D. Bovbjerg, Director:
Education, Workforce, and Income Security Issues:
Signed by:
Thomas J. McCool, Director:
Center for Economics, Applied Research and Methods:
[End of section]
Appendix I: Scope and Methodology:
To understand the Pension Benefit Guaranty Corporation's (PBGC)
procedures for developing and implementing its investment policies, we
examined PBGC's past investment policy statements and supporting
documentation, paying particular attention to the revisions made in
2004, 2006, and 2008. To determine the roles and responsibilities of
each of the participants in these processes, we interviewed current and
former board representatives, board agency officials, PBGC executive
directors, senior PBGC management officials, and advisory committee
chairmen. In addition, we reviewed the meeting minutes of both the
board of directors (2003 to present) and the advisory committee (2000
to present). For the 2008 policy, we reviewed the asset allocation
studies produced by consultants and analyzed the consultant's, the
advisory committee's, and the executive director's recommendations. To
gain perspective on the investment policy formulation process, we
attended an advisory committee meeting where the investment policy
options were discussed. To learn more about how PBGC manages and
monitors its investment program, we interviewed PBGC's long-time
consultant and current investment managers, discussing their respective
roles in implementing the investment strategy and managing PBGC's
assets. We reviewed relevant literature, statutes, and available data
and interviewed experts knowledgeable of PBGC and investment
approaches. We did not meet with the board members nor did we attend
any board meetings because PBGC policy does not open its meetings to
outside parties.
To assess PBGC's new investment strategy, we reviewed the analysis
provided to PBGC by its consultant, conducted sensitivity analyses on
the market risks--as measured by standard deviations--and returns of
PBGC's previous and new asset allocation policy, discussed the outcomes
with PBGC staff and the contractor, and reviewed relevant literature.
The PBGC's new asset allocation policy is partially informed by a
forecasting model that produces projections that are uncertain due to
imprecision in the underlying data and modeling assumptions. As a
result, we varied some of the major assumptions and recomputed some of
the estimates to determine how sensitive outcomes are to changes in the
assumptions. We also assessed other limitations of the analysis due to
reliability issues surrounding the data and assumptions on the various
assets classes. Our work is consistent with Office of Management and
Budget (OMB) guidance on the treatment of uncertainty in forecasting.
[Footnote 32] Appendix II provides further details related to our
analysis.
[End of section]
Appendix II: Description of GAO's Sensitivity Analysis:
The analysis that guided PBGC's decision to change its investment
policy was based on a forecasting model developed by PBGC's consultant-
-Rocaton Investment Advisors, LLC--and was driven by key assumptions
based on quantitative and qualitative assessments of various asset
markets. The consultant employed a stochastic forecasting technique,
known as a Monte Carlo simulation, to identify the risks and returns of
various asset allocation options and develop its recommendations to
PBGC. Monte Carlo simulation is a problem-solving technique used to
approximate the probability of outcomes by performing multiple trial
runs (simulations) and is widely used by researchers analyzing
financial markets.[Footnote 33] While the Monte Carlo technique has a
number of benefits, such as capturing the volatility of market returns,
critics believe the technique is limited in its ability to replicate
the actual behavior of capital markets since it is dependent on
assumptions of future asset returns, standard deviations, and
correlations. (Tables 4 and 5 show the assumptions for asset return and
risk and correlations used by the consultant.) Experts advise using
other tools, such as sensitivity analysis, to compare results from this
type of simulation and properly characterize the sources and nature of
uncertainty in the results.[Footnote 34] Because the consultant did not
test the sensitivity of its analysis to reasonable changes in the
assumptions, we tested the returns and risks of the consultant's
results under alternative assumptions.[Footnote 35]
Table 4: PBGC Consultant Assumptions, Returns and Risk:
Asset class: Treasury inflation-protected securities;
Compounded annual returns: 4.2%;
Standard deviation (risk): 5.2%.
Asset class: Long Treasury bonds (15 year);
Compounded annual returns: 4.3%;
Standard deviation (risk): 11.2%.
Asset class: Long high-quality bonds (10 year);
Compounded annual returns: 5.3%;
Standard deviation (risk): 8.4%.
Asset class: Long high-quality bonds (15 year);
Compounded annual returns: 4.9%;
Standard deviation (risk): 12.4%.
Asset class: Core fixed income;
Compounded annual returns: 5.2%;
Standard deviation (risk): 4.5%.
Asset class: High-yield bonds;
Compounded annual returns: 6.8%;
Standard deviation (risk): 8.5%.
Asset class: Emerging market debt;
Compounded annual returns: 7.4%;
Standard deviation (risk): 10.0%.
Asset class: Emerging market debt (local currency);
Compounded annual returns: 7.3%;
Standard deviation (risk): 11.0%.
Asset class: U.S. equities;
Compounded annual returns: 7.9%;
Standard deviation (risk): 15.0%.
Asset class: Non-U.S. equities;
Compounded annual returns: 7.7%;
Standard deviation (risk): 17.0%.
Asset class: Emerging equities;
Compounded annual returns: 10.0%;
Standard deviation (risk): 25.0%.
Asset class: Private equity (buyout);
Compounded annual returns: 9.9%;
Standard deviation (risk): 25.0%.
Asset class: Private equity (venture);
Compounded annual returns: 11.5%;
Standard deviation (risk): 35.0%.
Asset class: Private real estate;
Compounded annual returns: 7.3%;
Standard deviation (risk): 10.0%.
Asset class: Commodities;
Compounded annual returns: 4.3%;
Standard deviation (risk): 21.0%.
Asset class: Absolute return;
Compounded annual returns: 6.7%;
Standard deviation (risk): 5.0%.
Source: Rocaton Investment Advisors, LLC.
[End of table]
Table 5: PBGC Consultant Assumptions, Correlations:
Asset: 1. Long high-quality bonds;
1: 1.0;
2: [Empty];
3: [Empty];
4: [Empty];
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 2. Long Treasury bonds;
1: 0.9;
2: 1.0;
3: [Empty];
4: [Empty];
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 3. Treasury inflation-protected securities;
1: 0.2;
2: 0.2;
3: 1.0;
4: [Empty];
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 4. Core fixed income;
1: 0.6;
2: 0.7;
3: 0.3;
4: 1.0;
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 5. High-yield bonds;
1: 0.2;
2: 0.4;
3: 0.0;
4: 0.4;
5: 1.0;
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 6. U.S. equities;
1: 0.0;
2: 0.2;
3: -0.1;
4: 0.2;
5: 0.5;
6: 1.0;
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 7. Non-U.S. equities;
1: 0.0;
2: 0.1;
3: -0.1;
4: 0.2;
5: 0.3;
6: 0.6;
7: 1.0;
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 8. Emerging equities;
1: -0.2;
2: -0.1;
3: -0.1;
4: -0.2;
5: 0.2;
6: 0.3;
7: 0.6;
8: 1.0;
9: [Empty];
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 9. Private real estate;
1: 0.2;
2: 0.2;
3: 0.0;
4: 0.1;
5: -0.1;
6: 0.4;
7: 0.3;
8: 0.1;
9: 1.0;
10: [Empty];
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 10. Private equity (buyout);
1: -0.1;
2: -0.2;
3: -0.3;
4: -0.2;
5: 0.0;
6: 0.5;
7: 0.3;
8: 0.1;
9: 0.4;
10: 1.0;
11: [Empty];
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 11. Private Equity (venture);
1: 0.1;
2: 0.0;
3: 0.0;
4: 0.0;
5: -0.1;
6: 0.4;
7: 0.1;
8: 0.0;
9: 0.3;
10: 0.6;
11: 1.0;
12: [Empty];
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 12. Emerging market debt;
1: 0.0;
2: 0.1;
3: 0.2;
4: 0.3;
5: 0.4;
6: 0.2;
7: 0.2;
8: 0.3;
9: -0.1;
10: 0.0;
11: 0.1;
12: 1.0;
13: [Empty];
14: [Empty];
15: [Empty].
Asset: 13. Emerging market debt (local currency);
1: 0.0;
2: 0.1;
3: 0.2;
4: 0.1;
5: 0.3;
6: 0.2;
7: 0.4;
8: 0.4;
9: 0.0;
10: -0.1;
11: 0.0;
12: 0.4;
13: 1.0;
14: [Empty];
15: [Empty].
Asset: 14. Commodities;
1: -0.1;
2: -0.1;
3: 0.2;
4: -0.1;
5: -0.1;
6: 0.0;
7: 0.1;
8: 0.2;
9: 0.0;
10: 0.1;
11: 0.3;
12: 0.3;
13: 0.2;
14: 1.0;
15: [Empty].
Asset: 15. Absolute return;
1: 0.2;
2: 0.0;
3: 0.0;
4: 0.2;
5: 0.3;
6: 0.5;
7: 0.5;
8: 0.3;
9: 0.0;
10: 0.2;
11: 0.0;
12: 0.2;
13: 0.0;
14: 0.0;
15: 1.0.
Source: Rocaton Investment Advisors, LLC.
[End of table]
Measuring Returns under Alternative Assumptions:
To test the consultant's assumptions on expected return, we conducted
eight separate analyses that varied the assumed rate of return on fixed
income and the equity premium (see table 6). Each of these analyses
showed that the estimated rates of return were consistently higher for
the new allocation when compared to the previous allocation. This
analysis should not be considered as definitive evidence that the new
investment will outperform the old allocation and does not consider the
data limitations associated with alternative assets.
To construct the expected return on the portfolio of assets, we
weighted the expected returns of the individual assets as follows:
[See PDF for image of formula]
(1): Expected return of the portfolio equals the sum of the percentage
of the portfolio allocated to asset i times the expected return of
asset class i.
Table 6: Sensitivity Analysis of Portfolio Expected Returns:
Baseline assumptions:
GAO Analysis: Maintains all of the consultant's assumptions on expected
returns, assuming a U.S. equity premium of roughly 3.8%;
Expected return estimates: New allocation target: 7.60%;
Expected return estimates: Previous allocation target: 5.71%.
GAO analysis 1:
GAO Analysis: Lowers the U.S. equity premium to 2.0% and maintains the
consultant's assumptions on other asset returns;
Expected return estimates: New allocation target: 7.24%;
Expected return estimates: Previous allocation target: 5.26%.
GAO analysis 2:
GAO Analysis: Lowers the U.S. equity premium to 2.0%, adjusts the
return on international equities to maintain the consultant's
assumption regarding the relative relationships between all equities,
and maintains the consultant's assumption on fixed income;
Expected return estimates: New allocation target: 6.79%;
Expected return estimates: Previous allocation target: 5.26%.
GAO analysis 3:
GAO Analysis: Maintains the consultant's assumptions on international
equities, lowers the U.S. equity premium to 2.0%, and substitutes
historical returns based on Federal Reserve Bank data for the
consultant's assumptions on fixed income;
Expected return estimates: New allocation target: 8.10%;
Expected return estimates: Previous allocation target: 6.80%.
GAO analysis 4:
GAO Analysis: Combines the alternative assumptions used in analyses 1
through 3: Lowers U.S. equity premium to 2.0%, adjusts international
equity, and uses historical returns based on Federal Reserve data for
fixed income returns;
Expected return estimates: New allocation target: 8.04%;
Expected return estimates: Previous allocation target: 6.80%.
GAO analysis 5:
GAO Analysis: Lowers the U.S. equity premium to 2.5% and maintains the
consultant's assumptions on other asset returns;
Expected return estimates: New allocation target: 7.34%;
Expected return estimates: Previous allocation target: 5.38%.
GAO analysis 6:
GAO Analysis: Lowers the U.S. equity premium to 2.5%, adjusts the
return on international equities to maintain the consultant's
assumption regarding the relative relationships between all equities,
and maintains the consultant's assumption on fixed income;
Expected return estimates: New allocation target: 7.02%;
Expected return estimates: Previous allocation target: 5.38%.
GAO analysis 7:
GAO Analysis: Maintains the consultant's assumptions on international
equities, lowers the U.S. equity premium to 2.5%, and substitutes
historical returns based on Federal Reserve Bank data for the
consultant's assumptions on fixed income;
Expected return estimates: New allocation target: 8.20%;
Expected return estimates: Previous allocation target: 6.92%.
GAO analysis 8:
GAO Analysis: Combines the alternative assumptions used in analyses 4
through 7: Lowers U.S. equity premium to 2.5%, adjusts international
equity, and uses historical returns based on Federal Reserve data for
fixed income returns;
Expected return estimates: New allocation target: 8.26%;
Expected return estimates: Previous allocation target: 6.92%.
Source: GAO analysis.
Notes: The equity premium is expressed here as the expected return of
U.S. equities in excess of the long-term Treasury bonds. We used two
equity premiums in our analysis: a 2.0 percent equity premium based on
Holmer, Martin (2007) "PENSIM Analysis of Impact of Final Regulation on
Defined-Contribution Default Investments;" and a 2.5 percent equity
premium, which is the low end of estimates produced by Fama, Eugene and
Kenneth French (2002), "The Equity Premium," The Journal of Finance.
57(2): 637-659.
International equities include emerging equities and non-U.S. equities.
The consultant's assumptions characterizing the relationship between
the expected returns on these assets and U.S. equity are contained in
table 4.
Fixed Income includes long-term U.S. treasury bonds and high-quality
corporate bonds. The consultant's assumptions we used were 4.9% (long-
term U.S. treasury bonds) and 5.6% (high-quality corporate bonds). Our
assumptions for expected returns on fixed income securities are based
on historical monthly data from the Federal Reserve Bank of St. Louis,
representing 1953 to 2007 were 6.4% (Treasury bonds) and 7.2%
(corporate bonds).
[End of table]
We used arithmetic returns in this analysis. Producing statistics for
compounded returns at the portfolio level produced similar results.
Measuring Risks under Alternative Assumptions:
To assess the sensitivity of the new allocation to greater or lesser
levels of risk, we substituted common estimates of risk, where
possible, as expressed as standard deviations for different asset
classes, as shown in table 7. This analysis is meant to be illustrative
and does not produce definitive estimates of future risk for either
allocation. In our analysis, we retained the consultant's estimates of
risk for those asset classes where other estimates were unavailable. In
addition, we solved for the "critical value" of the standard deviation
for fixed income and equities to identify the point at which the risks
associated with the new allocation overlaps the risks of the previous
allocation. In doing so, we found that when the standard deviation on
high-quality corporate and long Treasury bonds is lowered by roughly 2
percent, the new allocation becomes riskier than the previous
allocation. Similarly, when raising the standard deviation on equity by
about 4.8 percent, the new allocation becomes riskier than the previous
allocation.
To construct the standard deviation of the portfolio, we weighted the
variance covariance matrix, such as in the following formula:
[See PDF for image of formula]
(2): the standard deviation of the portfolio equals sum Ij times sum
Ii, times percentage of portfolio assets allocated to class i, times
percentage of portfolio assets allocated to class j, times the measure
of the co-movements between the returns of asset classes i and j.
Table 7: Sensitivity Analysis of Portfolio Risk:
Baseline assumptions:
GAO analysis: Maintains all of the consultant's assumptions;
Standard deviation estimates (risk): New allocation target: 8.90%;
Standard deviation estimates (risk): Previous allocation target: 9.90%.
GAO analysis 1: 1926 - 2006 Equity:
GAO analysis: Substitute estimates on the standard deviation on U.S.
equity based on Ibbotson data for 1926-2006 (22%) for the consultant's
assumption and adjusts other equities accordingly[A];
Standard deviation estimates (risk): New allocation target: 10.85%;
Standard deviation estimates (risk): Previous allocation target:
10.67%.
GAO analysis 2: 1997 - 2006 equity:
GAO analysis: Substitute estimates on the standard deviation on U.S.
equity based on Ibbotson data for 1997-2006 (20%) for the consultant's
assumption and adjusts other equities accordingly;
Standard deviation estimates (risk): New allocation target: 10.27%;
Standard deviation estimates (risk): Previous allocation target:
10.43%.
GAO analysis 3: 1926 - 2006 fixed income:
GAO analysis: Substitute estimates on the standard deviation on fixed
income assets based on Ibbotson data for 1926-2006 on long high-quality
bonds and long Treasury bonds (8.5% and 9.2%) for the consultant's
assumptions (11.2%) and 12.4%);
Standard deviation estimates (risk): New allocation target: 8.34%;
Standard deviation estimates (risk): Previous allocation target: 7.73%.
GAO analysis 4: 1997 - 2006 fixed income:
GAO analysis: Substitute estimates on the standard deviation on fixed
income assets based on Ibbotson data for 1926-2006 on long high-quality
bonds and long Treasury bonds (6.6% and 9.4%) for the consultant's
assumptions;
Standard deviation estimates (risk): New allocation target: 8.32%;
Standard deviation estimates (risk): Previous allocation target: 7.50%.
GAO analysis 5: 1997 - 2006 fixed income and equities:
GAO analysis: Combines analysis 2 and analysis 4;
Standard deviation estimates (risk): New allocation target: 9.76%;
Standard deviation estimates (risk): Previous allocation target: 8.15%.
GAO analysis 6: JP Morgan assumptions:
GAO analysis: Substitute JP Morgan capital market assumptions on the
standard deviation, returns and correlations for the consultant's
assumptions except for certain alternative assets not covered by JP
Morgan[B];
Standard deviation estimates (risk): New allocation target: 8.75%;
Standard deviation estimates (risk): Previous allocation target: 6.21%.
Source: GAO analysis.
[A] Ibbotson data serve as a reference for U.S. capital market returns
and are recognized as the industry standard for illustrating historical
performance of different asset classes.
[B] JPMorgan, as a large asset and wealth manager, provide an
alternative set of assumptions on the range of asset classes included
in the PBGC's new allocation. According to JPMorgan Asset Management,
the institution has assets under supervision of $1.6 trillion and
assets under management of $1.2 trillion and more than 650 investment
professionals providing over 200 different strategies spanning the full
spectrum of asset classes, including equity, fixed income, cash
liquidity, currency, real estate, hedge funds, and private equity.
[End of table]
The substitutions conducted under Analysis 6--utilizing JP Morgan's
market assumptions--allowed us to test a larger set of the consultant's
asset class assumptions, including the correlations between classes,
which resulted in a greater difference in the standard deviations
between the previous and new allocations. (JP Morgan's long-term
capital market assumptions are displayed in tables 8 and 9.) Because JP
Morgan's asset classes do not align directly with the consultant's
analysis, we retained the consultant's assumptions for some alternative
assets, such as commodities and absolute return assets.[Footnote 36]
For consistency, we also retained the consultant's assumptions on
emerging market debt in U.S. currency. To ensure that the relationships
were sensible, we tested the correlation matrix and found that it was
inconsistent[Footnote 37]--some correlations (between a pair of asset
returns) were invalid. We adjusted the matrix using standard techniques
to obtain the nearest correlation matrix.[Footnote 38] The results for
the standard deviation were only slightly different--less than 0.04
percentage point for the previous and new allocations.
Table 8: JPMorgan Asset Management Long-term Capital Market
Assumptions, Returns and Risk for Select Assets:
Asset class: Treasury inflation-protected securities;
Compounded annual returns: 4.50%;
Standard deviation (risk): 5.09%.
Asset class: U.S. 10-year Treasury bonds;
Compounded annual returns: 4.50%;
Standard deviation (risk): 4.46%.
Asset class: Long duration government/corporate bonds;
Compounded annual returns: 5.50%;
Standard deviation (risk): 7.62%.
Asset class: U.S. aggregate (core fixed income);
Compounded annual returns: 5.25%;
Standard deviation (risk): 3.46%.
Asset class: High-yield bonds;
Compounded annual returns: 7.50%;
Standard deviation (risk): 7.28%.
Asset class: Emerging market debt;
Compounded annual returns: 7.00%;
Standard deviation (risk): 13.63%.
Asset class: U.S. equities;
Compounded annual returns: 8.00%;
Standard deviation (risk): 14.80%.
Asset class: Non-U.S. equities;
Compounded annual returns: 9.25%;
Standard deviation (risk): 17.78%.
Asset class: Emerging equities;
Compounded annual returns: 9.50%;
Standard deviation (risk): 24.08%.
Asset class: Private real estate;
Compounded annual returns: 7.00%;
Standard deviation (risk): 14.25%.
Asset class: Private equity;
Compounded annual returns: 9.00%;
Standard deviation (risk): 22.95%.
Source: JP Morgan Asset Management.
Note: JP Morgan's assumptions were augmented with some data from the
consultant to ensure that our analysis could include some alternative
asset classes. For non-U.S. equities, we use European Large Cap stock
minus the United Kingdom.
[End of table]
Table 9: JPMorgan Asset Management Long-term Capital Market
Assumptions, Select Correlations:
1; Asset: Treasury inflation-protected securities;
1: 1.00;
2: [Empty];
3: [Empty];
4: [Empty];
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty].
2; Asset: U.S. aggregate (core fixed income);
1: 0.80;
2: 1.00;
3: [Empty];
4: [Empty];
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty].
3; Asset: Long Treasury bonds;
1: 0.81;
2: 0.95;
3: 1.00;
4: [Empty];
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty].
4; Asset: Long high-quality bonds;
1: 0.81;
2: 0.95;
3: 1.00;
4: 1.00;
5: [Empty];
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty].
5; Asset: High-yield bonds;
1: 0.03;
2: 0.10;
3: 0.19;
4: 0.19;
5: 1.00;
6: [Empty];
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty].
6; Asset: Emerging market debt;
1: 0.18;
2: 0.15;
3: 0.17;
4: 0.17;
5: 0.48;
6: 1.00;
7: [Empty];
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty].
7; Asset: U.S. equities;
1: -0.21;
2: -0.21;
3: -0.17;
4: -0.17;
5: 0.49;
6: 0.54;
7: 1.00;
8: [Empty];
9: [Empty];
10: [Empty];
11: [Empty].
8; Asset: Non-U.S. equities;
1: -0.25;
2: -0.23;
3: -0.18;
4: -0.18;
5: 0.47;
6: 0.46;
7: 0.79;
8: 1.00;
9: [Empty];
10: [Empty];
11: [Empty].
9; Asset: Emerging equities;
1: -0.11;
2: -0.23;
3: -0.18;
4: -0.18;
5: 0.51;
6: 0.67;
7: 0.71;
8: 0.68;
9: 1.00;
10: [Empty];
11: [Empty].
10; Asset: Private real estate;
1: 0.13;
2: 0.05;
3: 0.08;
4: 0.08;
5: 0.34;
6: 0.37;
7: 0.31;
8: 0.27;
9: 0.33;
10: 1.00;
11: [Empty].
11; Asset: Private equity;
1: -0.14;
2: -0.14;
3: -0.09;
4: -0.09;
5: 0.56;
6: 0.49;
7: 0.61;
8: 0.63;
9: 0.70;
10: 0.33;
11: 1.00.
Source: JP Morgan Asset Management.
Note: JP Morgan assumptions were augmented with some data from the
consultant to ensure that our analysis could include some alternative
asset classes. For non-U.S. equities we use European Large Cap stock
minus the United Kingdom.
[End of table]
Limitations:
As with any analysis of estimated future financial returns and risks,
we faced certain limitations in conducting our work that may also have
implications on the analysis conducted by PBGC's consultant.
Results are inherently imprecise estimates:
Projections of future outcomes based on key assumptions produce
inherently imprecise estimates of funding ratios, asset returns, or
market volatility.
Standard deviation is an imperfect proxy for risk:
Standard deviation, which analysts traditionally use as a proxy for
market risk, measures volatility but cannot predict the full spectrum
of risks facing a portfolio over time. Therefore, a calculation of
standard deviation on various investment portfolios will not
necessarily provide complete information of the risks associated with
that portfolio or the appropriateness of an investment strategy for a
particular individual or institution. For example, even if the standard
deviation showed that PBGC's new portfolio was more volatile on a year-
to-year basis than the portfolio under PBGC's previous policy, this
does not necessarily mean that the new strategy is inappropriate or
necessarily inferior when considering the potential for higher returns
over a longer period of time. Another drawback of the standard
deviation measure is its inability to differentiate between volatility
when returns are positive, as opposed to when returns are negative.
[Footnote 39]
Inability to incorporate data on PBGC's liabilities:
When conducting our sensitivity analysis, we were only able to focus on
PBGC's assets because of difficulties obtaining consistent data to
combine the asset analysis with data on PBGC liabilities.[Footnote 40]
We acknowledge that a sensitivity analysis that incorporates PBGC's
liabilities and funded position would provide a more complete picture
of the risks that PBGC may face under the new investment policy.
However, similar to our partial analysis, the PBGC's expected funded
position will vary with changes in the major assumptions on asset
returns, standard deviations, and correlations.
Data on certain alternative assets have known limitations:
Data on private equity and emerging market data have several known
limitations.
* Private equity:
Managers of private equity funds are largely exempt from public
disclosure requirements. As a result, available data on private equity
returns are largely reported voluntarily by principal market
participants and statistics generated from these data cannot be used to
generalize about the entire private equity asset class.[Footnote 41]
Moreover, due to selective and infrequent reporting of private equity
returns and potentially subjective valuations, the returns that are
reported are likely overstated and standard deviations understated.
[Footnote 42] Research has shown that private equity funds vary widely
in their valuation practices and that different private equity firms
have different values for the same portfolio company during the same
timeframe. The lack of widely accepted benchmarks for the private
equity class limits the understanding of the risk, return and
correlation characteristics of private equity and therefore, the role
of private equity in a diversified portfolio. Therefore, the portfolio
diversification benefits of private equity presented in the
consultant's analysis may be less than the consultant assumed.[Footnote
43]
* Emerging market assets:
Recent market trends have challenged the notion that the U.S. markets
are de-coupled from other financial markets in the world. Although
there are limited historical data for emerging market assets, the data
that are available suggest that correlations among emerging financial
markets are unstable and emerging markets may, at times, be
significantly correlated with U.S. markets. If further integration of
global financial markets continues, the significance of these
correlations could increase over time. It is possible that the actual
correlation between emerging market assets and U.S. assets is higher
than those suggested in the consultant's model. For example, in
assuming a correlation between emerging market equity and U.S. equity
markets, JP Morgan Asset Management assumed a correlation of 0.71, more
than double the consultant's assumption of 0.3. Given this diversity of
assumptions, it is important to test the sensitivity of the initial
results to alternative, plausible possibilities. In addition, recent
research has shown that, in general, the correlation among multiple
asset classes appears to be inherently unstable.[Footnote 44] Since
correlations among assets are fundamental to portfolio construction and
portfolio diversification, this limitation should also be carefully
considered when interpreting the consultant's results.
[End of section]
Appendix III: Comments from the Pension Benefit Guaranty Corporation
Board of Directors:
Secretary Of Labor:
Washington, D.C. 20210:
July 8, 2008:
Mr. Gene Dodaro:
Acting Comptroller General:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Dodaro:
I am responding on behalf of the Pension Benefit Guaranty Corporation
(PBGC) Board to your request for comments on the Government
Accountability Office's (GAO) draft report entitled "PBGC ASSETS:
Implementation of New Investment Policy Will Need Stronger Board
Oversight" (GAO-08-667). This letter provides our general comments
concerning the draft report and our responses to the
recommendations.
In 2007, GAO reported on the Board's oversight of the PBGC and
documented the Board's efforts in this important area. I am pleased
that GAO's latest report has again recognized the commitment of the
Board to provide strong oversight over the PBGC. As the draft report
states, my fellow Board members and I instituted a policy for regular
review of the Investment Policy Statement with the first biennial
review in 2004, again in 2006, and most recently this year. We are
fully committed to strong oversight of the PBGC investment policy to
ensure that the policy is implemented appropriately.
The Board maintained oversight of the implementation of the 2004 and
2006 investment policy revisions and approved the path the PBGC was
taking to reach its investment targets. For a variety of reasons, the
PBGC did not achieve the 15% - 25% equity investment target range set
by the Board in 2004. The PBGC operated in a very dynamic financial
environment during this period. Equity values rose very rapidly, making
it harder to prudently sell sufficient amounts of equity assets quickly
enough to reach the equity investment target range. This difficulty was
compounded by the PBGC's trusteeship of billions of dollars in several
very large terminated pension plans with assets heavily allocated to
equities.
The Board and the Board Representatives asked for and received reports:
regarding the PBGC's efforts, and determined that the PBGC was taking
prudent measures to comply with the investment policy under the
circumstances. The Board considered these efforts as consistent with
the goals of the investment policy and transition guidance in the
policy.
The current policy was adopted by the Board only after an extensive
review process that began in mid-2007. The Director and the PBGC staff
facilitated the Board's review of the Investment Policy Statement by
engaging a consultant to provide a comprehensive review of the
investment policy and to recommend alternatives for the Board's
consideration. The Board was kept well-informed through the review
process by the Board Representatives and the Director, and provided
policy direction regarding the investment policy through its
representatives. The resulting diversified investment policy is
intended to help ensure the PBGC can meet its obligations to workers
and retirees who rely on the PBGC for a secure retirement.
The recently revised PBGC bylaws and current Investment Policy
Statement require the Board to review the PBGC's Investment Policy
Statement at least every two years and to approve the policy at least
every four years. The PBGC Director is responsible to the Board for the
implementation and administration of the investment program, which
includes keeping the Board and its representatives informed of
implementation decisions regarding the Investment Policy Statement. The
PBGC has already presented a preliminary implementation plan and has
scheduled a more complete implementation briefing in early July.
The Board recognizes the importance of its oversight and accountability
role. The Board already requires periodic reports on investment policy
and takes seriously the importance of making sure that the PBGC staff
adheres to implementation plans. The Board believes that the
presentations by the PBGC and verbal agreement and informal guidance by
the Board and the Board Representatives to the PBGC is appropriate
oversight.
The Board is dedicated to overseeing the management of the PBGC's
investment policy and to protecting the pension benefits of the 44
million Americans covered by the PBGC's insurance programs. We
appreciate having had the opportunity to review and comment on the
draft report.
Sincerely,
Signed by:
Elaine L. Chao:
Chair of the Board:
Pension Benefit Guaranty Corporation:
[End of section]
Appendix IV Comments from the Pension Benefit Guaranty Corporation:
PBGC Pension Benefit Guaranty Corporation:
Protecting America's Pensions:
Office of the Director:
1200 K Street, NW:
Washington, D.C. 20005-4026:
July 9, 2008:
Ms. Barbara Bovbjerg, Director:
Education, Workforce, and Income Security Issues:
Mr. Thomas J. McCool, Director:
Center for Economics, Applied Research and Methods:
Government Accountability Office:
441 G Street, NW:
Washington, D.C. 20548:
Dear Ms. Bovbjerg and Mr. McCool:
This responds to your request for management's comments on the
Government Accountability Office (GAO) draft report, "PBGC ASSETS:
Implementation of New Investment Policy Will Need Stronger Board
Oversight" (GAO-08-667). Your work in reviewing this important policy
area is appreciated.
As the draft report recognizes, PBGC's Board of Directors (Board)
instituted a policy of biennially reviewing the Investment Policy
Statement, with the first review in 2004 and the others following on
schedule. GAO's June 2007 report on Board oversight also acknowledged
that the current Board has been more active in its oversight of PBGC
than in the past. The adoption of the new investment policy, as well as
the Board's recent comprehensive revision of the PBGC by-laws, evidence
this Board's ongoing commitment to strengthening PBGC.
Background:
Any analysis of PBGC's investment policy must begin with a clear
understanding of ERISA.
ERISA makes it clear that the United States Government does not stand
behind the liabilities of the PBGC and that Congress does not want to
be confronted with the need to allocate billions of dollars to fund
PBGC's deficit. The previous policy was focused on asset-liability
matching, or what the GAO report refers to as "protecting its deficit
from volatility." Asset-liability matching was ultimately impossible,
however, because the PBGC has approximately $70 billion in liabilities
and approximately $55 billion in assets. "Protecting [our] deficit from
liability" risked locking in the deficit and virtually assuring the
need for an eventual Congressional bailout.
Investment Policy Objective:
PBGC's investment policy is now founded upon the principle, adopted in
the policy itself, that it is PBGC's responsibility to be able to meet
its obligations. Thus, the policy does not focus on short-term,
interest rate-driven snapshots of funded status. Rather, it seeks to
"prudently maximize investment returns in order to meet the
Corporation's current and future obligations." All investment policies
entail risk. This policy's use of risk is prudent, and it achieves
greater efficiency in its risk-return relationship.
Methodology:
The process that supported the adoption of this policy was complete and
robust. It included a thorough assessment of PBGC's long-term
obligations to plan participants and beneficiaries, exhaustive
discussion among numerous constituents, and in-depth analysis by
leading industry experts, including PBGC's investment consultant,
Rocaton Investment Advisors (Rocaton).
Rocaton and PBGC staff closely examined the characteristics of the
Corporation's liabilities, including duration and key risk factors. A
few months into the process, the Board Representatives and the Advisory
Committee agreed upon the investment policy's long-term Objective and
Guiding Principles. Rocaton then used an efficient frontier framework
to evaluate hundreds of possible portfolios. From these hundreds of
portfolios, Rocaton chose a sample set of 14 portfolios and subjected
them to detailed stochastic analysis. This analysis uses Monte Carlo
simulations to expose each portfolio to 5,000 different scenarios over
a 20-year period.
Rocaton's asset/liability model quantified the relative merits and
risks associated with different asset mixes, using the following
metrics: 1) investment returns, 2) volatility of investment returns, 3)
funded position over various periods, and 4) volatility of the funded
position. These metrics were evaluated over short, intermediate, and
long-term time frames. This analysis recognizes that PBGC faces
significant uncertainty. For that reason, it considers a wide range of
possible outcomes for each of these metrics. By considering these
metrics under different scenarios, including: "best-case" (99th
percentile), "expected" (50th percentile), and "worst-case" (1st
percentile), we were able to evaluate the risk/return tradeoffs
associated with different asset mixes and, therefore, determine an
appropriate investment policy.
From the numerous portfolios analyzed, the new investment policy
offered the most appropriate balance of liquidity, downside protection,
and long-term return potential relative to the Corporation's
obligations. Other key Rocaton findings included:
* The prior investment policy's focus on limiting the financial risk
exposure arising from a mismatch of assets against liabilities had a
very high opportunity cost while not adequately protecting PBGC from
downside risk;
* The prior investment strategy was relatively undiversified and had a
low likelihood of meeting PBGC's financial obligations over the long
term;
* PBGC would increase the likelihood of meeting its financial
obligations with a more diversified asset allocation strategy, expected
to deliver higher returns and better downside protection over the long
term; and;
* Shifting some of PBGC's allocation from fixed income to equities
and/or alternative asset classes would significantly improve PBGC's
ability to strengthen its financial position and significantly improve
PBGC's downside protection.
Responding To Risks:
GAO focused on the importance of fully understanding the risks involved
in this policy, and we agree.
Standard deviation of asset returns, which the draft report discusses
in detail, is one of the most commonly used calculations of risk.
According to our calculations, the standard deviation of asset returns
is actually lower in the current policy than in the prior policy. This
is due to the fact that diversification mitigates risk. However, GAO is
correct that different investment consultants and investment managers
make differing assumptions regarding the correlation of asset classes
and the likelihood of future investment returns, and it is clear that
changing those assumptions produces different results. This is
demonstrated by the fact that GAO used assumptions different than
PBGC's assumptions in some of its analyses. Some of GAO's calculations
concluded that the new policy had a higher standard deviation than the
prior policy. More important than this insight, though, is the fact
that none of the calculations offered by GAO results in a standard
deviation higher than 10.85 percent. This is a number well within the
mainstream of large institutional investment portfolios.
That figure would be completely consistent with the policy's objective
stated above, that the Corporation seeks to "prudently maximize
investment returns in order to meet its current and future
obligations." The important question here is not whether JP Morgan or
Rocaton or Ibbotson has the best assumptions. Rather, it is whether, as
a matter of direction and magnitude, including all kinds of risks as
well as return, the direction the Board has chosen - to prudently
maximize the chance the Corporation can pay benefits when due - is the
right direction for the Corporation.
Whether PBGC will have sufficient assets to pay benefits when due can
be addressed by assessing "asset-only" returns and risks, funded status
risk, and liquidity risk, as discussed below:
* "Asset-only" Returns and Risks
Rocaton performed its investment analysis using a Monte Carlo
simulation tool. It used inputs, including capital market assumptions,
to project a wide array of potential outcomes based on specified
distributions and provided expected values and levels of variability
associated with those expected values.
One of the most significant risks PBGC's portfolio and liabilities face
is interest rate risk. In addition to the thousands of outcomes allowed
in Monte Carlo simulation, Rocaton also incorporated into its modeling
a series of liability interest rates or "annuity shock factors" to
address interest rate volatility, especially since PBGC's annuity
interest factor is not a market-based interest rate.
Rocaton's analysis demonstrated that the new investment policy is far
superior to one based on asset-liability matching. In particular, this
policy, as compared to the prior policy, is expected to produce higher
portfolio/"asset-only" returns with lower volatility.
The table below illustrates the substantially higher expected portfolio
returns, on an "asset-only" basis, for the new policy as compared to
the prior policy (7.7 % versus 5.7 %). The table also shows the reduced
"asset-only" risk/standard deviation associated with the benefits of
diversification (8.2 % versus 9.9 %).
Table: Comparative Analysis of "Asset-only" Risks and Returns:
Expected Asset Compound Return:
New Policy: 7.7%;
Prior Policy: 5.7%;
Change: 2.0%,
Expected Asset Risk (standard deviation):
New Policy: 8.2%;
Prior Policy: 9.9%;
Change: (1.7%).
[End of table]
* Liquidity Risk
During this process, the Board requested a detailed analysis of cash
flow risks. Rocaton's liquidity analysis showed that, even for worst-
case scenarios, the new investment policy will readily allow PBGC's
trust fund to meet the projected cash flow needs of the Corporation
over the next 20 years. In fact, as shown in the attachment to this
letter, even in the worst-case scenario for any single year during a
twenty-year period, the maximum amount of PBGC's trust funds needed to
cover benefit payments and administrative expenses is only 13 percent.
This does not even consider PBGC's highly-liquid revolving fund which
is invested solely in U.S. Treasury securities - currently valued at
approximately $15 billion.
* Funded Status Risk
The new investment policy is designed to focus, not on the volatility
of funded status (or changes in the deficit), but on increasing the
likelihood that PBGC will be able to meet its liabilities. An
investment policy with a near-term focus on snapshots of funded status
makes it harder to achieve that goal. Nonetheless, in the longer term,
the most significant risk that PBGC faces is the risk that it will not
be able to meet its liabilities (or that it will require a
Congressional bailout in order to do so). This risk is best
characterized as funded status risk, and we conducted comprehensive
analysis of this risk.
The table below shows the impact of the new investment policy on PBGC's
funded status in 20 years, indicating that the worst case scenario for
funded status is far worse under the prior policy than under the
current policy - a difference with a net present value over $30
billion.
Table: Comparative Analysis of "Funded Status" Returns in the 20th year
(In Millions):
Best-Case (99th percentile):
New Policy: $276,953;
Prior Policy: $70,807;
Change: $206,146.
Expected (50th percentile):
New Policy: $43,549;
Prior Policy: ($9,809);
Change: $53,358.
Worst-Case (1st percentile):
New Policy: ($95,875);
Prior Policy: ($126,907);
Change: $31,032.
[End of table]
The standard deviation of funded status is also relevant. Under a
policy of asset-liability matching one would expect that the standard
deviation of the funded status - the degree to which the assets and
liabilities move together or apart - would be lower than in a policy
like this one, which is not based on asset-liability matching. That is
the case here. The standard deviation of funded status was 7.7 percent
in the prior policy and is 10.9 percent in the new policy.
However, this does not conclude the analysis. The range of possible
outcomes is broader under the new policy than the old, and this is why
the standard deviation number is higher. Standard deviation is a
limited tool, though, because it only measures the range of highest to
lowest outcomes. It does not distinguish between higher upside and
lower downside.
As indicated in the chart above, the prior policy had a much more
significant downside risk. This can also be shown by the bar chart
below which shows the range of outcomes for funded status (the standard
deviation). The bar for the prior policy has a narrower range, but a
lower minimum point.
Figure: A Comparison of the Range of Outcomes for Funded Status in the
20th Year:
[See PDF for image]
This figure depicts a stacked vertical bar indicating billions of
dollars for each of the following percentiles:
1st percentile;
25th percentile;
50th percentile;
75th percentile;
99th percentile.
Also depicted in a table indicating:
Funded Position - 20 years (in millions):
Percentile: 99th (best);
New Policy: $276,953;
Prior Policy: $70,807.
Percentile: 75th;
New Policy: $92,687;
Prior Policy: $10,475.
Percentile: 50th (Expected);
New Policy: $43,549;
Prior Policy: ($9,809).
Percentile: 25th;
New Policy: $2,138;
Prior Policy: ($32,805).
Percentile: 1st (Worst);
New Policy: ($95,875);
Prior Policy: ($126,907).
[End of figure]
Sensitivity Analyses:
PBGC agrees with GAO that many different advisers can have many
different assumptions and that varying assumptions can sometimes vary
outcomes.[Footnote 45] To that point, we asked Goldman Sachs to perform
a supplemental comparative analysis. Goldman Sachs indicated that their
sensitivity analysis used varied investment assumptions (e.g., return,
risk, and correlations) from alternative sources to assess the likely
performance of both the prior and the new investment policy in terms of
projected investment return and risk outcomes.[Footnote 464]
The following table and graph present Goldman Sachs's analysis and
illustrate the impact of using different sets of capital market
assumptions. The important point this chart shows is that even with
five varied sets of assumptions, the returns, the Sharpe ratios, and
the ultimate asset growth are all dramatically superior in the new
investment policy under each scenario.
Table: Goldman Sachs's Sensitivity Analysis:
Firm: Rocaton;
Expected Return, prior: 5.66%;
Expected Return, new: 7.66%;
Asset Volatility, prior: 9.78%;
Asset Volatility, new: 8.26%;
Sharpe Ratio, prior: 0.18;
Sharpe Ratio, new:0.46;
Incremental Asset Increases, prior: $61 billion;
Incremental Asset Increases, new: $83 billion.
Firm: Wilshire;
Expected Return, prior: 6.02%;
Expected Return, new: 7.64%;
Asset Volatility, prior: 12.44%;
Asset Volatility, new: 10.59%;
Sharpe Ratio, prior: 0.16;
Sharpe Ratio, new: 0.34;
Incremental Asset Increases, prior: $65 billion;
Incremental Asset Increases, new:$83 billion.
Firm: JP Morgan;
Expected Return, prior: 6.00%;
Expected Return, new: 7.64%;
Asset Volatility, prior: 6.80%;
Asset Volatility, new: 7.98%;
Sharpe Ratio, prior: 0.29;
Sharpe Ratio, new:0.46;
Incremental Asset Increases, prior: $65 billion;
Incremental Asset Increases, new: $83 billion.
Firm: Goldman Sachs;
Expected Return, prior: 5.70%;
Expected Return, new: 7.20%;
Asset Volatility, prior: 9.37%;
Asset Volatility, new: 8.16%;
Sharpe Ratio, prior: 0.18;
Sharpe Ratio, new: 0.39;
Incremental Asset Increases, prior: $62 billion;
Incremental Asset Increases, new: $78 billion.
Firm: Money Manager(D);
Expected Return, prior: 5.95%;
Expected Return, new: 8.12%;
Asset Volatility, prior: 8.59%;
Asset Volatility, new: 9.12%;
Sharpe Ratio, prior: 0.23;
Sharpe Ratio, new: 0.45;
Incremental Asset Increases, prior: $64 billion;
Incremental Asset Increases, new: $88 billion.
Note: The last column represents estimates of incremental asset
increases at the end of a 20-year period under the new and prior
investment policies, based on the following two assumptions: 1) simple
returns are used in lieu of compound returns, and 2) PBGC's annual
cash inflows approximately offset the annual cash outflows.
Figure: Comparison of Investment Results Using Alternative Sources:
{See PDF for image]
This figure is a plotted point graph depicting a comparison of
investment results using alternative sources.
[End of figure]
One final point about risk and return is relevant here. Both GAO and
the Congressional Budget Office (CBO) have recognized that the new
investment policy is likely to result in higher returns (draft report,
pp. 5, 23; CBO letter, April 24, 2008). In addition, both express
concern that this policy may invest in assets that are riskier than the
assets in which PBGC previously invested. However, the concern that any
observer should have is not for the risk of a particular asset class,
but the risk of the entire portfolio. The substantial diversification
and risk mitigation of the new policy can best be demonstrated by an
investment measurement tool that was not focused on in the draft
report - the Sharpe ratio.
The Sharpe ratio, like all investment measurement tools, has its
limitations, but it is the most commonly utilized measurement of the
risk/return efficiency of a portfolio, demonstrating excess return per
unit of risk. A higher Sharpe ratio indicates a more efficient use of
risk. It is important to note that in every analysis of every
portfolio, reviewed here or anywhere in the GAO draft report, whether
utilizing assumptions provided by Rocaton, JP Morgan, Goldman Sachs or
other sources, the Sharpe ratio is higher for the new policy than for
the prior policy.
Conclusion:
PBGC pursued a robust process, considering and measuring numerous risks
faced by this or any investment policy. Hundreds of portfolios were
tested; this policy and many others were each subject to testing
against the variation in 5,000 economic scenarios. The policy selected
takes better advantage of PBGC's long-term investment horizon and
utilizes the benefits of diversification to mitigate risk. Our
calculations indicate that the "asset-only" return standard deviation
and the worst-case funded status risk are both superior in the new
policy. All calculations have indicated that the Sharpe ratio of the
new policy is superior to that of the prior policy.
The sensitivity analysis that was done for PBGC, based on varying
assumptions, also indicates a standard deviation that meets the
objective of the new policy to "prudently maximize investment returns
in order to meet the Corporation's current and future obligations."
Finally, PBGC agrees with GAO that sensitivity analyses are important,
and we will continue to perform them going forward.
With nearly 44 million workers and retirees relying on PBGC's insurance
programs, the new investment policy is of critical importance. Again,
we appreciate your work and that of staff on this important topic, and
we look forward to working with GAO as we progress.
Sincerely,
Signed by: Charles E.F. Millard:
Attachment:
[End of section]
Appendix V: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Barbara Bovbjerg (202) 512-7215 or bovbjergb@gao.gov:
Thomas J. McCool (202) 512-2642 or mccoolt@gao.gov:
Acknowledgments:
Blake Ainsworth, Assistant Director, and Sara L. Schibanoff, Analyst-
in-Charge, managed this assignment. Other staff who made key
contributions throughout the assignment are Joseph Applebaum; Susan
Bernstein; Lawrance Evans, Jr.; Kimberley M. Granger; Kenrick Isaac;
Gene Kuehneman; Jonathan S. McMurray; Marc Molino; Jose Oyola; Jeremy
Schwartz; and Craig Winslow.
[End of section]
Related GAO Products:
Pension Benefit Guaranty Corporation: Governance Structure Needs
Improvements to Ensure Policy Direction and Oversight. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-07-808]. Washington, D.C.: July
6, 2007.
High-Risk Series: An Update. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-07-310]. Washington, D.C.: January 2007.
Private Pensions: The Pension Benefit Guaranty Corporation and Long-
Term Budgetary Challenges. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-05-772T]. Washington. D.C.: June 9, 2005.
Highlights of a GAO Forum: The Future of the Defined Benefit System and
the Pension Benefit Guaranty Corporation. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-578SP]. Washington, D.C.: June
2005.
Private Pensions: Questions Concerning the Pension Benefit Guaranty
Corporation's Practices Regarding Single-Employer Probable Claims.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-991R]. Washington,
D.C.: Sept. 9, 2005.
Private Pensions: Recent Experiences of Large Defined Benefit Plans
Illustrate Weaknesses in Funding Rules. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-294]. Washington, D.C.: May
31, 2005.
Pension Benefit Guaranty Corporation: Structural Problems Limit
Agency's Ability to Protect Itself from Risk. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-360T]. Washington, D.C.: Mar.
2, 2005.
Pension Benefit Guaranty Corporation: Single-Employer Pension Insurance
Program Faces Significant Long-Term Risks. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-04-90]. Washington, D.C.: Oct.
29, 2003.
Pension Benefit Guaranty Corporation: Long-Term Financing Risks to
Single-Employer Insurance Program Highlight Need for Comprehensive
Reform. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-150T].
Washington, D.C.: Oct. 14, 2003.
Pension Benefit Guaranty Corporation: Single-Employer Pension Insurance
Program Faces Significant Long-Term Risks. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-03-873T]. Washington, D.C.: Sept.
4, 2003.
Pension Benefit Guaranty Corporation Single-Employer Insurance Program:
Long-Term Vulnerabilities Warrant 'High Risk' Designation. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-03-1050SP]. Washington, D.C.:
July 23, 2003.
Pension Benefit Guaranty Corporation: Appearance of Improper Influence
in Certain Contract Awards. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO/T-OSI-00-17]. Washington, D.C.: Sept. 21, 2000.
Pension Benefit Guaranty Corporation: Contracting Management Needs
Improvement. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/HEHS-00-
130]. Washington, D.C.: Sept. 18, 2000.
Improving Financial Condition of the Pension Benefit Guaranty
Corporation and Insured Pension Plans. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO/HEHS-99-37R]. Washington, D.C.:
Dec. 18, 1998.
Pension Benefit Guaranty Corporation: Financial Condition Improving,
but Long-Term Risks Remain. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO/HEHS-99-5]. Washington, D.C.: Oct. 16, 1998.
High-Risk Series: An Overview. [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO/HR-95-1]. Washington, D.C.: February 1995.
High-Risk Series: Pension Benefit Guaranty Corporation. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO/HR-93-5]. Washington, D.C.:
December 1992.
[End of section]
Footnotes:
[1] PBGC administers two insurance programs: the single-employer and
multiemployer insurance programs. A single-employer plan is established
and maintained by one employer. Single-employer plans can be
established unilaterally by the sponsor or through a collective
bargaining agreement with a labor union. 29 U.S.C. § 1002(41). A
multiemployer plan is a collectively bargained arrangement between a
labor union and a group of employers in a particular trade or industry.
Management and labor representatives must jointly govern multiemployer
plans. 29 U.S.C. § 1002(37).
[2] GAO, High-Risk Series: An Update, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-07-310] (Washington, D.C.:
January 2007).
[3] Currently, the board representatives for each agency are the Under
Secretary for Economic Affairs at the Department of Commerce, the
Assistant Secretary of Labor for the Employee Benefits Security
Administration, and the Under Secretary of the Treasury for Domestic
Finance.
[4] For most of the plans insured by PBGC, the flat-rate monthly annual
premium for 2008 is $33.00 per plan participant and the maximum
guaranteed monthly benefit is $4,312.50 for beneficiaries first
receiving benefits as a single-life annuity from PBGC at age 65 from
plans that terminated in 2008. Some underfunded single-employer plans
pay an additional annual variable-rate charge of $9 per $1,000 of
unfunded vested benefits. In 2007, PBGC took in close to $1.6 billion
in premiums and paid about $4.3 billion in benefits.
[5] 29 U.S.C. § 1305. By law, the PBGC is required to invest certain
revolving funds in obligations issued or guaranteed by the United
States of America. Portions of the other revolving funds can be
invested in other debt obligations. PBGC's current policy is to invest
all revolving funds only in U.S. Treasury securities.
[6] GAO, High-Risk Series: An Update, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-07-310] (Washington, D.C.:
January 2007). In 1992, we placed PBGC on our list of federal programs
at high risk because a large and growing imbalance between its assets
and liabilities threatened PBGC's long-term financial viability. GAO,
High-Risk Series: Pension Benefit Guaranty Corporation. [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO/HR-93-5] (Washington, D.C.:
December 1992). To address PBGC's financial problems, Congress passed
the Retirement Protection Act in 1994, Pub. L. No. 103-465, 108
Stat.4809, which strengthened minimum funding requirements for plans
and increased premiums paid to PBGC by underfunded plans. In addition,
PBGC improved administration of its insurance programs. Consequently,
we removed PBGC from our high-risk list in 1995. GAO, High-Risk Series:
An Overview. [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/HR-95-1]
(Washington, D.C.: February 1995). GAO again added PBGC's single
employer insurance program to its high-risk series in July 2003. GAO,
Pension Benefit Guaranty Corporation Single-Employer Insurance Program:
Long-Term Vulnerabilities Warrant "High-Risk" Designation, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-03-1050SP] (Washington, D.C.:
July 23, 2003).
[7] GAO, Pension Benefit Guaranty Corporation: Structural Problems
Limit Agency's Ability to Protect Itself from Risk, [hyperlink,
http://www.gao.gov/cgi-bin/getrpt?GAO-05-360T] (Washington, D.C. : Mar.
2, 2005).
[8] Pub. L. No. 109-280, 170 Stat. 780.
[9] Duration measures the sensitivity of the value of a fixed-income
asset or liability to a change in interest rates. While rising interest
rates result in falling bond prices, declining interest rates result in
rising bond prices. As a result, for example, a bond with a duration of
5 would experience a 5 percent decline (increase) in its price if
interest rates rose (fell) by 1 percent.
[10] PBCG's policy also roughly matches that of one independent federal
agency--the Railroad Retirement Board--which administers retirement,
survivor, and disability benefits for railroad workers and their
families. The Railroad Retirement and Survivors' Improvement Act of
2001 established the National Railroad Retirement Investment Trust to
manage a portion of the Railroad Retirement Board's assets. Pub.L.No.
107-90, 105(a), 115 Stat. 878, 882-83. In fiscal year 2006, the target
allocation established by the Trust included investments in equities
(55 percent), fixed-income (35 percent), and alternative assets (10
percent). Prior to the passage of the law, the Railroad Retirement
Board's assets were invested solely in U.S. government securities.
[11] GAO, Pension Benefit Guaranty Corporation: Governance Structure
Needs Improvements to Ensure Policy Direction and Oversight,
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-808] (Washington,
D.C.: July 2007).
[12] PBGC officials told us that they have begun to draft an
implementation plan for the 2008 policy.
[13] According to PBGC officials, PBGC follows the federal procurement
process, which requires agencies to conduct a nationwide search,
publicize a request for proposals, hold a pre-bidders conference to
explain various technical issues and to answer questions, set up a
technical evaluation panel, receive bids, score applications to
determine which applicants meet the minimum mandatory requirements, and
perform due diligence before selecting the finalists.
[14] The policy indicated that newly trusteed assets from terminated
plans were to be transitioned to fixed-income investments. Assets held
at the time of the policy change were not used to begin implementation
of this strategy.
[15] The staff report accompanying the director's memo to the board
noted that there were sufficient additional assets in probable
terminations to complete the transition in 2006.
[16] PBGC had acquired assets under these new classes from terminated
plans, but it followed a policy to liquidate the assets as soon as
prudently possible and reinvest in assets approved under policy. At the
time it approved the new policy, PBGC held less than 1 percent of its
total assets in emerging market equities (0.6%), high-yield fixed
income (0.5%), and emerging market debt (0.9%), and approximately 1.7
percent in private equity.
[17] Diversification is the practice of spreading investments among
different asset classes or within an asset class to reduce risk and
increase return. Diversification across asset classes can help mitigate
the risk of isolating investments in one class without affecting
expected returns.
[18] PBGC's outside consultant utilized the Monte Carlo simulation to
conduct an analysis which produces useful insights beyond a
deterministic model. However, this technique has its limitations and
depends critically on the inputs--asset class returns, standard
deviations, and correlations between the performance of asset classes-
-entered into the model. Because reasonable experts can disagree on
estimates for these inputs, some sensitivity testing is warranted. For
more on the limitations of Monte Carlo simulation, see R. Ibbotson and
R. Sinquefield, Stocks, Bonds, Bills, and Inflation Yearbook, Ibbotson,
2008.
[19] While the circular specifically refers to cost-benefit analysis,
it provides a guide to the treatment of uncertainty in any model or
analysis with implications for important programs or policies.
According to the guidance, major assumptions should be varied and the
outcomes recomputed to determine how sensitive outcomes are to changes
in the assumptions. The assumptions that deserve the most attention
will depend on the dominant elements and the areas of greatest
uncertainty of the program being analyzed. See Office of Management and
Budget Circular A-94, Guidelines and Discount Rates for Benefit-Cost
Analysis of Federal Programs.
[20] Ibbotson data serve as a reference for capital market returns and
are recognized as the industry standard for illustrating historical
performance of different asset classes. JPMorgan, as a large asset and
wealth manager, provides an alternative set of assumptions on the range
of asset classes included in the PBGC's new allocation. According to
JPMorgan Asset Management, the institution has assets under supervision
of $1.6 trillion and assets under management of $1.2 trillion and more
than 650 investment professionals providing over 200 different
strategies spanning the full spectrum of asset classes, including
equity, fixed income, cash liquidity, currency, real estate, hedge
funds and private equity.
[21] The consultant assisted us in our efforts to review the results
and conduct sensitivity tests but could not provide the exact data
provided to PBGC. With some minor adjustments, we were able to
replicate the return and standard deviations on several of the
portfolios summarized in the presentation. In addition, because we
encountered issues reconciling data from PBGC's Pension Insurance
Modeling System with the data provided by the outside consultant, we
did not conduct sensitivity tests on PBGC's liabilities or funded
position. Because similar limitations would be present in a more
complete analysis that incorporates PBGC's liabilities and funded
position, additional sensitivity analysis would provide a more complete
picture of the risks PBGC faces under the new policy. The data
limitations are discussed in greater detail in appendix II.
[22] As with any predictive modeling and sensitivity analysis, our
input assumptions and quantitative approach has limitations. As a
result, our sensitivity analysis should not be considered definitive
estimates. Moreover, we did not address the data limitations associated
with some alternative assets (see app. II for more details).
[23] PBGC's consultant's assumptions are based on a 15-year duration
bond, Ibbotson's estimate is based on a 20-year maturity, and JP Morgan
is based on bonds with a maturity greater than 10-years. Generally,
bonds with longer maturities carry more risk than those with shorter
maturities. Collectively, these results demonstrate how the risk of the
portfolios varies with the assumption on fixed-income securities.
[24] In the first five cases in figure 6 the expected returns are 5.7
percent for the previous allocation and 7.6 percent for new allocation,
while in the case 6, the returns are 6.13 for the previous allocation
and 7.16 percent for the new allocation.
[25] Officials explained that PBGC accesses cash in different ways,
including liquidating incoming assets from terminated plans before
transferring them into PBGC's investment portfolio or liquidating
currently held assets. PBGC holds a certain amount of cash on hand.
According to the fiscal year 2007 management report, PBGC held $2
billion in cash at the beginning of the year and $2.2 billion at year's
end.
[26] We did not review the methodology used in making this
determination.
[27] PBGC reported that, as of September 30, 2007, it held $55.1
billion in total investments.
[28] See Alexander Ljungqvist and Matthew Richardson, The Cash Flow,
Return, and Risk Characteristics of Private Equity, National Bureau of
Economic Research, January 2003. S. Kaplan and A. Schoar, Private
Equity Performance: Returns, Persistence, and Capital Flows, Journal of
Finance, 60(4), 2005 suggest that the commitment to return capital is
usually on the order of 10 to 12 years in total.
[29] See CBO, "A Review of the Pension Benefit Guaranty Corporation's
Investment Strategy," letter to Chairman George Miller, Apr. 24, 2008.
[30] The Sharpe ratio is a measure of the excess return (reward) per
unit of risk and is represented as the ratio of the expected rate of
return minus the risk-free rate divided by the standard deviation.
[31] According to PBGC's 2007 annual report, the average maturity on
the fixed income assets in its portfolio was 16.7 years and the average
duration was 13.4 years. We used Ibbotson's historical data on bonds
with a 20-year maturity and JP Morgan's assumption on long bonds with
an average maturity greater than 10 years and duration of 11.2 years.
Our assumptions ranged roughly from 0.8 percent lower to 0.5 percent
higher than the volatility on the PBGC's actual fixed income portfolio
for the 1998 to 2007 period (8.4 percent). In contrast, the PBGC's
outside consultant assumptions results in an estimate that was over 3
percent higher. (We assume a 60-40 split between long Treasury bonds
and long corporate bonds and ignore the minor adjustments for the
correlation between long government and long corporate bonds for the
Rocaton and Ibbostson estimates.)
[32] Office of Management and Budget Circular A-94, Guidelines and
Discount Rates for Benefit-Cost Analysis of Federal Programs.
[33] GAO has used the Monte Carlo simulation in past reports, and it
has also been used by the CBO in Social Security projections.
[34] See R. Ibbotson and R. Sinquefield, Stocks, Bonds, Bills, and
Inflation Yearbook, Ibbotson, 2008. In addition, federal agencies are
advised to conduct sensitivity analysis on forecasts. See Office of
Management and Budget Circular A-94, Guidelines and Discount Rates for
Benefit-Cost Analysis of Federal Programs.
[35] We relied on the output from the consultant's forecasting model
although we did not verify the accuracy of the model. We were able to
independently reproduce the consultant's results to obtain estimates
roughly equivalent to those the consultant presented to the PBGC. We
found small differences between our results and the consultant's during
verification, but made small adjustments to the expected returns and
standard deviation of each asset to establish a base case upon which to
conduct our sensitivity analyses. The adjustments were made to better
align our results with the consultant's and to minimize the sum of
squared adjustments. As a result, these adjustments are spread over
different asset classes and are as small as possible for each asset
class. We confirmed our methodology with the consultant and discussed
reasons for the differences in estimates.
[36] Absolute return assets are typically derivatives used to implement
hedging strategies. The strategy seeks return through active asset
allocation (at the asset class and country level) by using long and
short positions, independent of a client's underlying asset allocation,
investments, or benchmark restrictions. Neither commodities nor
absolute return assets are a part of the new or old PBGC allocation.
[37] The correlation matrix had negative eigenvalues. Matrices with
these properties are referred to as negative semi-definite and will
impair portfolio optimization routines. Changing the assumptions of a
correlation matrix can lead to a logically inconsistent matrix but this
outcome is common even when actual historical correlations are used. In
such cases the matrix must be corrected by the nearest valid
correlation matrix that is positive semi-definite.
[38] We utilized Principal Components Analysis to correct the matrix.
From the original correlation matrix, we determined the eigenvalues and
matrix of eigenvectors (W) and then executed the following steps: (1)
use the eigenvalues as the main diagonal of a matrix A with the off
diagonals equal to zero, (2) set the negative elements of A equal to
zero, (3) determine the new correlation matrix as (W)(A)(W-1), (4) and
impose two conditions on the correlation matrix: the main diagonal
should be equal to one and assets with a zero correlation should
continue to be equal to zero (no information as to whether the
correlation should be positive or negative), and (5) calculate the
eigenvalues of the new matrix and determine if they are all positive.
If not, increase the elements in the main diagonal of matrix A that
were originally set to zero by a small amount and return to step 5. We
concluded when the correlation matrix was positive semi-definite. The
resulting correlation matrix was similar to the original matrix and the
differences in the results were trivial.
[39] While it is mathematically possible to have higher standard
deviations with no downside risk, the larger the variance in the return
for a given asset, the more likely it will produce negative returns.
[40] PBGC's consultant could not provide us with the projected asset
returns used to account for PBGC's liabilities. We attempted to gather
information from PBGC's Pension Insurance Modeling System (PIMS), which
is used to generate projections that forecast PBGC's funded status, but
the asset returns provided by the consultant were not comparable, and
we did not continue to pursue these lines of inquiry further given time
and resource constraints.
[41] Venture capital funds have opposed disclosing their internal rates
of return and some have restricted the participation of limited
partners that may disclose their investment strategy.
[42] While research showed that private equity as a class did not
outperform public equivalent instruments or did not do so
significantly, recent research suggests that private equity funds
actually under-perform the S&P 500, net of fees. For example, see S.
Kaplan and A. Schoar, "Private Equity Performance: Returns,
Persistence, and Capital Flows," Journal of Finance, 90(4), 2005, or
for an overview see L. Phalippou, "Investing in Private Equity Funds: A
Survey," The Research Foundation on the CFA Institute, 2007.
[43] A recent Center for International Securities and Derivatives
Markets' research paper noted that private equity investment can only
provide limited diversification benefits as both the Private Equity and
Venture Capital Indexes move together with the S&P 500. They generate
the highest returns when U.S. markets performed well and exhibited the
lowest returns when the S&P 500 experienced its worst returns over the
1990 to 2005 period.
[44] See W. Coaker, "The Volatility of Correlation: Important
Implications for Asset Allocation Decision," Journal of Financial
Planning, February 2006.
[45] Varying assumptions can affect the results of any sensitivity
analysis. However, those changed return and correlation assumptions
must be applied consistently to the same underlying assets as the
assets found in the portfolio that is being evaluated. JP Morgan's 10-
year duration fixed income assumptions were used to evaluate PBGC's
prior policy. It would be more accurate to have used JP Morgan's 15-
year duration fixed income assumptions, because PBGC's prior policy
actually had a 15-year duration fixed income portfolio. An analysis
that uses 10-year duration understates the total risk of the portfolio
under the prior investment policy. In addition, Ibbotson's fixed income
assumptions were also based on a shorter duration index (approximately
12 years as compared to 15 years).
[46] Goldman Sachs's sensitivity analysis incorporated assumptions
provided by JP Morgan that are consistent with the actual duration of
the PBGC portfolio under the prior policy.
[End of section]
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